Excerpt from the New York Times Bestseller, The Big Short / by DED

These are the sections of the book which first gave me the idea to apply LEAPS to Apple.  Which is what eventually led me to Steve.

As he scrambled to find office space, buy furniture, and open a brokerage account, Mike Burry received a pair of surprising phone calls. The first came from a big investment fund in New York City, Gotham Capital. Gotham was founded by a value investment guru named Joel Greenblatt. Burry had read Greenblatt’s book You Can Be a Stock Market Genius. (“I hated the title but liked the book.”) Greenblatt’s people told him that they had been making money off his ideas for some time and wanted to continue to do so—might Mike Burry consider allowing Gotham to invest in his fund? “Joel Greenblatt himself called and said, ‘I’ve been waiting for you to leave medicine.’” Gotham flew Burry and his wife to New York—and it was the first time Michael Burry had flown to New York or flown first-class—and put him up in a suite at the Intercontinental Hotel…

…what happened next led Jamie & Charlie, almost by accident, to the unusual approach to financial markets that would soon make them rich. In the six months following the news of its troubles with the Federal Reserve and the Office of Thrift Supervision, Capital One’s stock traded in a narrow band around $30 a share. That stability obviously masked a deep uncertainty. Thirty dollars a share was clearly not the “right” price for Capital One. The company was either a fraud, in which case the stock was probably worth zero, or the company was as honest as it appeared to Charlie and Jamie, in which case the stock was worth around $60 a share. Jamie Mai had just read You Can Be a Stock Market Genius, the book by Joel Greenblatt, the same fellow who had staked Mike Burry to his hedge fund. Toward the end of his book Greenblatt described how he’d made a lot of money using a derivative security, called a LEAP (for Long-term Equity AnticiPation Security), which conveyed to its buyer the right to buy a stock at a fixed price for a certain amount of time. 

There were times, Greenblatt explained, when it made more sense to buy options on a stock than the stock itself. This, in Greenblatt’s world of value investors, counted as heresy. Old-fashioned value investors shunned options because options presumed an ability to time price movements in undervalued stocks. Greenblatt’s simple point: When the value of a stock so obviously turned on some upcoming event whose date was known (a merger date, for instance, or a court date), the value investor could in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. “It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!

 The right to buy Capital One’s shares for $40 at any time in the next two and a half years cost a bit more than $3. That made no sense. Capital One’s problems with regulators would be resolved, or not, in the next few months. When they were, the stock would either collapse to zero or jump to $60. Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions. 

For instance, it assumed a normal, bell-shaped distribution for future stock prices. If Capital One was trading at $30 a share, the model assumed that, over the next two years, the stock was more likely to get to $35 a share than to $40, and more likely to get to $40 a share than to $45, and so on. This assumption made sense only to those who knew nothing about the company. In this case the model was totally missing the point: When Capital One “stock moved, as it surely would, it was more likely to move by a lot than by a little.

Cornwall Capital Management quickly bought 8,000 LEAPs. Their potential losses were limited to the $26,000 they paid for their option to buy the stock. Their potential gains were theoretically unlimited. Soon after Cornwall Capital laid their chips on the table, Capital One was vindicated by its regulators, its stock price shot up, and Cornwall Capital’s $26,000 option position was worth $526,000. “We were pretty fired up,” says Charlie.

“We couldn’t believe people would sell us these long-term options so cheaply,” said Jamie. “We went looking for more long-dated options.”

It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency—really anything with a price that seemed poised for some dramatic change—and then work backward to the thing the option allowed you to buy or sell. The options suited the two men’s personalities: They never had to be sure of anything. Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events. Both had trouble generating conviction of their own but no trouble at all reacting to what they viewed as the false conviction of others. Each time they came upon a tantalizing long shot, one of them set to work on making the case for it, in an elaborate presentation, complete with PowerPoint slides.

This is for education purposes only, past performance is never indicative of future results, this is not advice, nor am I or OP responsible for anything you do in your own account so don’t be dumb because it’s on you.  This is a social network for traders not Goldman Sachs.