How Baseball Stars Play Put Options

Baseball contracts are stealing a move from Wall Street

by Adam Warner

Published on Dec 18, 2015 at 9:07 AM

The Fed hiked, and all we got was more churn. They throw around the term "historic" about this rate hike over and over again because … I'm not real sure. "Historic" was the zero interest rate to begin with, I'd think. I mean, that's a record we're never going to take out. "Not historic" is positive interest rates. We have them all the time.

Did we make more of a big deal of this hike than ever because it was so "historic," or is it just the nature of the times? By that, I mean everything seems like a big deal in 2015, in a world of Twitter and Facebook and Instragram and everything else that spreads discussion and news in a millisecond. I'd throw in that financial TV is essentially niche programming, and as such there's a tendency to rehash the same story over and over again. There's an awful lot of hours to fill, and there's generally not hundreds of topics to divide the time on.

Long story short on volatility going forward is that with news out and holidays on tap, it's likely that the CBOE Volatility Index (VIX) drifts a bit. But hey, I've thought that before, and volatility has spiked in my rhetorical face. That's a topic for next week, though.

For now, the most interesting thing in options is … they're embedded in baseball contracts now. Seriously! Oh sure, they call them "opt-outs," but they're really put options. And all the cool kids get "opt-outs" now. And by "cool kids" I mean, "guys who get huge contracts." Like Jason Heyward and David Price, to name two.

Here's the deal. Jason Heyward signed for eight years/$184 million. But he can opt out after three years and about $70 million and become a free agent. He can also do that after four years.

So, what he's really done is sign a three-year contract with two embedded puts. After three years he can exercise his put and get another $23 million from the Cubs. And then, after that year, he can exercise his second put and get another four years and the remaining $90 million or so (not sure the exact breakdown each year).

What are those puts worth? It's tough. And it's variable to the specifics of each contract. Some guy did the math on David Price and it's worth about $10 million. Heyward is younger, and theoretically less likely to exercise -- but on the other hand, he has a second put thrown in and that has to be worth something.

It seems like a nice "get" for the players. If they do poorly or get injured or baseball money dries up, they can just exercise and rake in a very nice payday. If they do well, they exercise on the full knowledge that they will add years and more dollars to what they're already earning.

Why do teams do it? Well, it's a competitive bidding process, so presumably they have to in order to get the player. The better question is whether they get the guy any cheaper if they include the opt-out. Would it cost the Red Sox $227 million to sign Price without the opt-out? Tough to know, but I suspect not -- the teams are just adding value.

Don't hold a charity function for the owners just yet, though. As mind boggling as the contracts look, it's pretty certain the overall MLB revenues justify the expenses. What's more, the teams might actually like the opt-outs, as the Fangraphs articles note. No contract looks great in the later years. If I'm a team, I'm crossing my fingers my guy opts out and then I'm "rolling" the money into the next free agent, and hope he stays three to four years and opts out, too.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research


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