Case Study: The Anatomy of a Collar: An Options Strategy That Only The Wealthy & Privileged Know About!

Case Study: The Anatomy of a Collar: An Options Strategy That Only The Wealthy & Privileged Know About!

 

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 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 period of time, 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 might otherwise (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. As a result, the Stockholder does not need to worry about margin calls during the term. 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 did not appear to be a wise move, but in light of Yahoo’s current price of roughly $13 a share, it 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 collared and similar transactions.

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