Value Investing Forum

Wait. Scratch that. They did a split. I'm just an idiot.

There is an interesting section in Security Analysis, Chapter 46: "Stock-Option Warrants".

I haven't read it yet (just skimmed it… I'm still slowly pecking my way through this book) but Graham does make a few comments. This is probably the closest thing to our present day stock options. He does classify them as speculative. He claims there is a "qualitative" component: those aspects of the company that lead you to believe that a significant advance in price may be more likely than other issues . For the "quantitative" component, he offers three selection criteria:

1) A low price.
2) Long duration.
3) Strike price near market price.

My guess is that he would be OK with far out of the money options provided that it meshes well with the "qualitative" aspects and that the price is comparatively better than one that is more near the money but that's just my guess.

Yeah, investing vs speculation would be a good thread. I'll see if I can frame the question for it later. 

Aso for shorting, you probably wouldn't be dissapointed if you saved your shorts for IPO's. The groupon one in particular :p

Thirdly, who are you and what do you do!?

Post edited 12:11 pm – November 2, 2011 by somrh

I don't have a rule (perhaps I should) but I've been somewhere in the 10% range. Part of that, I think, is that I started using puts as an alterantive to directly shorting stocks. The clear benefit is that it caps my downside potential but it makes "shorting" more costly this way.

I still have mixed feelings about whether or not I want to short sell stocks. I've found it easier to find companies I don't like than to find companies I do so I like the idea of shorting but there are some substantial risks that make it different than buying stocks. Puts at least cap my capital losses.

The other benefit is that your "target" price doesn't necessarily have to be hit. Options have an "intrinsic value" (difference of the strike price and the stock price or $0 whichever is greater) and a "time value" (difference between the intrinsic value and the options price.) Sometimes I will sell if the intrinsic value + time value gives me a good return.

Let's say my price target for a stock is $15 and I buy a put option at a strike price of $20. So my target intrinsic value is $5. But the option might hit $5 before the stock hits the target price of $15. Let's say the stock goes down to $16 and the option is now trading for $5. I would sell in this instance.

I still largely believe that Graham would classify purchasing calls and puts as "speculation" but he did have room for "rational speculation" (or something along those lines.) I think options can be under/overvalued but that begs the question about what the value of an option was.

Cornwall capital was partly relying on the fact that Black Scholes assumes that volatility follows a random walk and is, therefore, normally distributed. Normal distributions understate tail events. Anything beyond 5 standard deviation events should not occur (odds of about 1 in 1.7million). Yet simply looking at daily returns of the DOW one can find many events that are well beyond 5 SD (the standard deviation for the Dow is about 1%. So any move greater than 5% is not supposed to happen if volatility was normallydistributed.)

As far as I'm aware, the only thing in finance that actually does follow a normal distribution are some of the lousy models that the finance academics come up with.

But I think option players have adjusted to an extent for this deficiency. I'm just not sure if the adjustment is sufficiently appropriate. Post Oct 1987, there has been a Volatility Smile observed.

I did find where Klarman claimed to have bought far out of the money puts on interest rates (see here). He called it "insurance". I think that's a misnomer. Put options can be insurance if you're buying puts on something you own. Apart from that, they aren't insurance and it isn't really a hedge. It's speculating. But if the price he paid understates the probabilities of the event, that may be "rational speculation".

Hypothetically, if there is a 1:10 chance of Greece defaulting, but an
option is priced to reflect a 1:4 chance, is that a value play by taking
that risk on the arbitrage? At what price does the price justify the
risk?

Here's where that whole "uncertainty" issue comes into play. You can ascribe probabilties to an event. But that's what I like to call the "number out of my ass" trick. And for reasons unknown to me, they always smell funny.

To give a recent example of mine, I purchased put options on HRBN. The fraud thesis is pretty solid. The open question was whether or not a proposed buyout would actually occur. As of now, the stock was delisted today. So far no one has received money yet so there is some possibility I could profit but it looks as though my puts will expire worthless.

What was the probability that a fraudulent company could get funding from the Chinese Development Bank in order to buy out the company? I have no idea. But considering I could have made out about 400% return on the price of the puts, I made the bet.

Was the bet undervalued? I have no idea. Were the odds appropriate? I have no idea. That's the uncertainty of it all. But I still acknowledge it was a speculative bet and I don't consider this to be "insurance" in any sense.