Like Speculation? Here Are Some High-Risk, High-Reward Ideas
Trading the Outcomes of IP Lawsuits
Traders
sometimes speculate on the outcomes of IP lawsuits; particularly jury-based
lawsuits, which tend to be unpredictable. The stocks of semiconductor-maker
Rambus Inc. and Research and Motion, maker of the BlackBerry e-mail device, are
two examples in technology. The outcome of SCO Group’s lawsuit against IBM
(ostensibly a software company, but which now has a litigation-based business
model) is another; SCOX has become a cheap vehicle to play the outcome (if I
were a speculator, which I’m not, I’d be short SCOX).
When
playing the outcomes of lawsuits, it’s essential to understand the relevant
legal issues, or find a legal consultant who can explain them and provide timely
information; and you need to be sure you’re right. For
my part, I don’t trade the outcomes of lawsuits; it just isn’t my edge and I
avoid it. It’s too risky and even if the outcome that was predicted actually
occurs, the stock price may not experience the expected reaction. (Although the
position could be hedged, of course, by way of puts or calls.) Some traders like
to hold the position during the events; and others exit the position before the
events occur, since they’re just trying to anticipate a move prior to these
events / catalysts and trading the buildup.
Aside from IP
lawsuits, examples of similar speculations in other industries include Food and
Drug Administration rulings or positive outcome expected on a certain date (past
examples include SUPG or CYBX); Homeland Security conference (ISON, MAGS, TBUS);
State of the Union address (usually see a bid in fuel cell stocks); another test
of a Mad Cow disease (EMRG) are just a few examples of these speculative plays.
Gaming the outcome of
the asbestos class is another example, and which, by
the way, I think should be settled more favorably helping stocks like CCK (Crown
Holdings. This particular situation could be played by owning the stock, call
options on CCK, or even by owning the company’s bonds that are trading at a
discount a 95 and yield 8%. The pharma and biotech sectors are also heavily
speculated on legal suits, fraud, FDA approvals, etc… but it’s no more than
gambling.
Rambus is
an example of a company being used as a trading vehicle to speculate on the
outcome of an IP infringement lawsuit.
Rambus licensed chips used
to increase the speed of computer memory systems.108
percent is a great return, particularly in three days. But the risks of
speculating on these legal outcomes are high. (IFX, Infineon’s stock, fell
modestly on news of the reversed decision.)
In the original case, Rambus
sued Germany’s Infineon Technologies AG, claiming Infineon infringed Rambus
patents in the design of some of Infineon’s computer memory chips.
In May 2001, a jury in
the U.S. District Court for the Eastern District of Virginia ruledÂ
that Rambus had committed fraud against Infineon. Two elements of the fraud
ruling were: 1) Rambus failing to properly disclose relevant patent information
when required by an industry standards body, the JEDEC to whom it had applied
for patents on come of its memory chips; 2) Rambus failing to disclose that is
was prosecuting patent applications targeting the JEDEC’s standards for SDRAM
(synchronous DRAM) memory chips. (SDRAM can synchronize itself with the system
bus and process speeds and can run at higher speeds than the previous EDO
(extended data out) random access memory, thus enhancing computer performance. A
good Web link to explain how memory works is Advanced Horizons Inc.)
The jury ruled that Rambus intentionally and unfairly took advantage of its
membership in the JEDEC in order to secure the standards for SDRAM chips. There
was more to the case, but that’s the gist of it.Â
On January 29, in a
two-to-one decision, a three-judge panel of the U.S. Court of Appeals for the
Federal Circuit overturned the original jury verdict against Rambus and the
original trial judge’s decision upholding that verdict. That event set off the
giant up move in RMBS stock: 57 percent that day, 108 percent over three days.
Take another
example: Research In Motion and athat the
Research In Motion BlackBerry infringed on five of its patents. The
killing on the short side would be made if the Patent Office ruled against
Research In Motion. During the 18 months or so that this case was in the works,
there were periods when there was a substantial overhang on RIMM due to various
court findings pertaining to its breach of patent rights and which could have
resulted in substantial payments.
In August
2003, a U.S. court awarded NTP $53.7 million in damages, plus a 8.6 percent
royalty on all revenue from BlackBerry sales in the U.S. Research in Motion
appealed the decision to the highest U.S. patent court. On Tuesday December 14
2004, a U.S. appeals court ruled
that Research In Motion had
infringed on NTPs patent – but sent the case back to a lower court for some of
NTPs claims to be reconsidered. The ruling caused RIM’s stock to fall 5 percent
from the previous day’s close of $90.09, to close December 14 at $85.44, and it
fell another 3 percent on December 15, to close at $82.6, after trading in the
stock (which trades on the NASDAQ) had been halted in early afternoon (see chart
2). Notice the wide
intra-day trading spread on the 14th: intra-day trading high of
103.56 to an intra-day trading low of 85.44. Notice also that RIMM had been
trading down into the decision since the week before from it’s December 2 close
of $92.85.
Chart 2: One-Month
Performance of RIMM
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Although the
rewards for being right might be high, it’s a pretty tough way to trade and the
risks are also high. Legal outcomes are extremely difficult to handicap because
there are so many variables that can really throw off what would otherwise be a
good trading strategy. Take a regular trading plan (which can be difficult
enough); then throw in a number of potential legal landmines to complicate
matters; then add to that the complex pricing of options (if you’re playing the
outcome with options and not equity) and this becomes a really difficult way to
make some money. So many traders have weighed so many scenarios for the legal
outcomes that the trading edge can be all but non-existent.Â
So it all comes
down to some cold hard numbers in terms of trading strategy: normal loss cutting
at, say, 5 percent to 7 percent, then cutting losses on the spread of a highly
volatile option (say 10 percent to 15 percent) on the capital of the capital put
into the option. That is a total of 15 percent to 22 percent, which is going in
someone’s pocket and it’s not mine. So, it’s a pretty tough way to make some
dough.Â
My best experiences
have come from nailing the timing with a cheap option and having invested
relatively little money in the position, or from catching the ramp in volatility
before the street has caught on to the implications of legal matters in
the story (and that inefficiency pops up on occasion). From my experience the
“put option” or shorting the stock is often a better way to go. First, the
public, which is inherently optimistic, always like to be long. Second, stocks
moves to the downside tend to be larger than moves to the upside, although not
without exception. Third, as the market rallies investors pay less “fear”
premium for puts because volatility is getting priced out generally speaking
(the reverse is not true for calls — as the market drops fear rises and so do
premiums). So, if you must trade on legal outcomes, I’d tend to trade on the
short side.
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