Derivatives 101 Part 2: Options Contracts and Basket Options
Remember, a derivative, in a nutshell, is a pricing guarantee. In principle, options contracts are no different. Again, the common elements of derivatives are:
There is a buyer and there is a seller.
Value is derived from the underlier.
There is a future price.
There is a future (exercise) date.
To make options accessible, let’s frame the concept around an everyday example: coupons. Let’s say I have a coupon* (a call-options contract) at Costco that lets me buy gold for $150 off; Costco sells 1-ounce gold bars (e.g., American Eagle, Buffalo, Lady Fortuna, Maple Leaf). If gold is currently selling for $2,379.99 (which is around 250 basis points above the underlier’s current spot price of $2,319) at Costco, then I can buy it for (a locked in strike price of) $2,229.99 with my coupon, which would be $90 below the spot price of gold – a great deal! The coupon has an expiration date, two months from today. That means the coupon becomes worthless two months from now.
Now, fast forward a month to the end of May: U.S. job growth is not continuing to tighten like we saw in April (when the unemployment rate ticked up to 3.9 percent) and geopolitical unrest in the Middle East is worsening. The price of gold (that Costco offers) goes up to $2,429.99 and the coupon still has not expired yet. Technically, the coupon (or call option) is now worth the difference between $2,429.99 (the increased price) and $2,229.99 (the strike price), or $220. Even though the price of gold (that Costco sets) changed 210 basis points in price, my coupon value changed 467 basis points. Ultimately, a call option is like a coupon: you get the right to buy a product at a (discounted strike) price (for some premium) since you hope the price of the underlier goes up. In this case, the gold could be bought at below-spot price and sold at above-spot price, theoretically.
*A few weeks ago, Costco had a coupon snafu in which $150-off coupons for jewelry (i.e., bracelets) were being applied to gold bars (likely inadvertently due to coding or classification errors), enabling folks to temporarily buy gold below spot price. Of course, this was remedied quickly.
Options Terminology
Before diving into options, let’s elucidate more of the basic terminology and lingo surrounding options contracts.
Buyer (Holder) of an Option: the one paying the premium to the seller has the right, not obligation, to exercise the option.
Seller (Writer) of an Option: the one receiving the premium is obligated to buy or sell the underlying asset if the buyer (holder) exercises the option.
Strike Price: also known as the exercise price, the strike price is the amount at which holders and writers agree to execute the options contract on a future (exercise) date.
Expiration Date: this is the future date the options contract expires, so the holder has until this date to exercise the right to buy or sell the underlying asset.
Premium: the buyer of an options contract must pay this amount to the writer (seller) to exercise the option on or before the expiration date.
Spot Price: this is the underlying asset’s current price at any given time in the market.
Contract Size: an options contract specifies the deliverable quantity of the underlying asset, and these quantities are fixed for the asset.
Options Style: there are two major types, American and European –
American Options: a holder can exercise the option any time before the specified expiration date in the contract.
European Options: a holder can only exercise the option on the expiration date.
Price Path: this is the course of the underlying asset’s price over time.
Random Walk: a price path with no real predictable pattern. Theoretically, all time-series price data is a random walk of some sort as no price is wholly deterministic.
Call vs. Put Options:
Call Options: Holder buys the right to buy the underlier from the writer at a specified strike price. You’re “calling it in” from the writer.
Put Options: Holder buys the right to sell the underlier to the writer at a specified strike price. You’re “putting it back” to the writer.
Moneyness (ITM vs. OTM vs. ATM):
“In the Money”: a call option that pays off upon exercise (when the underlier’s spot price is above the strike price) and a put option that pays off upon exercise (when the underlier’s spot price is below the strike price).
“At the Money”: a call or put option that is essentially worthless when the strike price equals the underlier’s spot price.
“Out of the Money”: a call option that does not pay off (when the underlier’s spot price is below the strike price) and a put option that does not pay off (when the underlier’s spot price is above the strike price).
