It’s been 25 years since Mark Cuban implemented an exceedingly well-timed and attractively priced hedge on shares of Yahoo. In this short podcast, we review the popular “zero cost collar” trade and discuss the factors that impact its pricing. Cuban is known for playing offense in investing, buying the Mavs and making deals on the Tank. But his defensive trade on Yahoo years ago has been critical in his wealth accumulation. We bring in Jensen Huang, the owner of a few shares of NVDA, and make the case that he ought to consider this risk reducing collar transaction. I hope you find the discussion informative. Feedback is welcome.
[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. Michael Jensen was a legendary financial economist who passed away earlier this year
[00:00:24] at the age of 84. His contributions to our understanding of the complexities of markets and finance are many. In 1976, along with William Meckling, he published Theory of the Firm, which built upon many years of his impactful research on agency costs.
[00:00:42] His expansive body of work also includes efforts to measure risk-adjusted return. Today, Jensen's Alpha is a widely used industry calculation that serves as a cornerstone of how we measure the results produced by an investment manager.
[00:00:57] Over the next 15 minutes, I'd like to propose a new form of Jensen's Alpha and, in an unexpected twist, invoke both Mark Cuban and the options market for NVIDIA in the process. Jensen in the forthcoming exercise is not Michael Jensen but Jensen Huang, the slightly
[00:01:15] wealthy CEO of this stock with most sizzling returns, NVIDIA. With the stock up 150% already this year, Jensen's Alpha may appear self-evident. There is no doubt extreme wealth creation afoot in the halls of the firm's Santa Clara headquarters.
[00:01:37] But Jensen's Alpha contemplated in this podcast invokes derivatives and is about wealth retention rather than wealth creation. This Alpha is captured by the currently glorious setup in the favorable prices of puts and calls on the stock that Jensen Huang owns in size.
[00:01:55] Who's ready for a discussion of collar pricing and who's interested in how another billionaire Mark Cuban will make his way into this short pod to substantiate the opportunity for Jensen? Buckle up and, as Logan Roy would often say, let's get into it.
[00:02:11] First, some particulars on terminology or lingo, as one might say. The collar is a hedging trade in which a long stockholder, Jensen in this case, simultaneously buys a protective put option and sells a call option both on the stock that is owned.
[00:02:27] The trade creates a band in which the stock can move up or down. Oftentimes, the trade is structured so that the put premium paid and call premium received perfectly offset each other. The collar becomes then zero cost. No fuss, no muss.
[00:02:44] The pricing exercise often starts with choosing the put strike and then solving, somewhat iteratively, for the call strike for which the premium matches that of the put. The investor is left with no cash flows on trade date, leaving the Wall Street middle
[00:02:58] office folks with one less thing to do. That's the trade. Buy a put and sell a call against your long stock. If the stock implodes, the put caps your loss by how far out of the money you strike it.
[00:03:10] If the put option strike price is 10% below the stock price on trade date, then at expiration of the option, the most you can lose is 10%. My goodness, if Jensen Huang lost 10% on his Nvidia position, he'd be out more than $10 billion.
[00:03:27] Ah, but he would be left with $100 billion, wouldn't he? Not the worst, Le Tote's would say in an ironic understatement. The second part of the collar is the short call. This generates the premium that pays for that put protection.
[00:03:42] And because there's no free lunch in markets, you give something up in selling the call and that is the foregone stock appreciation above the call strike. Enter Mark Cuban. Before he owned the MAVs, missed on Uber, and became a presence on Shark Tank, he
[00:03:57] executed one of the more brilliant of these so-called collar trades. I mean, this is legendary stuff. Let's review it. Cuban's an interesting guy with a nose for playing offense. That is, minus the Shark Tank. By his own count, he's made 85 investments on the tank, throwing cash at businesses
[00:04:15] like Beatbox Beverages and Plated. I'm not sure the 25 grand he threw at I Can Draw a Cat for You has been monetized. And yes, the company mission was to do exactly that. Cuban bought the MAVs in 2000 for $285 million.
[00:04:32] He made a lot of changes, focusing on the player's comfort and morale. He invented the locker room experience, spending $606 million on a renovation in 2017. NBA Hall of Famer Kevin Garnett said Cuban changed the game with his first-class treatment of players.
[00:04:49] Cuban was also a huge fan, getting thrown out of more than one game and threatened many times over. By his own calculation, he's paid more than $3 million in fines over the years. You gotta love it. He sold the team in 2023 for $3.5 billion.
