Ben Graham once said that investing works best when it is most businesslike. In that spirit, I view my investing activities as identifying a collection of businesses whose assets sell for less than they are worth and are capable of remaining a going concern. To institute a margin of safety, I prefer companies where the liquidation value under reasonable circumstances will yield as much or more than I paid for the securities. I also want to generate cash flows wherever possible in the form of dividends or other cash payments. And I want time and price to be on my side to the greatest extent possible at all times.
I use every tool available to accomplish my goals. I have no restrictions on the capital structure of the business and I will buy common stock, preferred equity and even bonds if the margin of safety exists and they trade for substantially less than my calculation of value. In the past decade, I added options to my toolbox to improve my chances of long-term investment success. A solid grounding of option knowledge helps me as a value investor, and gives me an advantage when dealing in securities with a long-term perspective.
In recent weeks, I have seen several articles dealing with options trades on undervalued securities. These authors suggest buying out-of-the-money call options, hoping the stock appreciates and brings large gains. The theory is if you buy these options and the company has a strong earnings release or catches a takeover bid, you could gain profits of 100% or more. While that's true, it's also true that if the roulette wheel comes up red and you have bet appropriately, you can double your money. But if you didn't bet red, you lose it all. That is not how I want to run my business.
None of the articles addressed the issues of time frames or options pricing. They did not consider options prices or the probability of a 20% or more price move in the underlying stock in such a short time frame. The options suggested for purchase all had less than a year to expiration and, in my mind, that is not an investment, it is just a speculation -- and a poor one to boot. I love to gamble but I prefer racetracks where at least I can have a cocktail or two with friends while I make mathematically unsound wagers. When it comes to the markets, I want to stay as businesslike as possible and run my portfolio like a company.
As a value investor there will be times when buying options makes a measure of sense. The vast majority of the time, however, it makes far more sense to be a seller of options. Many others have embraced the concept of selling options by implementing a covered call strategy. I confess that I use this approach once in a great while as a hedge but, in general, I am not a fan. It is not a truly efficient hedge and can lead to premature selling of issues I prefer to hold. If an issue is overvalued, I prefer to sell it rather than sell a call and hope it rises enough to be called.
The real value of options to me, as a long-term-oriented value investor, is as a seller of out-of-the-money put options. Selling puts obligates me to buy the underlying shares at a specific price at expiration. If the stock does not fall to my stroke price or below before expiration, I get to keep the premiums I collected for the sale. If the stock does fall, I have to buy the stock at the strike price but I still get to keep the premium collected.
Obviously, the optimal way to make this work is to make sure I want to own the underlying stock at the current price, and be even more willing to buy shares lower. I have to do the research on the particular company and feel the stock offers a margin of safety and is sufficiently undervalued to offer a profit opportunity. Many value stocks take a long time to turn around, and selling options in this manner can give me a stream of cash flow on an otherwise dormant stock. If I have to buy the shares at the strike price, I own a stock I like at a lower price than I would have obtained with an outright stock purchase.
Where many people make a mistake selling options is not going further than the stock analysis. I also want to evaluate the options and sell them for a fair price. Before selling an option, take the time to run the trade through an option calculator like the free one at CBOE.com. You are trading against an army of Ph.D.'s with supercomputers. Don't be today's lunch money by selling your options at less than their fair value.
I also want market conditions to be favorable for my trades. I like to sell options when volatility is rising and options premiums are swelling. When I look at the underlying security, I want the implied and historical volatility to be well above the average levels of the past few months. I do not have to trade, so I do not until the conditions are favorable.
If you start with underlying stocks that are safe and cheap and use common sense about options pricing, they can be a successful part of your market trades.
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