Replicating "The Greatest Trade Ever" by Bill Ackman's
Summary
· 100x in 30 days, with huge amounts of money
· Here is how a small investor could have replicated the same returns or better.
· Would it work now?
· The real reason Ackman trade was so good, and we may not see one like this in our lifetime.
Last night I was writing an analysis on the theory of hedging portfolios, where I explain that you have 3 options: 1) do nothing 2) sell some or all 3) buy insurance (also known as hedging).
As I was describing hedging, of course, I had to talk about the best hedging trade of all times, what the media called “The Greatest Trade Ever” from Bill Ackman in 2020 when he saw the Covid pandemic approaching before most people.
He invested $27 Million dollars and made $2.6 billion, over 100x his investment in just 30 days! This is even more remarkable if you consider the gigantic amounts of money he is managing.
I had the misconception, as most of you probably do, that this could only be achieved by utilizing specialized financial vehicles not accessible to normal investors like us, and that it was an incredible story with not much to learn from. Oh, boy was I wrong!
As I started analyzing different instruments like CDFs, futures, and even options to see if a retail investor could have done something similar. I realized not only could you have replicated his results, but you could also have done even better.
“The greatest trade ever”
Bill Ackman (aka: “baby Buffett”) saw Covid come days before the markets did. This was a time when most people thought it was just a flu. And how could you blame them? There was no data, and the worldwide pandemics of the last century like the Swine flu, AIDs, Zika, Ebola, etc. were in one way or another contained without the world having to lock down or mandating vaccination.
Whatever information Bill Ackman had convinced him that this time we were out of luck.
To hedge his portfolio, he bought a financial instrument called “Credit Default Swap” as insurance for the market crash. Don’t worry I’ll explain everything.
“On March 23rd, we completed the exit of our hedges generating proceeds of $2.6 billion for the Pershing Square funds ($2.1 billion for PSH), compared with premiums paid and commissions totaling $27 million, which offset the mark-to-market losses in our equity portfolio” – Bill Ackman
How Ackman decided to hedge was by buying insurance in case companies started to default on paying their debts, called “corporate bonds”. As you can see from the chart below the yield that the bonds from these corporations were paying were already at historical lows, interest rates were already low, and the market didn’t see any major danger yet to demand a bigger payout.
This bonds index shows that corporations were paying on average 2.89%.
Ackman’s biggest danger was that interest rates would continue to lower. And as you will see in the calculations below small changes in that interest rate create big changes in the valuations of these instruments.
Here you can see the initial yield of the insurance rate, when he bought them it was 0.5% and 30 days later they jumped to 1.35%.
Wait… how do you make billions just because some interest rate went from 0.5% to 1.35%?
Doesn’t seem like a lot right? Well, Ackman bought insurance for $64.7 Billion in corporate bonds… that he didn’t own.
In simple terms is like getting insurance for a house you don’t own (yes you can actually buy insurance for something you don’t own in the stock market), and then the whole town starts burning hours after you bought the insurance. Now everyone is running like crazy looking for insurance, so you sell them yours.
We’ll ignore discount “risk-free rates” to make it easy. This just means that we will be off in our calculations by 1.5% for every year in that contract, for our example is ok.
Here is how it worked:
- Ackman: I want insurance for $67.4 Billion please Mr. Market.
- Mr. Market: “Ok. Do you see the chart? The current rate is 0.5% but you need at least 5 years of insurance”
-Ackman: “no problem”
- Mr. Market: “That would be $67.4 Billion *0.5% a year = $230M year… around $27M a month please”
-Ackman: “here is my first payment see you next month, for my next payment”
Then Covid hits
News headlines: “Everyone is trying to buy as much credit protection as they get their hands on because they don’t know where this is going,” said the head of debt capital markets at one large US bank. – Ft.com
- Mr. Market: “I need to buy back the insurance!”
- Ackman: “Ok. Do you see the chart? The current rate is 1.35% and the contract has 4 years and 11 months left.”
- Mr. Market: “no problem, I need insurance now!”
-Ackman: “That would be $67.4 Billion * 1.35% a year = $874M… around $73M a month for 59 months that I still have left… $4.2 Billion please”
- Mr. Market: “Take my money!”
Hope the silly chat made it easy to understand. He bought insurance initially worth $1.6 Billion and sold it 30 days later for $4.2 Billion. Keeping $2.6 Billion profit. Remember he just paid one month of the premium. So he made around 100x his initial investment.
As you can see he got extra lucky with the timing, and he will be the first one to tell you that. The timing in this trade was impeccable. (see arrows below)
“interviewers: I think you only had 21 million or 26 million in total invested.
-Ackman: ...really understates it’s not credited default swaps are not like options so a CD’s. As a contract is a commitment to make payments over time and we at the peak had 70 billion actually 71 billion of notional insurance that cost about an average of 70 basis points per annum so about 500 million dollars, a committed to make 500 million dollars a year in payments for five years so that's you know two and a half billion dollar commitment again for a seven half-billion-dollar enterprise you know it's not a small number and that's why it's something that an individual really can't do… it was a worst-case we'd be taking it off in 90 days so I thought about that as not a five hundred million risk but rather we're going to spend hundreds… theoretically, we could lose all… 700 million dollars which are, you know, almost nine percent of the assets” - The Hidden side of Bill Ackman
Could you have done it?
