Betting against the market on lawsuits

Larry Ribstein —  5 June 2011

Ted Frank’s making a big play on Wal-Mart.  He’s

very confident that Wal-Mart v. Dukes will result in a reversal of the class certification in the enormous multi-billion dollar class action against it. But the things that make me confident in that result—the briefs, the tenor of the oral argument, the language in AT&T Mobility v. Concepcion about the importance of protecting the rights of unnamed class members—did not produce movement in the market price of Wal-Mart stock. This leads me to suspect that the market is undervaluing the probability of reversal, and will be surprised when the Supreme Court does reverse later this month.

So, criticizing “economists [who] make clever predictions but aren’t willing to bet on them,” Ted’s

put my money where my mouth is: with the dip in stock prices last week, I invested a bit over 10% of my net worth in a leveraged bet that WMT stock will bounce this month when the Supreme Court releases its decision through purchases of July and September out-of-the-money call contracts.

He admits he could be wrong about the result or about whether the market has priced it in, or be right and be punished anyway because the market could move for other reasons and he’s paying a lot to make the bet.

I agree with Ted about the risks, particularly including the risk the market’s already priced this given Wal-Mart’s huge float and analyst following, and about the costs of making the bet.  On the other hand, Ted’s post illustrates the costs of arbitrage, and therefore why markets could be wrong. It also illustrates how making betting against the market cheaper would increase market efficiency (and, as Ted notes, counteract a trial lawyer strategy).

But my main point here concerns my views about a potentially expanded role for legal information experts in capital markets. Here’s an excerpt from Kobayashi & my Law’s Information Revolution (footnotes omitted):

Law-related matters generate many types of information which can have significant market value because of the potentially high stakes of legal outcomes. In particular, litigation significantly affects asset values.  All firms have some litigation risk, and some firms have a lot riding on actual or potential tort or intellectual property litigation.  * * * This suggests a market demand for legal analysis in connection with firm valuation. 

So if Ted survives his Wal-Mart gambit, he might consider bundling this sort of activity with his main gig.

Larry Ribstein

Posts

Professor of Law, University of Illinois College of Law

12 responses to Betting against the market on lawsuits

  1. 

    Got to be honest … I think we’ve had enough promo of the legal information markets piece.

  2. 
    Mo Strategist 6 June 2011 at 6:38 pm

    I made a boatload of money this way betting on Philip Morris (/Altria) stock several years ago.

    Bought a bunch of LEAP call options that ultimately returned well over 200% each.

    Its a good strategy *IF* and *ONLY IF* you have a good handle on how the legal risk has affected the stock price, plus have some reasonable sense of the timeline for a decision (timing of SCOTUS opinions can be hard to predict). Otherwise, its just a shot in the dark, because you can be right, and right for the right reason, yet still not be able to capitalize on a stock move.

    Incidentally, risk of this sort of position is *NOT* 100% unless you’re stupid enough to buy at the money (or worse, out of the money) call options with short expiration dates. Yes, if you do that, and if you’re right, you can quadruple your money in a day, but if you’re off in timing or magnitude, you can lose all of it.

    There are other types of options positions that could make more sense, depending on what kind of move you’re trying to capitalize on and in what time frame.

    LEAPs are good this way, because they’re basically just like leveraged stock positions. Lower reward, and lower risk than short-expiration time options.

  3. 

    My wife and I have discussed a similar strategy, but have not executed it. The strategy is to be in court when an important decision comes down then step out of the room and execute the appropriate online trade before newswires publicize the decision. With the proper preparation, I think it’s absolutely doable.

  4. 

    The decision will come down before July 1 and I’ll exit within 24 hours of the decision. I waited until after the May 16 earning report release to reduce risk unrelated to the release of the decision.

  5. 
    north fork investor 6 June 2011 at 5:32 am

    At least you are buying very low vol at decent chart points. And there does not appear to be any increase in implied volatility in these options since the arguments were made by other speculators. All to the good. Because you don’t have a lot of alternative routes on the July exit. As I am sure you are aware it is difficult to believe you can be bailed out by the general market for the July series. The Street is very down on retail except for the highest end chains as a function of higher gasoline costs and inflation at the grocery store. Perhaps you have multiple exits for the September series. Maybe all it would take is a good employment number.

    If between now and July 16 you get the decision you predict and get a strong WMT reaction putting your July position solidly in the money, it might be more efficient (trading costs and spread) to short WMT against (some or all of) your July calls if you have the capital to do so which could give you additional trading opportunities if the WMT decision-related “pop” is short lived.

    Good luck. It’s a cheap enough trade that I’ll probably join you on the Septembers. I’ll be tracking the stock and the decision.

  6. 

    1100 contracts July 55 call
    300 contracts September 55 call

    I am an options neophyte aside from my graduate-level finance classes twenty years removed. The 10% of my net worth is coming out of my gambling budget; I view it as a very good Kelly bet. “Playing with house money” is an economic fallacy (I won it, it’s now my money), but I’m playing with house money from a decade of gambling profit, so you’re on to something when you say this is more like gambling than sound finance.

    • 
      north fork investor 20 June 2011 at 11:31 am

      Ted. So the decision was out and whle WMT did tick up a bit (to give it back later on in the day) it appears to be a non-event for the most part. I think because of the low vol depending on your entry you should not have lost too much if you exited today as you said you would. Which is all to the good–it was a big bet.

      I asked several other event risk hedgies whether they were speculating on the decision and didn’t find you had much company among the pros. I put on a slightly different derivitive position however that benefited from WMT’s recent bounce (but probably not the decision.) I’m exiting some and keeping some.

      Thanks for blogging about it. An interesting trade nonetheless

  7. 
    north fork investor 5 June 2011 at 9:50 am

    I hate the idea of anyone betting 10% of his net worth on a position that could be worthless regardless of whether he is right on the Supreme Court decision. No professional would put on this position in this size. A gambler perhaps. (I’d like to know the exact calls purchased.) Plus the way he described the trade costs and the position he took kind of makes me think he is a neophyte in managing option positions.

    However I hope he is right in all respects and quintuples his bet. Then we’ll match him up to a professional manager and raise him a fund.

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