Options vs. Futures vs. Warrants
These three financial instruments are similar flavors of financial derivatives that investors can use to speculate on price actions or to hedge risk. There are nuances, however, among the three: warrants are traded on the principles of a spot market, whereas options and futures are traded on the principles of a futures market. For warrants, the writer of a warrant (contract) and the underlying stock issuer are the same party. For instance, AAPL writes a call option on its own stock: this is just a warrant. The major delta between options and futures is that options give buyers (holders) the right to buy (or sell) an asset at a strike price, whereas futures obligate the buyers (holders) to buy (or sell) the underlying asset.
Disclaimer: None of what I write is intended to be any kind of financial advice, nor should it be interpreted it as any kind of investment, tax, legal, or financial advice.
Basket Options, MAPS Options, and COLT Options: Weiss Multi-Strategy Advisers and Renaissance Technologies
On July 22, 2014, the United States Senate Permanent Subcommittee on Investigations held a subcommittee to investigate the abuse of structured financial products, specifically the “Misusing [of] Basket Options to Avoid Taxes and Leverage Limits.” The subcommittee was chaired by Carl Levin, with John McCain as the ranking minority member.
At a high level, the findings highlight that two banking institutions – Deutsche Bank AG and Barclays Bank PLC – and two major hedge funds – Renaissance Technologies LLC and George Weiss Associates (known more recently as Weiss Multi-Strategy Advisers LLC) – used basket options to help the hedge funds avoid taxes and circumvent leverage limits on buying securities with borrowed funds. The banks, Deutsche Bank AG and Barclays Bank PLC, serving as brokers offering these “options” ultimately reaped hundreds of millions in financing fees charged to the hedge funds.
Tactically, the way it works is the basket-options holder would always be the hedge fund: the hedge fund would enter into a contract with the bank to buy an “option” on the performance of an unspecified basket of assets placed in a designated account at the bank. The account was essentially operated as its own proprietary trading account and opened in the bank’s name – that meant the assets were all purchased in the name of the bank as well, not the hedge fund.
The “premium” requirement was roughly 10% of the total capital to be invested in the account, functioning basically as collateral for the account in the bank’s name at the bank’s institution. That meant the other 90% was financed by the sponsoring bank, so the bank would earn financing fees on this 90% from hedge funds that entered into this type of options contract. Then, the designated account used the premium amount (10%) and the bank’s credit extension (90%) to conduct trades until the holder (the hedge fund) exercised the option. If the option was exercised and there was a profit in the securities traded in the basket, then the bank would have to pay the hedge-fund holder the profits (less the trading and financing fees).
That all seems roughly okay, but the Subcommittee emphasizes that “the banks always appointed the general partner of the hedge fund client to act as the investment advisor for the trading account holding the referenced assets during the duration of the option…[and] the investment adviser exercised complete control over the securities included in the option account, designing its own trading strategy and using the bank’s own facilities to execute the trades…[and roughly] executing more than a 100,000 transactions per day.” In the Subcommittee’s eyes, the option holder (the hedge fund) is serving as the investment adviser, so controlling the trading strategy, the timing of trades, the assets being traded, and the risks associated with the trading. “Many of those trading positions lasted minutes, and the overall composition of the securities basket changed on a second-to-second basis.”
What’s neat is that RenTec minimized their risk: “the option contract contained several provisions designed to limit trading losses in the account to the 10% premium provided by the hedge fund.” Once a “knockout” amount was reached, the option ceases to exist, triggering the bank to liquidate the account’s assets.
