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Value investing in options?


ItsAValueTrap
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If you look at Warren Buffett, sometimes he has tried new investment strategies such as:

a- Hoarding physical silver.

b- Trading copper futures

c- Selling puts on Burlington Northern

d- Selling very long-dated put option contracts on stock indices.

 

Do you think that there is any merit in buying options that seem underpriced?  (e.g. the volatility is too cheap)

 

There are some cheap-ish growth stocks out there where the options aren't expensive at all.  AAPL, DTV, AZO, GOOG are some names with huge amounts of growth and cheap options.  These growth stocks often trend in one direction (sometimes down) and the options on these stocks may not be priced correctly.

 

On the put option side, JOE puts seem a little mispriced to me considering the short interest and past borrow costs (14%+ or something; can't remember).  JOE is a massively shorted stock... these stocks usually go down and the options tend to get really expensive due to the borrow costs throwing a wrench into put/call parity.

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Guest deepValue

I think this makes sense in event-driven situations, but I'd simply go long the common stock if I thought it was undervalued. You can't put a large percentage of your portfolio in near-the-money/out of the money calls, but you can load up on the common stock. I don't see any reason why you should add volatility risk to your holdings, but it's not a terrible strategy if you take small positions with huge upside (and I think these situations are marked by clear catalysts, not simply undervalued common stock).

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Based upon my experience, buying LT options is a lot more difficult than it first appears.  This is because you are betting on both timing and undervaluation or over valuation.  The timing is aspect is the most difficult to determine.  When you own the stock you have an embedded option to extend which can be very valuable.  That is why the TARP warrants are so attractive.  I would only put a small percentage of my capital in any position due to the high number of losers versus value investing in equity.  One question I always ask is who is one the other side of the trade why is this cheap.  On average sellers of options are the winners so you need to pick you spots carefully.

 

Packer 

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well i have been using options to get premium

 

i usually sell options for stocks that i have a long thesis on but the prices are not to my liking or i use it for something more speculative

 

but i sell long term puts at very low strike prices (usually half of current stock prices). i also only do this obviously for stocks that i wouldn't mind owning and the puts are selling at 10% or greater relative to the strike price

 

this doesn't happen very often but i get it every now and then to generated an extra 1 to 2% of return

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In theory, it is possible, but it may be very hard to execute for the retail investor. You have to be a lot more diversified because of the nature of options (as someone else pointed out, if Mr. Market doesn't agree with your on expiration date...), but options typically have much bigger trading costs. Every time I look at options, I think about the fees per trade, per contract, and for the potential exercise and wonder how the heck can I make money on this? I think you need to get institutional pricing in order to have a chance.

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Guest deepValue

Every time I look at options, I think about the fees per trade, per contract, and for the potential exercise and wonder how the heck can I make money on this? I think you need to get institutional pricing in order to have a chance.

 

Interactive Brokers charges $1 per contract. Not sure how much cheaper you want.

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Based upon my experience, buying LT options is a lot more difficult than it first appears.  This is because you are betting on both timing and undervaluation or over valuation.  The timing is aspect is the most difficult to determine.  When you own the stock you have an embedded option to extend which can be very valuable.  That is why the TARP warrants are so attractive.

Which TARP warrants do you find attractive?

 

I don't see the BAC warrants as a great deal in terms of the implied volatility you're paying on them.  I might be inclined to buy shorter-term options and roll them over when they expire.  Volatility will likely be lower and you might pay less.  Of course you might pay more... but you don't have to put on the subsequent trades.

 

-------------

I guess what I really want to get at is this:

1a- You can view options like any other financial instrument that might be mispriced by Mr. Market.

1b- If you look at Buffett's purchase of Genre, derivatives are a special case as there are some perverse incentives that cause certain parties to lose a lot of money in derivatives.  Genre lost a lot of money on derivatives.  Buffett learned things the hard way, which led him to try to rip off other people with derivatives with the equity put contracts.

 

2- In what situations might options be wildly mispriced?