[00:05:05] But it's Cuban's defense, not his offense, that links him to this podcast on Zero Cost Collars and the recommendation that Jensen Wang ought to at least consider this basic hedging trade. 25 years ago, in 1999, Cuban sold his broadcast.com to Yahoo for $5.7 billion.
[00:05:26] This stock-for-stock transaction left him long nearly 15 million shares of Yahoo with a market value at the time of $1.4 billion. Don't put all your eggs in one basket, they say. One might be inclined to add, especially if those eggs are wildly overvalued and volatile. Cuban took that good advice.
[00:05:46] Always industrious, the tech bankers and their equity derivative counterparts followed high-profile transactions closely and would eventually get their hands on Cuban. OTC structured products like Zero Cost Collars are, quote, sold, not bought, as the saying goes, to reflect Wall Street's appetite to find marks for their products.
[00:06:08] Back in the day, they were called hedging and monetization desks. These folks had three things firmly on their side. A giant knowledge gap on the valuation of derivatives. Second, almost no transparency in pricing. And third, the tax code.
[00:06:24] Protect the downside, finance that by forgoing the upside and borrow against the stock wealth that, with the collar overlay, will fluctuate only minimally. Pay no taxes for years, even as the vastly reduced exposure coupled with the pile of upfront cash via the loan approximates a sale.
[00:06:42] As my main man, Larry David, would say, pretty, pretty, pretty, pretty good. The economics and pricing of a collar are easy to understand and can be powerful. For Cuban, this setup could not have possibly been better.
[00:06:56] Let's go through four factors that impact pricing and consider the combination of them from Cuban's long put short call standpoint. First, Delta. Since the put and call delta are opposite one another and one's bought, the other sold, the deltas go the same way.
[00:07:14] For example, a 35 delta put and a 35 delta call give the collar a negative 70 delta. Makes sense. An entrepreneur like Cuban would be left with exposure to just 30 percent of his original shares. That's the main idea. Reduce the sensitivity to stock price moves.
[00:07:32] The second factor that matters in a zero cost collar is that non-Greek letter Greek we option geeks call Vega. The sensitivity to implied volatility. Vega answers the question. If I hold all other factors constant, but move the implied volatility input up or
[00:07:50] down by a point, what happens to the price of the trade? A year before Cuban embarked on the collar, LTCM learned a little bit about Vega. It was a tough lesson. You can check out Alpha Exchange podcast LTCM 25 years later for a deep dive.
[00:08:07] Remember, this was the Internet bubble and stocks like Yahoo were moving anywhere between 3 and 20 percent on a given day in 1999. The peddlers of collars, because they were focused on achieving both risk reduction and tax deferral, typically trafficked in long dated options.
[00:08:24] This would enable a longer period of tax deferral. For Cuban, his put and call option had three years to expiration, a little different than today's rage of three hour expirations. It turns out for longer dated options, the Vega of the call option sold
[00:08:40] exceeds that of the put option bought. That is on balance, entrepreneurs like Cuban were net sellers of vol in these trades. This was a good thing for him because vol on stocks like Yahoo was sky high because he was shorting vol at high levels.
[00:08:56] The economics were better for him. The third factor was the differential between the put and call implied volatility level. Cuban's economics would be better to the extent that the dealer, in this case Goldman, awarded him a higher call vol relative to the put vol he was charged.
[00:09:12] And again, this set up well for Cuban. Around 2000 markets largely operated in the land of make believe. Remember, stocks were exhibiting legendary up shocks, days when the fear of missing out caused them to spiral higher. This was meme like behavior before Jan 21.
[00:09:31] But like the GME and AMC craze, a signature characteristic of the internet bubble was that realized vol in stocks owed a great deal to the up moves. It was a period of rampant speculation, asset price inflation and the fabled stock up vol up dynamic.
[00:09:50] And this brings us to the fourth factor going in Mark Cuban's favor, interest rates. When he implemented his collar in 1999, the Fed was tightening and three year treasury yields were north of five percent.
[00:10:02] Just as the Delta exposure of the collar is additive, so too is the interest rate exposure. The put option purchased cost less as interest rates go up. The call option has the opposite sensitivity. It's worth more as interest rates rise.
[00:10:18] Since Cuban bought the put and sold the call that interest rates serve to better the economics of his trade. The net result, the put in Cuban's collar was struck at 90 percent of the stock price. The call incredibly was struck at 205 percent, 10 percent of the downside and
[00:10:35] more than 100 percent of the upside. Gorgeous. It's worth a mention that Yahoo is viewed to have vastly overpaid for broadcast dot com and closed the business by 2002. Mark Cuban's decision to hedge was likely instrumental in his wealth accumulation over the last 25 years.
