How Not to Front-Run the News

What does Warren Buffett's purchase of Duracell have to do with options?

Nov 14, 2014 at 9:05 AM
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When the going gets tough, the tough buy batteries:

Berkshire Hathaway just announced it would acquire the Duracell brand of batteries from Procter & Gamble.

According to the announcement, the deal will include approximately $1.7 billion in cash. P&G will also receive $4.7 billion worth of P&G shares currently owned by Berkshire Hathaway.

It probably has more to do with Berkshire Hathaway Inc. (NYSE: BRK.A) CEO Warren Buffett seeing a way to cash out some Procter & Gamble Co (NYSE:PG) shares than any particular bullishness on Duracell. But, who knows? And, unless you're invested in Buffett, who really cares? The media is obsessed with finding clues in everything Buffett does; but it really doesn't affect anyone but Buffett. He has major investing dollars, which means he gets offered opportunities unlike anyone else. At the end of the day, he's the equivalent to an advantage gambler, albeit a particularly brilliant one. Give him enough edge, and he'll likely take on the risk.

But, this deal interests me because of the name "Duracell." In a past life, I was a market maker (MM) on the American Stock Exchange (AMEX). Our book had maybe 10 to 15 options in front of us, and before automation improved by leaps and bounds, you could really only trade what you could see (at least as far as options were concerned).

One of our sleeper options was none other than Duracell. It hardly ever traded. And then one day, someone comes in and pays up for Duracell call options. So, we sold a few. And then we raised the volatility a little. And then the same broker came back and bought more. And we raised them again, and he just kept buying. Or rather, he kept trying to buy. We smelled a rat at some point: when a buyer doesn't seem to care how much he pays, it's a good clue he's onto something.

Anyway, this dynamic played out for a couple days and then magically, news broke. Gillette, an independent company at the time (this was about 15 years ago), was going to take over Duracell. My position was lousy. I was long stock and short calls on a ratio. It was a lousy day in an otherwise great time to be an options market maker.

Fortunately (for me at least), the story had a happy ending. I'm as skeptical as anyone that the exchanges and the Securities and Exchange Commission (SEC) do much of anything to protect smaller players. In this particular instance, the system worked. The call buy orders were so "coincidentally" well-timed that the accounts were immediately frozen. And that was a good thing -- the initiator resided offshore, so once he withdrew his money, no one would see it again. He was given the opportunity to contest the freeze, but he chose to just simply walk away, forgoing illegal profits for (I suppose) the chance of some sort of punishment. So, yada yada yada. We got reimbursed.

I had a few other instances like this while I was a MM, and the system didn't work out quite so well. They ultimately ended in class actions, and we got back pennies on the dollar, something like five years later. So, I guess the moral of the story is don't front-run news in such a ridiculously obvious way.

Oh, and one other lowlight: Somewhere in the midst of the AMEX part of the investigation, they looked back on past expirations. Turns out, I exercised something like 10 calls that were right at-the-money at a couple months before the takeover. They called me to find out why. I pointed out that if I knew something was up, I hid it well by getting clocked when the news actually broke. Anyway, that's my nostalgia break. Back to our regularly scheduled CBOE Volatility Index (VIX) programming next week.

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



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