 

a- Mergers/takeovers for cash.  IV usually drops as the market tends to be forward-looking.  The options are a play on superior offers and/or the merger failing.

b- Pre-spinoff.  Discussed in Greenblatt's book.

c- Companies that are about to make announcements.  e.g. Contango will likely announce 2 wildcat drill results in November (read their press releases).

Resolution of lawsuits, auction results might be other events.

d- Overall market volatility is low and therefore options are cheap.

e- Earnings.  The market tends to be forward-looking... IV rises before earnings, drops afterwards.

f- Heavily-shorted stocks with high borrow costs tend to have cheap calls and expensive puts (due to the cost of the borrow).  I don't know how to profit from this.  If the borrow is not yet expensive and you anticipate it to be expensive, then you may want to buy puts instead of shorting the common.

g- If your commission costs are really low and you can get great execution, then you can try to execute Taleb's option strategy and bet on the mispricing of far out of the money options.  The appropriate volatility smile is highly uncertain.

h- I have no idea if this is a great strategy, but I think that growth stocks (as in... stocks with huge earnings growth) usually trend upwards with a small chance of a big crash in the stock.  Growth stocks usually also tend to rise more than the index and fall more than the index.  e.g. Apple.  Sometimes I don't think that the IV on options is high enough to take these factors into account.

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I think that if you are a value investor, the better way to play options is to accentuate your investment view via options.

 

Say you believe BRK.B is a good stock, but you only feel it's 20% undervalued, but want to buy it at 40% discount. So you should sell put options at that particular price. That way you make money off the premium, and if the option is exercised, then you get the stock you want at your price, because option cost effectively reduces the price.

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I feel like that is often a sucker move.

 

You want to sell volatility when it is crazy 2008/2009 expensive.  And you want to buy volatility when it's cheap.

 

Also, I'm not a fan of trades with little upside and a lot of downside.  Those trades are dangerous if you don't know what you're doing.  (I guess you can draw some kind of analogy to reinsurance.  You better damn well be getting a lot of premium with a good margin of safety.)

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Guest deepValue

I think that if you are a value investor, the better way to play options is to accentuate your investment view via options.

 

Say you believe BRK.B is a good stock, but you only feel it's 20% undervalued, but want to buy it at 40% discount. So you should sell put options at that particular price. That way you make money off the premium, and if the option is exercised, then you get the stock you want at your price, because option cost effectively reduces the price.

 

Don Yacktman's son uses options to enter and exit positions. http://www.ycginvestments.com/option_enhancement

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Based upon my experience, buying LT options is a lot more difficult than it first appears.  This is because you are betting on both timing and undervaluation or over valuation.  The timing is aspect is the most difficult to determine. 

 

Due to the timing aspect there is not really a margin of safety, e.g. if mr. Market disagrees with your valuation at the expiration date, you have nothing.

 

I have found both of these to be true.

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Buying options seems very reasonable to me -- you have the potential for a big win but a small loss (100% is small when you consider the potential upside). 

 

The thing that I find interesting is that options are priced on volatility, not the value of the underlying, which seems to assume an efficient market.  I don't believe in the efficient market -- I believe if I find a stock that is undervalued, then it will typically return to its intrinsic value over a reasonable time period.   

 

What's more, to me, the volatility actually isn't that relevant over a long time, because I believe that in a couple years, both a non-volatile stock and a volatile stock each have a good chance of trading at their intrinsic value.

 

Thus, I'm happy to buy options on undervalued stocks with low volatility.

 

All that said, the money management is the key.  If you're betting on a the roll of a die, and get paid 8 times your bet when a 6 is rolled but lose your bet when a 1-5 is rolled, then it's a bad idea to put 100% of your money on a single bet.

 

So, my rules are:

1. Bet small on any given option.  You will lose frequently.

2. Estimate how often you'll lose (say two-thirds, of the time), and figure out how much you need to make from your winners to cancel out that loss and add a decent profit (say 400%).  That should be your target.

3. Don't make the bet if you can't reasonably envision a profit greater than your target.

4. Only close out below your target if you're close to expiry, where "close" is defined as "the market's random gyrations are likely to have a bigger effect on the stock price than any return to fair value".

