What to make of directors’ dealings

Zero-cost collar. 

Sounds like the tie your grandfather gave you, with soup stains. 

Or was that just my grandfather? But the zero-cost collars that I am referring to are a feature of director dealings on the JSE.

And it’s worth understanding for us normal shareholders.

Firstly, they are completely within JSE listing rules – as long as they have the usual director dealing disclosure (whereby a director has to notify the market, via Sens, of the deal within three business days).

Broadly, a zero-cost collar means that shares held by the person doing the zero-cost collar have both an upside and downside limit. 

Above the upside limit they’ll make no profit, and below the downside limit they won’t lose any money.

How it works

The process is that one sells call options at a price above the current share price. 

By selling call options, the buyer of those options has the right to buy the share at the agreed price and will exercise that right if the share price is above the agreed price on expiry. 

Thus, the director selling the call options won’t profit above the agreed upside price point. 

This sale of call options then generates positive cash flow for the shareholder and they then use that cash to buy put options. 

These put options give the buyer the right to sell the shares at a set price and, if the shares are below that level, they will most certainly exercise that right. 

So now the director has a price floor below which they won’t lose money.

If done smoothly, it is possible that the cash from the sale of the call options offsets the cost of the put option purchase, so it doesn’t cost anything for the director. 

But as mentioned above, this does limit the upside while also protecting the downside, thereby creating a range.

Another important point is that these options will all have an expiry date and if the share price is within the range on expiry, then the options are worthless and fall away, leaving the shareholder with their shares.

The issuer of this zero-cost collar structure will also be hedging, albeit an option hedge is not as linear as a hedge on a futures contract – but that’s a topic for another article. 

But it does mean that the issuer may end up holding a pile of shares that, ultimately, they want to sell because holding shares is not how they like to do business. 

This can of course put pressure on an already weak share, but no more pressure than if the director was just selling shares themselves in the open market.

Should we care?

The question that should then be asked is whether or not shareholders should be concerned when a director places a zero-cost collar.

Certainly, the director is thinking that the share is unlikely to move much higher – otherwise they wouldn’t be giving away upside. 

And they’re also concerned about the share falling. 

But we have to consider a few important points here. 

Firstly, directors are usually over-exposed to their own stock as they receive shares as bonuses and the like. 

Therefore, this is, to a degree, a wealth-management exercise. Also important is that directors are seldom any good at valuing their own (or any other) stock. 

I’ve seen zero-cost collars go horribly wrong as the price continues higher, and yes, I have also seen it work a treat as the share collapses. 

So, I do not let a director’s share dealings inform my investing or trading decisions.

As a last point: We as normal shareholders are fully entitled to enter into our own zero-cost collars. 

We just need to find a broker prepared to put the structure together for us. 

And that usually means we need to have a significant holding.

This article originally appeared in the 4 July edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.