Stock Option Case Study: The
Anatomy of a 'Collar'
An Options Strategy That
Only The Wealthy & Privileged Know About!
...And YOU Will Learn This Option Strategy In John's 'Monthly Cash Flow' Course!
How
Mark Cuban, a 'Billionaire', Saved a Billion Dollars By Utilizing This One
Strategy!
For years
now, stockholders have "collared" shares to lock-in gains, especially when the
stock represents a significant percentage of a person's net worth or overall
portfolio. The bursting of the dotcom bubble has brought prominence to some of
these collars, including Mark Cuban's collar of his Yahoo stock. The following
article gives an example of the anatomy of a collar using the publicly available
information about Cuban's Yahoo collar. A collar is essentially a risk shifting
agreement between parties allowing the current stockholder to lock-in gains at a
certain level (frequently with an accompanying loan). Under a collar, the
parties (the "Stockholder" and the "Bank") agree to place both a floor and a cap
(or ceiling) on the price of stock for a defined period of time, effectively
creating a "collar" around the stock. If the price of the stock is below the
floor at the end of the collar, the Bank pays the Stockholder the difference
between the current market price and the floor. If the stock price is above the
cap, the Stockholder pays the Bank the difference between the stock price and
the cap. If the Bank held the shares as collateral for the collar (and a loan),
the Bank will return the shares to the Stockholder once all payments are made
and any loan is repaid. The Stockholder may elect to sell some of the shares to
pay any losses on the collar (in this case, any gain recognized on the sale of
the stock may be offset by the loss on the collar).
Both the
floor and the cap can be set at almost any point, but are generally priced so
that the transaction is costless for the Stockholder through the setting of the
floor with a corresponding cap. The cap is generally set at a price that would
equal the cost of the floor. Accordingly, a higher floor price will result in a
lower cap price, and vice-versa.
The actual
pricing is based on the term of the collar and the volatility of the stock. The
Stockholder could actually pay for a higher floor with additional funds, but
most choose to have the floor at a level of approximately 80 - 90% of the
current market price, and the ceiling set at a price of equal value. A collar is
frequently married to a loan. This allows the Stockholder to borrow money
against the stock on better terms than he could without the collar (the
Stockholder can usually borrow up to 90% of the floor price at desirable
interest rates). In addition, as the Bank will require that it hold the shares
as collateral, it is fully secured during the term of the collar. As a result,
the Stockholder does not need to worry about margin calls during the term of the
collar. In this manner, the stockholder may hold on to his stock (differing from
a taxable sale), lock-in a certain minimum value, and obtain cash on reasonable
terms.
In the
Cuban example, Cuban held approximately 14.6 million shares of Yahoo, which were
trading at $95 per share, for a total market value of almost $1.4 billion. Cuban
had the option to: (i) sell his shares and recognize his gains, (ii) hold the
shares in hopes of future gains but at the risk of a future loss, or (iii)
engage in a collar or other hedging transaction to lock-in certain gains. Cuban
chose to enter into a three-year "costless collar" for his Yahoo stock. In this
case, it has been estimated that Cuban received a floor of $85 a share and a cap
of $205 per share. Initially, when Yahoo soared to $237 per share in January of
2000, Cuban's collar did not appear to be a wise move, but in light of Yahoo's
current price of roughly $13 a share, the collar may have saved Cuban over one
billion dollars.
In more
recent times, forward sales and other derivatives transactions have been used to
replace some collar and loan arrangements resulting in improved tax and lending
terms. Please contact a member of the Derivatives and Hedge Fund Practice Group
for further information and assistance regarding collars and similar
transactions.
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