One of the great misconceptions of our time is that derivatives by nature are risky. Market professionals, however, know listed equity options have helped to diversify risk and hedge portfolios since their inception in 1973. Option market makers, large pension fund and portfolio managers have long used options to define risk and reward to maximize returns.
TiVo drew our interest because of the ongoing patent disputes, as well as the timing of upcoming court cases concerning the technology. Generally, TiVo was challenging companies that had similar recording DVRs as infringing on patents held by TiVo. Any court decision would have an effect on the stock price, but we tended to believe that TiVo, (who had won the case in a Texas court in June), would once again be successful in the higher court. For the purpose of this trade it seemed unnecessary to analyze all the variants of outcomes; instead we assumed two possible outcomes: TiVo wins the court case, or TiVo loses the court case. First, let’s look at the history of the stock price, and the timeline of the court battles.
TIVO Legal Timeline
SOURCE: Multichannel News research
January 2004: TiVo files lawsuit against EchoStar (SATS).
April 2006: Federal jury finds against EchoStar.
August 2006: Texas district court issues injunction against EchoStar ordering Dish Network (DISH) to disable infringing DVRs.
June 2009: Texas court finds EchoStar/Dish in contempt for violating 2006 injunction; awards TiVo $103 million more.
November 2009: U.S. Court of Appeals for the Federal Circuit hears EchoStar/Dish appeal of contempt ruling; that decision remains pending.
January 2010: Microsoft (MSFT) sues TiVo over two patents, intervening on behalf of its customer AT&T.
If we look at the price of the stock in June 2009, we see a spike upward that correlates to the Texas court decision awarding TiVo 103 MM. It is therefore reasonable to assume similar decisions in TiVo’s favor would also positively affect the stock price.
click to enlarge
Given that the US Court of Appeals in Washington heard the case in November, we assumed the timing of a ruling was within 90 days or so of the hearing date so the earliest we could expect a ruling was sometime in early February 2010. Given the probability of this scenario, we examined option premiums starting in March and subsequent expirations to capitalize on the stock movement and to look for the most advantageous premiums.
Our bet was this:
1) We believed that the courts had already upheld TIVO's position several times since 2004, so a positive outcome was greater than a 50/50 chance and probably as high as an 80% likelihood.
2) This decision was important enough to TIVO so as to impact its stock price meaningfully (greater than 25% in a single day)
3) Options were pricing in such a manner as to allow us to place a 50/50 bet on a positive outcome.
As it happened, TIVO option activity and implied volatilities accelerated as that early February 2010 date approached. Late January implied volatility for February and March Option contracts reached over 100%. These elevated volatilities implied the markets expected a large move soon. Not an unreasonable prediction given previous reactions to the appeals in this case.
So now it gets interesting for us. With TiVo trading slightly below 10 dollars per share in early February 2010 we felt we could make a very high probability assumption that a decision in the case would be announced by March expiration and we also assumed a 99%+ chance that a decision would occur by May expiration.
After looking at various option contracts, we decided on the following trade.
With the stock roughly $ 9.80 we bought 400 TIVO March 7 1/2 puts at $ .55 and sold 400 March 10 puts for approximately $1.80. That trade created a 50/50 bet based on the likely outcomes of the pending decision. We made a fundamental assumption that the court decision’s effect on stock price would be either below 7 ½ in the case of a negative ruling, or above 12 in the case of a ruling in TiVo’s favor. While there was an argument to be made as to how valuable the decision would be we were not concerned with or even interested in those predicted outcomes.
Option pricing allowed us to make a positive expectation bet and that is what game theory is about. It allowed us to define risk vs. reward. This is just one example of the many interesting trades that have limited risk characteristics. In retrospect, given the market's reaction to the ruling it would have been very rewarding to buy option premiums or purchase the TIVO common shares outright, but that was not and is not our game.
Important to this analysis is that the margin was not necessary in this position: we viewed the positive expectation payoffs just as any retail investor would.
Our positive expectation could be calculated like this .80*($50,000)-.20*($50,000) = $30,000. Remember we believe the chance of a positive outcome is 80% plus. We sold 400 spreads for a credit of $50,000 dollars ($1.25 credit per spread). Our maximum gain was that credit and the maximum loss was the difference in strike prices of 10 and 7 ½ or 2 ½ times 400 spreads, which is $100,000 less the premium received of $50,000 or $50,000 risk.
Graphing the TIVO credit spread payoff diagram
TIVO: DAILY 1 YEAR VOLATILITY CHART
Option Volume April 2009 –March 2010
Disclosure: We are short Tivo vertical put spreads which is a hedged bullish position.