Event-driven investments, inflection points ..and how I made 32x my money in two weeks
My favourite part of the book ‘The Big Short’ is the narration Lewis gives of Jamie Mai and Charlie Ledley’s investment strategy at Cornwall Capital Management. Over a period of four years from 2002 to 2006, the hedge fund famously grew from two friends operating out of a Berkeley garage with $110,000 “in a Schwab account” to managing over $120 million after the subprime crisis. How did they do it?
At the tender age of 30 neither Jamie or Charlie had much experience with managing money, or even making actual investment decisions on their own. From their brief stints working in private equity, the only tangible experience they had come away with were two views of the world which would eventually end up guiding their investment decisions:
- Public markets are less efficient, due diligent and prudent than private markets; and
- Investors in public markets as a consequence typically end up with much narrower interests and focus, often missing the bigger, overall picture of what is going on.
In other words, in their view, mechanisms in the public market were most always likely to be more flawed and prone to erroneous assumptions and/or calculations than mechanisms in private markets.
Taking their view of the world to the market, Cornwall Capital first hit it big when they came across a subprime credit card company named Capital One whose stock had dropped 60% in two days from speculations about how much collateral the company should be holding and accusations of fraud among the company’s directors.
And although the company’s financial performance seemed stellar and nothing had yet materialized from the SEC’s investigation — the stock didn’t seem to want to move. To understand why, Jamie and Charlie did their own due diligence of the firm and eventually decided that: 1. Either the company was run by crooks and was worthless; or 2. The company had strong fundamentals and its stock was vastly undervalued by the market. Regardless of which was true, they knew that the stock shouldn’t be trading at the level that it was at the time.
This wonderfully binary situation meant that there was going to be a big fork in the road for Capital One’s stock in the short to medium term, as their regulator would reach its verdict about what was going on internally. When this occurred, the stock would undoubtedly experience an inflection point, moving rapidly and markedly either up or down.
In the options market, where one ventures into contracts about rights to buy or sell an underlying asset at a predetermined price on or before a given date, prices are initially determined based on mathematical models. Underpinning such models, are a set of assumptions about things like volatility, the efficiency of the market, dividends, interest rates, distribution of returns and liquidity.
In situations where the future price of a stock is strongly correlated to something akin to a binary (either/or) set of events which is likely to cause an inflection point, it turns out that the assumptions underpinning such models tend to break down. In other words, although a stock’s rise or fall over the course of a future period of time certainly isn’t consistent with constant volatility or gaussian distribution of returns, its options (especially longer term options) may still be priced as if though they were.
For Jamie and Charlie, who eventually decided for themselves that Capital One was not run by crooks, that meant that if their assumptions were true, their $26,000 in long term call positions (LEAPS) had been bought at an extraordinary discount. Sure enough, as the company was vindicated by the SEC its share price inflected up to pre-crisis levels and Cornwall Capital’s option position appreciated in value to $526,000.
What attracts me to Jamie Mai and Charlie Ledley’s investment thesis is the extraordinary asymmetry that existed between the potential upside of gains relative to the level of downside risk. Stemming from its event-driven nature, the strategy makes use of the disconnect that can exist between prices set by mathematical models and the valuation made by a rational investor. Being outside of the 95th percentile of most VaR (value at risk) models, the likelihood of such events occurring are simply viewed as so unlikely that they are discounted in the pricing that the model makes (read: The Financial Crisis of 2007–08).
And so, rather than buy the Capital One stock and hope it would appreciate back up to $60 (approximately 75% returns), wrongly priced option contracts instead earned Jamie and Charlie a 2000% return on their investment.
My first options trade, ever
Never really having bought or sold any financial instruments besides stocks, in early 2016 I was completely new to the mechanics and practicalities of options trading. However, as losses were mounting I had been tracking the prices of a few oil service companies who were taking big hits as the price of oil was declining. One such company, Seadrill ($SDRL), was being particularly hammered by short sellers, dropping from NOK31 to NOK15 in under a month.
