Real World Options Example: How Mark Cuban Used Options to Survive the Dotcom Crash

The Genius Options Trade that Saved Mark Cuban Billions of Dollars

If you’ve ever watched Shark Tank you’ve probably heard the intro to the show introduce the “billionaire investors” including Mark Cuban.  But not many people know how Cuban made those billions or how he employed a genius options strategy to prevent his billions from turning into nothing during the dotcom crash at the end of the 90’s.

In this post I’ll break down Cuban’s strategy and also post a ton of Mark Cuban gifs so get ready.

How Cuban Made His Billions

In 1995 Mark Cuban and his business partner, Todd Wagner, created Broadcast.com.  This website streamed audio and video for radio, TV, and sports.  Now days that’s nothing impressive but in 1995 when most people weren’t even using the internet, it was revolutionary.

At the same time, Yahoo! had a market cap of $130 billion.  In the run-up to the dotcom crash they reached a peak valuation of $300 billion before crashing all the way down to $10 billion.  Yahoo! bought Broadcast.com from Cuban for $5.7 billion.  As part of the deal, Mark Cuban received 14.6 million shares of Yahoo! stock which were worth about $95 at the time.  This meant his net worth, on paper, was worth roughly $1.4 billion.  One of the restrictions on the sale was that Cuban wasn’t allowed to sell the stock for 3 years.

Having all of your net worth wrapped up in one single company is a recipe for disaster.  Just ask anyone who worked at Enron or even Yahoo! during the dotcom crash.  Your entire net worth could evaporate and leave you broke.  So if you can’t sell the stock, what can you do? Cuban was smart and he hired some smarter guys from Wall Street to come up with a way for him to protect his wealth via stock options.

The Costless Collar

The strategy Cuban used is known as a costless collar.  A collar is used when you own stock and want to protect yourself from any downside risk.  The way to do this is to buy a put option.  If you have 100 shares of stock worth $95, you can buy a put with a $90 strike price which means if the stock drops below $90, you can sell the person who sold you the put all of your stock at $90 per share.  Even if the stock goes to $0, that person is still obligated to buy your stock for $90.  This is how you limit your downside.


Here’s a picture showing visually what a costless collar would look like.  The x-axis shows the price of the stock and the line on the graph is your profit.  As the stock price moves down, your profit never crosses $0, guaranteeing no losses.  As the stock price moves up, you can actually make money up to the strike that you sell your calls at.

Picture from theoptionsguide.com


The problem with this trade is that it costs money.  Depending on the volatility of the stock, these options could cost anywhere from $0.05 to $5.  I don’t have any exact pricing data from 1995 but in Cuban’s scenario with 14.6 million shares of stock, to protect all downside risk he needed to purchase 146,000 options contracts (since 1 option contract controls 100 shares of stock, just divide 14,600,000 by 100 and you can figure out how many contracts are needed to offset your stock position).

Purchasing 146,000 puts would not be cheap, especially on such a volatile stock like Yahoo!.  Also since Cuban’s contracts were 3 years out in time, the premium on these would be really expensive.  If you own Yahoo! at $95, the odds of it going to $90 in 1 day are pretty low so the put option expiring 1 day out would be very inexpensive.  But the odds of Yahoo! going below $90 3 years from now are much higher, probably 50/50 assuming random movement. 

To avoid losing part of his $1.4 billion to buying put options, Cuban also sold call options that would offset the price paid for the puts.  Selling a call option on stock that you own is a common strategy known as a covered call.  This strategy limits your upside by guaranteeing that if the stock passes a certain price, you will be obligated to sell your stock to the person who purchased the option you sold.

The Nuts and Bolts of Cuban’s Trade

  • Cuban owned 14,60,000 shares of !Yahoo at a value of $95 per share.
  • Cuban bought 146,000 put options with a $85 strike.
  • Cuban sold 146,000 call options with a $205 strike.

The premium paid for the put options was equal to the premium he received for the call options which meant he paid $0 (except the fat commissions the investment bankers earned).

So at the time of the trade Cuban’s net worth was $1.4 billion.  If Yahoo! tanked, Cuban was guaranteed he could sell all of his stock at $85 per share and receive $1.2 billion.  If Yahoo! took off and went up past $205, Cuban was going to be forced to sell his shares for a total of $3.0 billion.   

 

Options: Not Just Speculative Gambling

A lot of people are quick to dismiss options as risky derivatives or legalized forms of gambling on stocks but that couldn’t be further from the truth.  With the right strategy and gameplan, options can be a critical part of your portfolio and in some situations, like the one Mark Cuban found himself in, they can literally save you from losing billions of dollars.  Of course the hard part is getting the billion first; protecting it is much easier.

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