So this is my “A-ha moment”.
If you are going to buy insurance (“hedge”) your investments, the next question is how much should you protect?” Do you think the market will fall 10%, 20%, 30%, etc. if so, in what timeframe?
Here is a chart of the worst crashed in the last 100 years:
How much would you be willing to risk? Ackman was paying around 0.5% of his fund every month for this insurance.
Options
I found the best way to replicate the trade was through options.
If you are not very familiar with the option, don’t worry in this paragraph I’ll explain very quickly the basics of this instrument:
· Here we will buy insurance betting that prices will go down.
· If it goes up, we lose our payment. Just like the monthly insurance premium for your car.
· But you have to be right in the price you think the market will end up in this time frame.
· We call the price you are betting the market will eventually crash to the “strike price”.
· If you miss the strike price your contract will be worth $0 in the end, so you have to sell this contract as soon as you can in order to recoup some money before it turns into $0.
· The closer the strike price you chose, the worst your return, you are playing it safe, but if you miss it you may end up with nothing.
The importance of timing
Ackman made 100x on 0.5%, this profit represented 50% gains for the fund. If his thesis had taken 3 months instead of 1, he would have had a 33x instead of 100x, and a 15% gain instead of 50%. As you can see timing has a huge effect on these instruments, you better get this right if you are going to play the hedging game.
Dates
We’ll assume he entered in the exact top when SPY reached $340 on Friday, February 14, 2020, and we´ll also assume we sold the positions 30 days later, on Monday 16/3/2022.
Expiration time of the options
Ackman only planned to stay in the trade for 90 days, so we will have bought the contracts expiring on “15 May 2020”, which gives us 91 days.
I´ll backtest multiple scenarios:
Since we would have had not to clue how low the market would have gone let’s just test everything, for 10%, 20%, 30%, 40%, and 50% drop in price.
10% expected drop scenario:
We buy puts at $306 strike for $2.29 for each contract, which we end up selling at $66.70, or 29x times your investment.
20% expected drop scenario:
We buy puts at $275 strike for $0.73 for each contract, which we end up selling at $43.91, or 60x times your investment.
30% expected drop scenario:
We buy puts at a $240 strike for $0.26 for each contract, which we end up selling at $ 26.59, or 102X times your investment.
40% expected drop scenario:
We buy puts for a $205 strike for $0.11 for each contract, which we end up selling at $13.97, or 127x times your investment.
50% expected drop scenario:
We buy puts for a $170 strike for $0.04 for each contract, which we end up selling at $6.09, or 154x times your investment.
This was my A-ha moment! A normal investor could have had the same return as Ackman, and even better with financial instruments available to anyone!
Perfect timing theoretical trade at 34% drop scenario:
However, just in case, you are wondering about the perfect trade where we would have guests almost perfectly where the market was going to fall. That lowest low was on the 23 of March which represented a 34% drop, that day the market closed at $222.
The closest contract then was the $220 strike at $0.16 each. And then you could have sold each for $18.76, or 117x times your initial investment.
You may have noticed that we would have made more money if you bought contracts that expected a 50% drop, rather than perfectly hitting the exact price.
Why is this?
The implied volatility of the Options almost doubled. This is financial lingo to say, people got really scared and wanted insurance, so they were willing to pay twice as much for these contracts as 30 days before, so the price of all the contracts just skyrocketed.
Before you get excited and try to go out and buy puts every time you think the market is going to crash, here is a reality check: the problem in real life is volume. The day we got IN this trades there was no volume for the $170 contract for our 50% drop and potential 15400% winner. Most likely you would have put an order and come out empty-handed, we would never know. You could have raised the price enough for a logarithm to take your trade or maybe you could have waited to finally go to another contract with less return but more liquidity.
Would it work now?
As you know the market recently went down -10%. That day I received multiple calls from investors in my fund asking what to do and if we could buy insurance just in case. Which prompted me to write this article.
The question is: Could we have used this technique last month to hedge our portfolio? The answer will surprise you.
The $SPY, an ETF that represents “the market” picked at $480 on December 31.
Looking to hedge for 90 days, as we did before, we would have chosen the closes contract that expires on “14 April 2022” which would give us 104 days. (note: the 90 day “31 Mar 22” is too illiquid and won’t allow us to get the contract we want)
We used our “proven” technique of buying insurance, assuming it drops 50% at $240.
The contract that day of $240 strike could be bought at $0.41 each and sold a month later for $0.35. That’s a 15% loss. Wait… what happened? Where is our 30x, 60x, 100x? The market just crashed 10% already in two weeks, sure it has come back, but we are still down 6% in less than a month. Where are our amazing returns?
Implied volatility, when we bought, was 68.33% and when we sold was 61.53%.
Meaning: the market was already expecting something like this and priced it accordingly, so our hedge wouldn’t be very attractive.
Could we have used this technique last month to hedge our portfolio? No.
The real reason Ackman trade was so good, and we may not see one like this in our lifetime.
This gives us the last piece of the puzzle to understand Bill Ackman Greatest Trade, he bought the instruments already cheap because the market didn’t know what to expect of a pandemic, everyone was expecting “business as usual”, and this is really what makes Ackman’s trade so remarkable.