Here’s a quick history on these basket options: The first basket option was designed by the Royal Bank of Canada in 1996-1997. Weiss’ employees used the basket-option structure on a managed trading account to circumvent the leverage restrictions specified in Regulation T, so they could get more leveraged than the 2:1 limit. Then, Deutsche Bank developed its own version of the structured financial product in 1998, calling it the Managed Account Product Structure (MAPS). Weiss became involved in these MAPS basket options: Weiss used them on low-volatility utility stocks to magnify LSD (low-single-digit) positive returns into higher, magnified gains. The MAPS options sold to Renaissance Technologies generated $17 billion in profits for the fund. Then, in assessing counterparty (credit) risk, Renaissance Technologies convinced Barclays to create their own basket-options product, otherwise RenTec risked bringing their business elsewhere to another broker on the street. This led to the birth of Barclays’ COLT options product, which produced $18.5 billion in profits for RenTec and $655 million in revenues for Barclays.
The Barclays’ COLT structure is fascinating:
“Barclays developed the COLT basket option structure in 2002, at the request of RenTec, and it was used solely by that hedge fund over the next decade. The COLT structure was designed and administered by the bank’s Structured Capital Markets (SCM) group until 2013 when Barclays disbanded that group for involvement with overly aggressive tax strategies.
Under the COLT structure, Barclays created a Cayman Island Special Purpose Entity (SPE) named Palomino Ltd. Palomino was a shell corporate controlled by Barclays; it had no full-time employees or physical offices of its own. Its directors and officers were Barclays employees who worked for other Barclays entities. Each basket option account was opened in the name of Palomino, which was the nominal owner of all of the account assets. The accounts were opened as prime brokerage accounts with Barclays Capital Inc. in the United States and by Barclays Capital Securities Limited in the United Kingdom.
In connection with each COLT option, Palomino hired RenTec to be its investment advisor under an Investment Management Agreement that gave RenTec the exclusive right and the “full” discretion without the need to consult with Barclays to execute transactions directly into the Palomino prime brokerage accounts in the United States and United Kingdom, subject to general guidelines specified in the agreement. While RenTec representatives told the Subcommittee that they merely recommended or suggested trades to Palomino, given the company’s shell status, the extraordinary number of daily trade executions, and the provisions in the option contracts, the facts indicate that all transactions in the accounts were actually fully controlled by RenTec.
After the accounts were opened and the Investment Management Agreement signed, Palomino sold options on the performance of the accounts to the U.S. branch of Barclays Bank PLC, which in turn sold identical options to Badger Holding LP, a shell entity set up in 2004 and fully controlled by RenTec. Like Palomino, Badger had no employees or physical offices of its own. Prior to Badger, RenTec used a company called Bass Equities Ltd., which was originally incorporated in Bermuda. Badger was later incorporated in the United States. Badger served as the official option holder for the COLT options on behalf of RenTec.
The COLT options were generally established with three-year terms, meaning that the option holder could exercise the option at any time prior to the maturity date which was three years after the option was established. RenTec representatives told the Subcommittee that one of the benefits of the option structure was that it gave the hedge fund access to long-term financing. In many of the COLT options reviewed by the Subcommittee, however, the option holder – RenTec – exercised the option shortly after 12 months.”
Ultimately, the incentives and takeaways of these structures are clear:
the hedge funds are able to attain a leverage ratio as high as 20:1, despite the much lower federal limit of 2:1 (from Regulation T that’s intended to prevent systemic risk);
the hedge funds, by holding these basket-option contracts for more than a year, are able to carry out countless millions of trades, virtually all on a time horizon less than 12 months, and characterize the majority of those profits as long-term capital gains (instead of short-term trading profits, which are taxed much higher); and
the banks are able to collect financing, trading, and other fee revenues, cumulatively, totaling over a billion dollars.
The best part of reading all of the transcripts is the sentiment of the investors’ counterarguments:
“In the Tax Court case, Weiss argues that the options had business purposes beyond tax savings: They offered more leverage than was available in a typical brokerage arrangement, while at the same time limiting the firm’s risk of loss. …Renaissance has made similar arguments in defense of its transactions.”
In other words, ‘hey, I’m not just avoiding taxes – margin requirements too!’
Disclaimer: None of what I write is intended to be any kind of financial advice, nor should it be interpreted it as any kind of investment, tax, legal or financial advice.