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Is an options strategy that creates “synthetic” stock just like owning actual shares of a company? Apparently the SEC thinks so as they list Bill Ackman’s Pershing Square Capital as the proud owner of 12.5 million more shares of Valeant Pharmaceuticals (VRX - Analyst Report) in November, boosting his stake to 9.9% of the company.

In an SEC 13D filing on Monday, Pershing Square revealed that four of its funds were the recipients of a massive OTC (over-the-counter) options trade that cost the firm over $61.5 million and could net Ackman and his investors over $575 million if VRX stock rallies above $165 by January of 2017. 

In the video that accompanies this article, I describe the entire synthetic trade and all its moving parts using an option risk/reward profile graph. The trade is a fascinating study of how options can be used to increase stock exposure with leverage and the unique flexibility of options.

I also explain why this trade was done OTC or “off-exchange” with an international investment bank as the likely counterparty. The primary benefits for Pershing Square were privacy and the ability to negotiate one transaction price with the bank without moving the market before the options contracts worth millions of shares could be secured. 
 
Investment Ownership, or Pure Speculative Leverage?
 
But I disagree with these call options as representing another 4% ownership in Valeant shares for Pershing Square. Here are my three reasons…
 
First, equity option holders do not enjoy the rights due stockholders (e.g., voting rights, regular cash or special dividends). A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.
 
Second, none of the call options are in the money, so Ackman couldn’t (or at least shouldn’t) exercise them even if he wanted to.
 
Third, Ackman executed this strategy of buying call spreads and selling puts because he didn’t have enough cash to buy the shares outright.

All of which probably means he won’t be exercising the long calls anytime soon. Additionally, he’s obligated on the short puts and short calls portions of the trades. So the only real way to cash-in on these trades if they are profitable is to go back to the investment bank he did the deal with and close them.

Instead, I think he plans to hold these trades for some time and realize the profits of his extremely bold genius. One wonders though how well he will sleep at night with this kind of leverage and risk in a company that might have some continuing issues before the stock sees much daylight above $100 per share again.
 
The Clock is Ticking
 
On November 19, I put together a video report and article on the big investors who just watched huge profits evaporate as Valeant shares plunged from $240 to $80 in two months. Very few of these investors have bought more on the way down, except the two biggest shareholders, the Sequoia Fund and Pershing Square. 

For those who have held on to their shares, it could be a long wait to see their investment recouped. But Ackman is on a different clock with part of his money. Let me explain.
 
The big Pershing Square options trade I describe with an expiration in January 2017 was for 9.12 million shares of stock. That trade has a little brother worth 3.38 million shares (combined they equal 12.5 million) with an expiration on February 8, 2016.
 
This trade has a break-even price of $101.18 and thus will begin to create profits for Pershing Square when Valeant shares are above that price. And for his nearly $4 million investment in this strategy, he can realize full profits of over $97 million if the stock only gets above $130 by February 8.
 
Therein lies the problem. That’s only about 10 weeks away. And as I write on Wednesday November 25, the stock is still floundering under $90. While the risk/reward on this trade is fantastic with a $4 million bet to make 24 times that amount, the clock is definitely ticking… loudly.
 
Selling Puts is Great… As Long As You’re Ready to Buy the Stock
 
In the above trade with the February expiration, Ackman sold the 70-strike put to help finance the purchase of the 100-130 call spread. Selling puts is a favorite strategy of many savvy investors (and me) whereby you get paid for taking the risk of buying the stock cheaper.
 
For instance, Ackman’s Pershing Square sold 3.38 million February 8th, 2016 70 puts for oddly enough $3.38 per share. This income reduced the cost of the 100/130 call spread to only $1.18, thus the break-even price of $101.18 on the strategy.
 
If Ackman’s bullish stance on VRX is correct and the stock never goes below $70 by the February expiration, Pershing Square keeps the entire amount collected for those short puts. But if it does drop and stay below $70, he’s on the hook to buy 3.38 million shares at $70. According to the firm’s latest quarterly filing, they don’t have that kind of cash left.
 
To get all the details of these trades, be sure to watch the video that accompanies this article.
 
Ringside as a Hedge Fund Fights for Its Life
 
Some may get tired of hearing about Bill Ackman and Valeant Pharma, but I think studying this investment – its ups, downs, tricks, and traps – is a fascinating study in both the power of derivatives and that of investing bias that makes a guy double-down on a great trade gone wrong.
 
If this all continues to go wrong for Ackman in the next year, you can explain it all to your friends because you’ll be an expert after watching my video.

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