With overall depreciation of 95% over the previous three years, a bleak outlook for the industry, debts maturing and nothing on the horizon that seemed likely to encourage investment, the stock’s options prices showed a similarly negative outlook. On the 22nd of February, with the price of the underlying asset at NOK15.4, an American call option expiring on 06/16 with strike price NOK30 could be bought for the mere sum of NOK0.55 per contract, 350 basis points. And so I did.
My thinking was very simple. Looking at how the stock had depreciated over the past two years and how it reacted to daily fluctuations in the price of oil I decided for myself that the market viewed the two as strongly correlated. Calculating this correlation ratio at various points in the period, I could see what I thought to be (at least) a superficial relationship between the two prices, which I determined to be that: if the price of oil went from its current level of $37 per barrel, to say, $45, the Seadrill stock would move to $27. Needing to cover their bets, many short sellers would at this point likely be squeezed, which could cause the price to soar higher.
What I essentially bought for NOK0.55 per contract, was a lottery ticket on the price of oil. Except instead of there being one drawing of numbers, every day from the 22nd of February to expiration on the 16th of June, the price could potentially be going up. And instead of betting on random numbers, I was betting on geopolitics, macro economical uncertainty and a company whose stock had been hammered so hard that even the slight hint of some good news was fuelling weekly spikes in its share price of several percent.
A few days later, as the price of oil rose to $40, the price of the options had more than doubled. The following week, as the company’s largest shareholder John Fredriksen liquidated large parts of his position in another company, rumours began trickling around that this was an indication that Seadrill could be recapitalized, potentially abolishing doubts about its ability to service its maturing debts. The next night I woke up to pandemonium as the stock had soared 108% on the NYSE.
Mapping it (NYSE: SDRL) to the stock listed on the OSE, I could tell that what I had hoped would happen, just had. Ignited by the (rather speculative) rumour and propelled by short sellers covering their bets, the stock was hitting a major inflection point. History made me right, the options I had bought had been priced wrong. All bets were off.
The stock opened 60% up at the OSE and the price of my options had moved from about NOK5 the day before, to NOK20. What had originally been contracts to be allowed to buy the Seadrill stock at some point in the future were now contracts valued 25% higher than the stock itself had been at the time that I bought them. I closed half my position at NOK18.5 in the morning with 3264% return and the rest in the afternoon slightly higher.
As in Jamie and Charlie’s case, my returns ended up being over ten times higher betting on the option than they would have been betting on the stock.
Why it worked
As this was my first options trade ever and I have restrained myself from entering into any new positions since, I am choosing to be humble about how much of what occurred was lucky and not. What I do know about what happened is that:
- The stock was not adhering to the assumptions of its options’ pricing model, i.e. its options had not been priced correctly in the first place. It was neither experiencing constant volatility, nor could its future returns be expected to be normally distributed.
- The stock had been hitting its lower support levels for weeks with no sign of breach. Neither the options, nor the underlying asset was likely to move lower (barring any news or other major events in the market).
- The stock was deep into a loss cycle and highly sensitive to positive news of any kind.
- The stock was being shorted heavily. In typical fashion, as the stock began to show signs of strengthening, the short squeeze that followed in a sense functioned as a leveraging/gearing mechanism, amplifying the gains further.
In certain situations where a stock has depreciated heavily (or appreciated for that matter) over a period of time, the pricing model valuing its long-term options can run into trouble, as its assumptions about level of volatility and distribution of returns break down.
The signs of opportunity underpinning each such situation are always different, but can typically be described as event-driven. In the case of Jamie Mai and Charlie Ledley’s Capital One investment, that event was the SEC’s ruling. In the subprime housing crisis, the event was increasing rates of mortgage foreclosures. In my case it was a series of events related to an increase in the price of oil.
In all three cases, inefficiencies in pricing models allowed someone with an opinion about a fairly binary outcome to position themselves extremely cheaply for gains far beyond what is typically possible.
This essay was first published in Blue Poles, a weekly Medium Publication featuring investment ideas, essays and analysis.