Synthetic Stock: How Ackman Doubled-Down On VRX

Video Length: 00:15:41

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.