5. Don't necessarily sell out when you hit your target.  If the strategy works, it works because of big winners. 

6. If you like, after you've got a decent profit, you can sell in thirds or quarters, to take your risk of the table and play with the house's money.  (You're fooling yourself if you think it's the house's money -- at that point it's your money -- but if this illusion helps you avoid taking small profits, it's probably fine.)

 

The other thing that could be helpful is spending some time with a die recording the results and looking for losing strings of numbers.  I think people in general believe random numbers are far more evenly distributed than they actually are -- the long term takes a long time to arrive.  Just like you'll have a big series of wins, you'll have a big series of losses, and will feel the losses more than the wins.  So, thinking through your feelings about a long strings of losses can be useful.

 

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  • 4 months later...

http://blogs.barrons.com/focusonfunds/2013/03/01/buffett-puts-prospered-in-2012/?mod=BOL_hpp_blog_fof

 

[L]et’s postulate that we sell a 100- year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.

 

To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher. Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor.

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I think a great target for covered call strategies are relatively stable stocks that aren't moving too much, things like MSFT, Loews etc. If you have a strong idea of the firm's intrinsic value, this is another great way IMO of expressing that view and gaining an extra return because you are going into the trade more informed than your counterparty because you know the stock so well. This strategy IMO, is perfect for value investors. I believe WEB himself began his position in BNSF by selling puts.

 

 

If I was investing a bigger amount, I'd totally do this.

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Back in Aug 2009 I wrote deep-in-the-money FFH calls (to hedge that position while raising cash) and used the proceeds to purchase ORH deep-in-the-money calls on speculation of the buyout.  I did it this way to avoid paying capital gains tax on my FFH position.

 

Once the buyout happened, I sold the ORH calls and bought back the FFH calls I'd sold.  I paid tax on the ORH sale, but did not also have to pay tax on my FFH position.

 

The "constructive sale" rules changed the holding period of my FFH position for US tax reasons -- it reset the short-term capital gains clock on my FFH position to the date of the hedge activity and restricted me from selling or hedging FFH for the next month (the penalty being a taxable event if I did).

 

Given that value investors often seek to trade into positions of better opportunity (and possibly trade back later on), this is a valuable trick to know about.  Important though to read all of the rules on this -- you need to close out that hedge at the latest by the end of the first month of the new year.  So really it's utility is limited to short-term purposes.

 

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Back in Aug 2009 I wrote deep-in-the-money FFH calls (to hedge that position while raising cash) and used the proceeds to purchase ORH deep-in-the-money calls on speculation of the buyout.  I did it this way to avoid paying capital gains tax on my FFH position.

 

Once the buyout happened, I sold the ORH calls and bought back the FFH calls I'd sold.  I paid tax on the ORH sale, but did not also have to pay tax on my FFH position.

 

The "constructive sale" rules changed the holding period of my FFH position for US tax reasons -- it reset the short-term capital gains clock on my FFH position to the date of the hedge activity and restricted me from selling or hedging FFH for the next month (the penalty being a taxable event if I did).

 

Given that value investors often seek to trade into positions of better opportunity (and possibly trade back later on), this is a valuable trick to know about.  Important though to read all of the rules on this -- you need to close out that hedge at the latest by the end of the first month of the new year.  So really it's utility is limited to short-term purposes.

Can you direct to any sources on these types of option strategies? I.e. using options to maneuver into/out of a position for an indirect benefit. I.e. avoiding taxable events, selling puts to enter a position, selling calls to exit a position, etc.

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Back in Aug 2009 I wrote deep-in-the-money FFH calls (to hedge that position while raising cash) and used the proceeds to purchase ORH deep-in-the-money calls on speculation of the buyout.  I did it this way to avoid paying capital gains tax on my FFH position.

 

Once the buyout happened, I sold the ORH calls and bought back the FFH calls I'd sold.  I paid tax on the ORH sale, but did not also have to pay tax on my FFH position.

 

The "constructive sale" rules changed the holding period of my FFH position for US tax reasons -- it reset the short-term capital gains clock on my FFH position to the date of the hedge activity and restricted me from selling or hedging FFH for the next month (the penalty being a taxable event if I did).

