A few years ago my family was thinking about buying a Smart, these super-trendy cars that were in everyone´s mind. Suddenly I saw Smart cars everywhere in the city. I once heard that this tendency of humans to focus on things recently learned about is based on the activity of our reticular activation system basically helping us to focus on things of “importance”, but I am not a biologist. The same thing has happened to me recently and is connected to the Deutsche Bank trade idea that I indicated in the last post. Unfortunately, I was a little pre-euphoric about this idea (as so many times in my posts). But here is my idea.
Do you remember Jack D. Schwager´s book “Hedge Fund Market Wizards”? I wrote an entry about it and mention it quite frequently! Anyway, I love the book and have been listening to the audio book 24/7 for the last few weeks. The lessons of two managers especially captivated me. These men are Joel Greenblatt and Jamie Mai. The former is the author of “The Little Book That Beats The Market” which I recently wrote about (I am still analyzing the performance of the magical formula – there are some issues with the data though). The latter hedge fund manager has been loosely portrayed in Michael Lewis´ book and the movie “The Big Short”. He made a killing during the financial crisis buying Credit Default Swaps on mortgage backed securities, multiplying his capital 80 times .
What connects these hugely successful hedge fund managers is their emphasis on bets expressing limited risk with unlimited return potential, so called skewed bets. Fundamentally, buying options offers this potential. Generally, options are found to be overpriced in the market and as many as 90% expire worthless out of the money. However, both Greenblatt and Mai spotted situations in which options can be of great use. These are “special situations”. A special situation occurs when the stock performance depends on an uncertain outcome.This could be due to a lawsuit, regulatory action, or a pending acquisition. In this case the market is uncertain about the future development of stock. What we can almost certainly assume however (which the market does not do), is that at the point in the future when the uncertainty is resolved the shares will not trade at the current level. They will either trade much higher or much lower, corresponding to the result of the special situation.
Option pricing formulas contrary generally assume a normal distribution when a multimodal distribution seems more appropriate (see the difference below).This leads to possible large price inefficiencies of options in these kinds of situations. Thus buying a call option of a company that currently is target of an acquisition might express a skewed bets. As Mai puts it the market generally over discounts the share price in special situation related to possibly negative results.
Let´s relate this now to the Deutsche Bank case. Since the disclosure of negotiations with the U.S. Department of Justice and possible fines of up to 11 billion Dollars the stock lost much of value and I thought to have found one of these special situations. According to U.S. Authorities´ decisions either Deutsche Bank shares would recover or crash.
Since its low in mid September however, the stock has already regained its losses and it is hard to evaluate the upside of a possible trade and whether the skewed bet still exists at this time. It was an interesting idea, but I was a little slow.