Platinum Peacocks
Volume #125: April 13th, 2023
Good Friday, Easter Monday. It’s all Spring Break to me.
The tulips are blooming and the crowds are swelling. Tourist season is officially open as everyone looks to make the most of their school holidays. While my day to day is fairly insulated from the fanny packed mob, I do get to vicariously experience the joy of our visitors exploring the city.
My oldest friends came this past week. There’s nothing better than falling back into the same old rhythms and jokes, while watching the next generation get to know each other. Plans for future babysitting opportunities abounded.
After trudging through boring Montmartre and sitting through HOURS of lunches, we took the last day just for the “kids”. The Jardins d'Acclimatation is a verdant gem nestled right at the edge of the city, but three metro stops and a short walk away. There are carousels and roller coasters, guarded by dovecotes and spotted with peacocks. Wandering around the pond view pagodas is an ostentation of fowl, flaunting their feathers and honking their mating calls.
As we sat down to lunch, there was a peacock just on the other side of the window from us, lounging in his garden. He gave one long crow to announce his presence as we took our seats, and then a few minutes later another screech got at least one person to jump.
The obvious question was asked. “How many more times is he going to do that?” I immediately start pricing the distribution because no easy answer will do here. I put the over-under at 2.5 because half of the kids’ lasagna is gone and our glass separated table mate has already sat down and tucked his feathers in.
The six year old thinks for a minute, respecting the valuation, and says he thinks it will be more. Deal.
Theta decays and I’m feeling pretty good about the peacefully settled bird. But our friend had friends. With plenty of time left on the clock, the muster out front started getting excited. Two. Three. Four….Fifteen.
These peacocks were letting out a punctuated performance, and each pause ran the scoreboard even further against me. As my defeat was precisely enumerated, I couldn’t squeeze a word in edgewise about how we’d obviously agreed about this specific bird, and that really those should be counted as one long scream.
The terms of a deal matter. If you don’t get your contract specifications right, you’re going to have a bad time. Even the Oxford comma or absence thereof implies an intent.
Most of the deals we make or contracts we trade have terms so well hammered out that scrolling to the bottom and blindly hitting “accept” is unlikely to do you much harm. If I click to buy 100 shares of AAPL in my brokerage account, despite having not the slightest clue about the thousands of pages of documents I signed to open that account, exist in the listing prospectus, or regulate my order routing; my position is going to look exactly how I want it to.
Things can and do get wonky though. The standard options contract will deliver 100 shares of stock at the price set forth in the strike terms when it is in the money. If a stock splits, that number of shares will change. The goal is to deliver the same financial exposure, regardless of the corporate action.
Options 101 says that a call is the right to buy the stock, and a put is the right to sell the stock at the strike price. The cheeky market maker who slings vol and whacks variance will tell you that a call is a put and a put is a call. This put call parity exists because the returns from buying a call and selling 100 shares of stock are exactly the same as buying a put. Just like buying a put and buying 100 shares of stock replicate a call option.
While at face value this is true, there are some assumptions about selling or buying stock that it glosses over. The carrying costs, namely interest and dividends, will have a big impact on whether that parity holds true.
If a company pays a quarterly dividend, that future estimate is baked into the options pricing. When they announce that the distribution will be $.50 instead of $.45, the positions which are short stock (i.e. net long calls, short puts) will be losers as they will have to pay a nickel more than they’d priced into putting on that options position.
Not all dividends are perfectly forecast, and a corporation can also issue a special dividend. If a dividend is special, then there are provisions for the options contract to be adjusted. Prior to 2007, the 10% rule was the de facto standard, stating that all dividends were considered ordinary if they were less than 10% of the stock price.
As options trading volumes grew, and companies had incentives to pay dividends due to tax code changes, the effects of not adjusting for special dividends less than 10% became increasingly pronounced. The rules changed, specifying that any dividend was special if it was not “pursuant to a policy or practice of paying such dividends or distributions on a quarterly or other regular basis.”
That introduces some subjectivity to the rule, but it also cleans up a lot of fairly arbitrary windfall profits. Sure markets are designed to price risk and speculate on outcomes, but if participants are seeing PnL volatility due to arbitrary corporate decisions unrelated to options valuation, they’re going to provide less liquidity.
The people that don’t like this change, are those who think they can capitalize on less savvy market participants. This rule had been in place for a few years when it really got put to the test.
Certain types of companies have distribution schemes that always prickle your spidey sense. IFN (The India Fund) is a mutual fund that invests in Indian equities, and produces a fairly high, but volatile dividend stream. Quarterlies are paid in small amounts, and if there’s a good year, they tack on a much larger, additional year end distribution.
In December 2010, a whopper of a distribution got announced. They were going to pay $3.78 on a stock trading around $38. When this kind of news hits the tape, the first thing you want to do is widen out your quotes and confirm the terms of the deal. How this dividend gets treated matters a lot.
We were fairly confident that it was going to get treated as a special dividend, and that strikes would be adjusted. The problem is, there’s usually at least one trading session between the corporate announcement and the OCC InfoMemo. The OCC wouldn’t tell us anything, and no exchange official was willing to stick their neck out on any kind of guidance.
Other participants did not think this would be adjusted, and started aggressively looking to get long stock. They were overbidding for puts, because if the strikes don’t get adjusted then that deep put will go up in value by the amount of the dividend as the shareholders get their cash out of the fund’s NAV.
Loggers were screaming with edge messages, this customer was insatiable. Risk had to put limits on individual positions sizes, as no matter how good that trade looked, you didn’t want to bet the firm’s month on it. The fact that it was so closely under 10%, even if that’s an old rule, felt fishy. We held our breath and our short puts. The next day the dividend was declared special and the strikes all had $3.78 lopped off.
It only took a week after the adjustment was announced for these other participants to unmask themselves in the form of a lawsuit. Platinum Partners is a “Value Arbitrage Fund” that saw a mirage of opportunity and jumped head first into it. They added 50,000 contracts to their existing 25,000 opening long the day of the announcement. They didn’t pay $3.78 over for all those shares, but even if they averaged at $1 over, that’s a $7.5M loss.
They sued the OCC and the CBOE first on the grounds that the adjustment was erroneous and when that was rejected under the regulatory immunity clause, accused the organizations of unfairly disclosing the terms of the settlement to other market participants. When that was dismissed, the claim became even more contorted that the financial incentives of the SROs (Self Regulatory Organization) was conflicted to generate additional volume from providing limited disclosure about the adjustment terms.
I’m not the biggest fan of regulatory immunity, but I understand why it has to exist. I’ve seen it turn years of miscalculated transaction fees into a pauper’s refund. But giving exchanges SRO status (under a strictly regulated framework) does allow for cost effective efficiency and innovation by insiders.
As someone who was sitting at a firm holding a lot of short puts, I can tell you that there was certainly no information leakage in our direction. We knew what the standard was, had a strong hunch that it would be applied in this case, and put our capital at risk.
Years later the case took another interesting twist. The founder of the billion dollar fund was sentenced to 30 months in prison. He had used Platinum's slush fund to cover up a $60,000 bribe to a police union official in exchange for directing a multi million dollar investment into the fund. Unfortunately the pensioners didn’t get value or arbitrage, just a couple of courtside Knicks tickets for their boss.
Peacocking is an appropriate zoomorphism here. If you’re going to spread your feathers wide and let out your call, you’ve got to be certain there aren’t any predators lying in the bushes, wading through the detailed terms of the deal.