November Surprise: Put Options Arrive at Christie's Watches

Over the past two days I've heard rumblings of a somewhat unprecedented event when it comes to watch auctions.

A screengrab

Instagram stories and a WatchPro forum discussion revealed that a Christies auction in Geneva started an hour late. The auction in question involved timepieces from a single owner: consignor Mohammed Zaman. When bidding began, the reserve price for watch lots was reset at a higher level, spreading confusion among participants. Hodinkee's Tony Traina has a pretty good discussion of the controversy which includes official statements from Christie's. (Note to readers: this post is a little light on imagery because the material below deals with some fundamental finance issues).

I'd like to translate the "Christie's surprise" from the language of the auction world to the language of finance. Yes, you may now point back to my prior post about how watches are too often treated like financial instruments when they are not. But in this case, Christies and Zaman participated in contracts which do exist in the world of finance so I'd like to explain because I'm not sure anyone has explained it in this way.

So, here is what happened.

The Chronopulse total watch market index.

First, we should acknowledge that, of late, watch prices have a downward momentum, as shown by Chrono24's new ChronoPulse watch price index (full disclosure, I collaborate with Chrono24 as an outside "consultant" of sorts). In those circumstances, sellers face greater risk that their product, in this case a watch, will go unsold because it fails to meet a reserve price at auction. It is worth noting that sellers do bear a cost when consigning a watch to an auction because it often goes on world tour (and maybe even has a "sleepover" with a collector, as explained by Eric Wind on an episode of the Significant Watches podcast). So the cost to a consignor is really an opportunity cost in the sense that the owner can not wear or enjoy the watch while it is exhibited. For this reason, an unsold watch is a problem to be avoided.

So, a shrewd observer realized that there was an opportunity for mutual gain. Let's call this person Mr. Hedgehog. Hedgehog realized that Zaman (the consignor) may be willing to pay in order to guarantee a floor on proceeds from the sale. So, Hedgehog proferred a financial derivative contract. Actually, what was offered was a contract of contracts for each lot. Zaman paid Hedgehog for this derivative contract. We refer to the payment as a premium. This language is similar to the payment for an insurance policy with good reason. Properly reinterpreted, insurance is actually a derivative contract but let's not get into that.

A little more context before we delve into the details. Hedgehog is bullish on watches. He thinks prices are temporarily sluggish but they will go up in the future. He is willing to go long (buy) watches. Zaman (the consignor at Christies) is bearish on watches, he is worried about all those indicators that prices have faltered (because they have) and he does not want a whole bunch of unsold watches at the end of the day. So the bull and the bear can dance and have fun.

The derivative contract in question is a put option. A put option gives the buyer the right to sell something at a prespecified price. Zaman bought a put option (or collection of put options) which gives him the right to sell each of his watches to Hedgehog at a reserve price which was higher than the reserve price that Christies initially stipulated in their catalog. The new, higher, reserve price negotiated between Zaman and Hedgehog (and perhaps Christies) is equivalent to the strike price in the put option. The high bid price is equivalent to a spot price. If the high bid (spot price) is below the reserve price (strike price) offered by Hedgehog, then the put option is "in the money" and Zaman would exercise the option and sell at the reserve (strike) price. If the high bid is above the reserve price, the put option is "out of the money" and Zaman would allow the put option to expire unexercised.

I'll offer a more concrete example. Lot 2008 was a Ludovic Ballouard "Upside Down" (see first picture above). Christies initially placed a reserve price of CHF 40,000 on this lot. Hedgehog came in and offered a put contract to Zaman of CHF 66,000 which became the new reserve price. Zaman paid a premium for this option. The high bid was CHF 88,200. So Zaman had no reason to exercise the put option, instead he took the spot price (high bid). In this case, the options contract was a loss for Zaman. He was out of pocket the premium he paid Hedgehog for this particular lot.

We can see that Zaman, then, only had upside risk during the auction. If bidders are enthusiastic, he earns more than the new, higher reserve price. If bidding is lackadaisical, he earns the reserve price. Keep in mind that Zaman is also now possibly insured against non-payment from deadbeat bidders (this actually happened with the first Patek Tiffany Nautilus which was sold at auction not long ago, wherein the high bidder failed to deliver funds). You can see why Zaman would be interested in this deal.

Hedgehog immediately earns the premium from selling these put options to Zaman. He only faces downside risk: if bidding is too soft he may have to outlay everything he earned on the premium plus more in order to acquire the watches. But if he is actually interested in owning watches, broadly speaking, and believes that they will rise in price in the future then he does not really expect to lose from this transaction.

This is a classic situation in which two parties with divergent interests / beliefs engage in a transaction which is mutually beneficial. It is certainly true that collectors and bidders outside of the arrangement are potentially left scrambling and dealing with fallout. A whale like Hedgehog makes a big wave.

It is fascinating that this type of financial engineering has arrived on the scene at a watch auction. It remains to be seen if this practice will spread. Part of the reason this strategy works for people like Hedgehog is due to the fact that auction houses have an incentive to artificially suppress the reserve price on a lot. This price is the amount insured by an auction house while it holds timepieces. The lower it is, the less an auction house has to pay the insurance company. Given that this incentive is in place for all auctioneers, there are plenty of opportunities for more Hedgehogs to jump in, profer higher reserve prices, and sell put options to consignors.

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