Options Experts - Could use your help

[FlyingArrow]

I'm appealing to the options guru's on the site to help me value a financial option on an asset. This is not a stock option.

 

I can purchase this option for $15k which will enable me to purchase an asset in 48-60 months at a price that will be $300k below market value at that time. This is a binary event. It will happen or it will not. I estimate the likelihood of it happening being approximately 25-35%. Hence, I am purchasing a $15k option which has a 25-35% chance of being worth $300k in 4-5 years and a 65-75% of being worth zero.

 

This is part of a larger financial transaction so I'm trying to determine how to calculate the value I might assign to this component and how that value might vary based on the chance of occurrence, the timing of the occurrence and the final value.

 

Thanks for your help.

 

Cheers

 

Mark

[Packer16]

Will the payout for the option only occur if the event comes to pass?  You state a $300k below market value.  How is that determined?  Does it include a lack of liquidity discount?  What is your opinion on the value of the underlying asset (i.e. is it undervalued, overvalued or fairly valued)?  My initial take is to run a sensitivity analysis with varying probabilities of the event occurring, time frames and lack of marketability discounts (if applicable).  You have identified 2 payout scenarios are there any other likely scenarios?  If you are trying to allocate a total purchase price for what purpose is this? If it is for your own investment you may want to use a scenario analysis (described above) if for financial reporting or tax you may want to use an option model (BS or Binomial if value of the option is significantly dependent on factors other than the underlying asset price) as the reviewers of the analysis will be comfortable using this method.  The best approach is dependent upon the specific facts of the case. 

 

Packer 

[SharperDingaan]

 

30% chance of 300K is 90K, for which you're paying 15K.

Alternatively to recover the 15K the chance of the 300K occurrence must > 5%.

 

The numbers say do it, the fact that you've asked - say no.

When you're more concerned about the loss its usually a sign that you aren't yet ready.

 

SD

[biaggio]

 

30% chance of 300K is 90K, for which you're paying 15K.

Alternatively to recover the 15K the chance of the 300K occurrence must > 5%.

 

The numbers say do it, the fact that you've asked - say no.

When you're more concerned about the loss its usually a sign that you aren't yet ready.

 

SD

'

 

 

65-75% chance of it going zero tells me that you should not do it or you should do it with relatively small portion of your portfolio...I am probably wrong, just putting this out for my own education

[twacowfca]

 

30% chance of 300K is 90K, for which you're paying 15K.

Alternatively to recover the 15K the chance of the 300K occurrence must > 5%.

 

The numbers say do it, the fact that you've asked - say no.

When you're more concerned about the loss its usually a sign that you aren't yet ready.

 

SD

 

 

Excellent advice!   There are other factors that urge caution.

 

The time value of money.  4 to 5 years to close

 

The value to you if this works out favorably may be only about half the $ 300K you estimate because holding an asset at a discount to market value is not the same as treating the discount as a gain.

 

Using the Kelly Criterion helps clarify the risk of buying the option.  Reducing the value of a favorable outcome to $150K suggests that you should risk no more than 22% of your funds that you can afford to lose to buy the option.  Risking no more than a half Kelly, 11% of your funds at risk should be the max IMO because scenarios such as the one you describe are usually riddled with overly optimistic biases.

[FlyingArrow]

Thanks for the feedback. I realize you're all "flying blind" as I can't disclose all details.

 

This option is a kicker on a much larger transaction which in itself is not an investment per se, but an asset I will use for my business. I will be doing this regardless as the 15k is a very small cost component of the overall transaction. The $300k is already discounted due to it being a future asset you'd have to flip to realize the gain. If it comes together it's more like $600-$700k benefit and I might actually keep and use the future asset vs. sell it right away and take the gain. As to the timing, it could happen as much as 7 years out but I'm thinking if it doesn't happen in 5 it won't happen at all.

 

I posed the question because I'm trying to value this kicker against the rest of the transaction. It's a bonus that could lead to a 20 bagger on the $15k which would significantly reduce the cost of the base transaction (which I'm actually fine with even if this doesn't come to pass).

 

So the question isn't "should I invest the $15k" as I'm quite sure I will as it seems like a no brainer. The question really is "what is this option worth?" My gut tells me it's well north of the $15k I'm paying hence I can treat it as a further discount on the base asset purchase.

 

SD:

"30% chance of 300K is 90K, for which you're paying 15K.

Alternatively to recover the 15K the chance of the 300K occurrence must > 5%."

 

That's kinda the no brainer side of it that I saw. But it doesn't allow me to put a value on the option. i.e I'm getting an option that's worth say $60k based on some calculation for $15k.

 

 

Thanks again

 

 

[twacowfca]

Thanks for the feedback. I realize you're all "flying blind" as I can't disclose all details.

 

This option is a kicker on a much larger transaction which in itself is not an investment per se, but an asset I will use for my business. I will be doing this regardless as the 15k is a very small cost component of the overall transaction. The $300k is already discounted due to it being a future asset you'd have to flip to realize the gain. If it comes together it's more like $600-$700k benefit and I might actually keep and use the future asset vs. sell it right away and take the gain. As to the timing, it could happen as much as 7 years out but I'm thinking if it doesn't happen in 5 it won't happen at all.

 

I posed the question because I'm trying to value this kicker against the rest of the transaction. It's a bonus that could lead to a 20 bagger on the $15k which would significantly reduce the cost of the base transaction (which I'm actually fine with even if this doesn't come to pass).

 

So the question isn't "should I invest the $15k" as I'm quite sure I will as it seems like a no brainer. The question really is "what is this option worth?" My gut tells me it's well north of the $15k I'm paying hence I can treat it as a further discount on the base asset purchase.

 

SD:

"30% chance of 300K is 90K, for which you're paying 15K.

Alternatively to recover the 15K the chance of the 300K occurrence must > 5%."

 

That's kinda the no brainer side of it that I saw. But it doesn't allow me to put a value on the option. i.e I'm getting an option that's worth say $60k based on some calculation for $15k.

 

 

Thanks again

 

 

 

 

I think you have answered your own question.  The expected gain as SD pointed out is $90K.  Allowing for the time value of having your money tied up for a few years, the value of the option would be about the $60K you estimated.  :)

[BargainValueHunter]

So, Flying Arrow, how is this working out for you so far?