My friend Mark Cuban is known for many things, but not many people are familiar with his acumen in the markets. His best trade may have been one that saved him from losing his fortune. Long before he became owner of the Dallas Mavericks, Cuban used a collar trade to lock in profits from his $5 billion-plus sale of Broadcast.com to Yahoo at the height of the dot-com bubble. The trade gave Cuban exposure to some upside but limited the downside in a position where he could not sell the stock due to a lock-up period prohibition. This is obviously an extreme example, but it underscores for all of us the value of collar trades in situations where you must own the underlying asset. They can be designed in a variety of ways to protect positions and/ or profits.
One of the great things about being a retail trader is that you usually don’t have to hold onto such positions. For example, a bull call vertical spread has essentially the same profit/loss profile as a collar, without the necessity of owning the stock. The margin requirements are also significantly lower on a call spread than on a collar. (See our Education section.)
Still, there are other lessons to be learned about the Cuban trade, including the concept of the zero-sum game. This is an idea that trips up a lot of new players in the option market.
If we flip a coin and you get $1 on heads and I get $1 on tails, that is a zero-sum game. But people use options in different ways and for different reasons, so it is far more complex than that. For example, we recently could have bought an SPY March 128 call for $4, with the SPY trading at $126. On March 1, 2012, it was worth $10 when the SPY was priced near $137. So the call buyers profited and the call sellers lost, correct? Well, not necessarily.
Certainly the outright buyers profited if they held the calls. They made $6 on a $9 stock move, equating to a 150 percent option profit. Even as time decay accelerated, the calls went further into the money and produced profits.
But if sellers simply treated the trade as a covered call, they profited $6 as well, earning $2 on the stock move up to $128 and a $4 credit for selling the call.
The call seller could also have been delta-hedged, which is what market makers do. When you buy a call the other side of the trade is almost certainly a market maker who immediately hedges the sale with stock. Such hedged positions essentially equate to selling the implied volatility of the stock and collecting the actual volatility—making a profit on the difference between the two.
The implied volatility of the SPY options at the end of 2011 was around 22 percent, while the actual volatility last week was less than 8 percent. So the dealer who sold the call and delta-hedged it also made a very nice profit.
This goes to show that just because one person turns a profit on options doesn’t necessarily mean that money was lost on the other side of the trade. Of course, being realistic, it is entirely possible that both sides lose on the play as well.
That’s why it’s so misleading to call this a simple zerosum game.
Jon “DRJ” Najarian
Jon ‘DRJ’ Najarian is co-founder of optionMONSTER® and co-lead analyst for the InsideOptions™ trade idea alert systems. He spent the first 29 years of his trading career trading in and around the pits of the Chicago exchanges. Jon is a frequent contributor to CNBC, the Wall Street Journal, and other prominent financial media organizations. Mr. Najarian also co-developed the patented trading algorithm the Heat Seeker®, used to detect unusual trading activity.