 

Given that value investors often seek to trade into positions of better opportunity (and possibly trade back later on), this is a valuable trick to know about.  Important though to read all of the rules on this -- you need to close out that hedge at the latest by the end of the first month of the new year.  So really it's utility is limited to short-term purposes.

Can you direct to any sources on these types of option strategies? I.e. using options to maneuver into/out of a position for an indirect benefit. I.e. avoiding taxable events, selling puts to enter a position, selling calls to exit a position, etc.

 

I don't have any sources.  No book or website that I know of.

 

My usage of options comes from knowing that calls give you the right to buy at a certain price, and puts give you the right to sell at a given price.  From that knowledge, think strategically.

 

 

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Back in Aug 2009 I wrote deep-in-the-money FFH calls (to hedge that position while raising cash) and used the proceeds to purchase ORH deep-in-the-money calls on speculation of the buyout.  I did it this way to avoid paying capital gains tax on my FFH position.

 

Once the buyout happened, I sold the ORH calls and bought back the FFH calls I'd sold.  I paid tax on the ORH sale, but did not also have to pay tax on my FFH position.

 

The "constructive sale" rules changed the holding period of my FFH position for US tax reasons -- it reset the short-term capital gains clock on my FFH position to the date of the hedge activity and restricted me from selling or hedging FFH for the next month (the penalty being a taxable event if I did).

 

Given that value investors often seek to trade into positions of better opportunity (and possibly trade back later on), this is a valuable trick to know about.  Important though to read all of the rules on this -- you need to close out that hedge at the latest by the end of the first month of the new year.  So really it's utility is limited to short-term purposes.

Can you direct to any sources on these types of option strategies? I.e. using options to maneuver into/out of a position for an indirect benefit. I.e. avoiding taxable events, selling puts to enter a position, selling calls to exit a position, etc.

 

I don't have any sources.  No book or website that I know of.

 

My usage of options comes from knowing that calls give you the right to buy at a certain price, and puts give you the right to sell at a given price.  From that knowledge, think strategically.

 

 

 

I dont think it can be taught via a book.  This needs alot of thinking and a lot of practical experience.

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Put away the text book & think. Buy a 1 year call today of XYZ for $.50 at a $10 strike, or buy a T-Bill maturing 1 year out & use the proceeds to buy XYZ at $10 in 1 year ?  If the intent is to buy, the T-Bill route is preferable (minimum risk); if the intent is to speculate the option is better.

 

If the intent is to speculate why are you not selling the call for premium (at high volatility) and buying back under low volatility? Time decay works in your favor, & 70% of options expire worthless.

 

Then keep in mind that you could just buy in XYZ on margin anytime you want to stop the potential loss on your short call; you do not actually have to buy the call back. That now deep-in-the-money call you sold has value, but no market, & bankers are not going to lend against it.   

 

Some things are not in the textbook for a reason ……

 

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SharperDingaan,

 

i am trying to understand you comment "That now deep-in-the-money call you sold has value, but no market, & bankers are not going to lend against it."

 

i assume you mean if the call option you sold is now deep in the money, along with the sold call you can buy the underlying stock to cover the call instead of buying back the call? Why would you need to do that if you are deep in the money with the sold call?

 

or are you refering to if the sold call has not gone your way so instead of buying back the call (which can be expensive if the option doesn't have much volume) you can just buy the stock instead to cover the sold call?

 

sorry if i misunderstood something, just trying to understand what you meant.

 

hy

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You are short via the sold call; therefore if XYZ goes up another $1 you lose another $100.

 

Instead of buying in the call you buy in 100 XYZ, & do it on margin; now if XYZ goes up another $1 you lose another $0, as the unrealized loss on the call is offset by the unrealized gain on the XYZ position. If you can margin XYZ at 65%, you had to put up $350 (100 x $10 x (1-. 65)) of equity to buy in the XYZ position.

 

If that deep in the money call call costs more than $3.50 ($350 equity/100 shares), it is cheaper to buy in the shares vs the call. If you own that call you suddenly have a valuable asset that nobody wants to buy.

 

 

 

 

 

 

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