Intelligent Option Investing in Three Easy Steps

This is the capstone video of my introduction to intelligent option investing series. It ties together topics from the three earlier videos to explain the essence of intelligent option investing in three easy steps.

Better Options for Ackman's Investment in Target

Source: Hedgeye.com

There are two main reasons why this investment did not work out for Ackman and his investors: overleverage and bad timing. This article--a follow-up to a previous posting--discusses these root cause elements and suggests a way that Ackman could have used options to better effect in his investment in Target.

Overleverage

The research I did to write the YCharts Focus Report onTarget convinced me that the retailer does indeed have some deep problems related to its culture and management style. Ackman, as an activist investor, invests in companies that have value-destructive faults, so it is no wonder that he was drawn to Target.

The position of an activist investor is sort of like that of a house flipper, except in the latter case, the house is not actively attempting to thwart the owner’s attempts at rehabbing it!

What is Intelligent Option Investing?

Intelligent Option Investing consists of:

1. Rationally assessing the value of a stock.
2. Seeing clearly what the option market is forecasting for the stock's price.
3. Using a sensible combination of stocks, options, and cash to tilt the risk / reward odds in your favor when a stock's value deviates from its price as forecast  by the option market.

Institutional Option Investing Case Study: Bill Ackman’s Calls on Target

Executive Summary

• Even though Ackman’s investment in Target was unsuccessful, the option portion of the trade is well-documented, and an analysis of the structure of this investment is instructive.
• This article analyzes Ackman’s use of the “listed look-alike” option market and how institutional option transactions are structured and traded.
• We find Ackman’s use of In-the-Money (ITM) options to be an intelligent, measured approach and discuss why, in general ITM options should be a go-to strategy for stock investors.
• We find that a combination of overleverage and poor timing lay at the root of Ackman’s losses in Target, and discuss what might have been done better.

Ackman’s Options

While researching the most recent YCharts Focus Report onTarget, I started to get interested in Pershing Square founder Bill Ackman’s ill-fated investment in the company—especially in the substantial option let of it. Derided as “speculative” by Target’s management and taken as an example in the media of how “dangerous” options can be, I was expecting something entirely different from what I found.

While Ackman’s investment in Target investment was not successful, the example holds some valuable lessons for intelligent option investors, especially those of you looking at using options in an institutional context. Unlike Ackman’s Herbalife put options, for which we had little hard data,[1] information regarding his call options on Target are well documented in an SEC form 13-D.[2]

Institutional Option Case Study: Ackman's Investment in Herbalife

My ears perked up listening to Bill Ackman's Herbalife presentation as he talked about his use of options as an investment vehicle in his bearish investment in the company. In October 2013, Ackman informed the limited partners of his hedge fund, Pershing Square, that he had closed about 40% of his fund's short position in Herbalife (which had been suffering mark-to-market losses) and replaced it with long-dated, over-the-counter, out-of-the-money (OTM) put options.

Then, in January of this year, listed OTM put options in Herbalife saw an enormous spike in volume and pundits surmised that either Ackman was doubling down on his bearish bet, the counterparty broker was trying to "hedge out" its exposure to Ackman's investment, or that there was another investor piling in on Ackman's side.

Because this is a bearish position, there is no obligation for Pershing Square to file a form 13-D (required for investors holding more than 5% equity in a public company) or a 13-F (a quarterly listing of all stocks held by investment advisors). As such, we cannot look at detail at Ackman's put positions*, but there are some interesting insights to be gleaned from the various announcements.

Decoding the press announcements gives a good view to how a well-informed institutional investor uses options in an investing program. Let's look at three things in particular--the market in which Ackman is transacting, his strike selection, and the large listed transaction.

Praise for the Intelligent Option Investor

My old boss, the founder and CEO of Morningstar, JoeMansueto, was kind enough to take the time to read through an early version of my manuscript and has this to say:

The Intelligent Option Investor reflects Erik’s keen understanding of how companies create value for their owners, which is essential to successful option investing. In addition to showcasing Erik’s expertise in developing option investment strategies based on fundamental security analysis and a long-term time horizon, this book delivers the information in a way that’s accessible to individual investors, offering them the resources to use options to help them meet their financial goals.

Thanks for the support, Joe!

Understanding Options

Like I explained in my post The Essence of Intelligent Option Investing, the The Intelligent Option Investor is split into three parts. Here's the introduction to Part I, which covers everything an intelligent investor needs to know about options and option pricing.

The Essence of Intelligent Option Investing

What does it mean to be an Intelligent Option Investor? 

The following excerpt from my book (on schedule to ship in August!) explains its essence. I also outline why, even if you never make an option transaction in your life, understanding what the option market is saying will give you an advantage as an equity investor.

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Introduction

You have a tremendous advantage over algorithmic trading models, investment bank trading desks, hedge funds, and anyone who appears on or pays attention to cable business news shows. This book is written to show where that advantage lies and how to exploit it to make confident and successful investment choices. In doing so, it explains how options work and what they can tell you about the market’s estimation of the value of stocks.

Even if, after reading it, you decide to stick with straight stock investing and never make an option transaction, understanding how options work will give you a tremendous advantage as an investor. The reason for this is simple: by understanding options, you can understand what the rest of the market is expecting the future price of a stock to be. Understanding what future stock prices are implied by the market is like playing cards with an opponent who always leaves his or her hand face up on the table. You can look at the cards you are dealt, compare them with your opponent’s, and play the round only when you are sure that you have the winning hand.