[00:10:54] And that brings us to Jensen Huang. This may be a good time for a brief interlude on a fantastic bit from comedian Gary Gorman on billionaires. He wonders out loud how someone like Bill Gates would look at Donald Trump, who he calls a billionaire, barely.
[00:11:09] I remember being worth two billion Trump. That's adorable. Keep swinging says Gates. Does Jensen Huang worth 110 some odd billion look at Mark Cuban worth a pathetic seven and a half billion with disdain. It's cute to still count the point five says Gorman. Check it out on YouTube.
[00:11:27] Things are going well for Jensen Huang to say the least. So much so, in fact, that he recently signed a woman's chest and escaped cancellation. Brass bell backwards is our by will note. Talk about the Midas touch.
[00:11:41] Never in history has a company added market cap with the ferocity that Nvidia has. It took the company 23 years to reach one trillion in market cap. It took nine additional months to add a second trillion and its market cap
[00:11:55] went from two trillion to three trillion in four additional months. Along the way, there have been a few options on the stock traded. Ken Griffin's algorithms have worked so much over time one can't help but wonder if there's a discussion amongst these bots about pursuing unionization.
[00:12:12] Talk about overworked. A sim 500 founder, Rocky Fishman reports that over the past month, Nvidia has averaged 65 billion a day of notional put volume and 95 billion a day of notional call volume. Now, today's option bros don't have much of an attention span and
[00:12:30] the puts and calls they traffic in rarely sport expirations longer than a week. Who can think that far ahead anyway? But the fine folks at the options exchanges have done us the favor of listing options all the way out to December 2026.
[00:12:45] And with those option expirations, we can start to appreciate some of the wealth management opportunities at the fingertips of Jensen Wang. And because it's Jensen's world and we only live in it, things are setting up in incredible fashion on the hedging front for him.
[00:13:00] Just like for Mark Cuban and Yahoo 25 years ago, today's vol and rate surface in Nvidia give Jensen all kinds of things to do. He's got the same three pricing factors going his way. The level of implied volatility is very high because well, Nvidia is a volatile stock.
[00:13:18] Second, the relative pricing of put vol versus call vol skews very much in his favor because Nvidia derives most of its vol on up shocks. Since 2023 for example, the realized vol is 54% on up days and just 39% on down days.
[00:13:36] That sounds like the vol profile of corn or wheat, not a $3 trillion market cap company. But this is 2024 after all. And lastly, interest rates which make put prices lower and call prices higher. Let's take a quick look at the December 2026 expiry listed options.
[00:13:56] We see that the 112 200 collar is essentially zero cost down 10%, i.e. what stockholders have made in the last few days and up 60%. Not a bad trade off. Now, a large portion of the zero cost collar business is as suggested earlier implemented using OTC options.
[00:14:18] That is bilateral contracts in which an individual like Cuban faces a bank like Goldman directly. This enables customization including long dated expirations beyond those on the listed exchanges. It also enables a financing component to be easily embedded in the trade.
[00:14:35] That is in combination, the long stock, long put and short call have a defined monetary value within the collar band that the hedger can then borrow against. It's considerably easier to do this on an OTC basis because the long
[00:14:49] stock can be pledged as collateral against the short call. If we did a similar pricing exercise and chose Cubans three year maturity, the 9175 collar in Nvidia is zero cost. Now that is before Wall Street takes its chunk out but goodness Jensen Wang life is good.
[00:15:08] Let's bring this chat to a close. Over a recent three day period, Nvidia stock lost 13% and nearly 500 billion in market cap in the process. When a gigantic stock moves on a 50 vol such as the easy come easy go outcome with respect to staggering sums.
[00:15:27] Jensen Wang himself lost 10 billion over this period. Welcome to the neighborhood said Elon and Jeff. The Nvidia option complex is as alluded to incredibly active in liquid. Even still, it's not likely well positioned to absorb a trade on the CEO's 866 million shares who probably wants the upside anyway.
[00:15:49] Wang would be remiss to send the wrong signal to the marketplace as well. So let's consider this a thought exercise for the moment, shall we? But hopefully one that nonetheless has expanded your thinking on the zero cost collar and the factors that drive the pricing.
[00:16:05] I've had some fun putting this together and I hope you enjoyed it. I wish you a prosperous week. Until next time. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend.
[00:16:17] And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus.
[00:16:30] Please email us at feedback at alpha exchange podcast.com. Thanks again and catch you next time.