Author Topic: How to think about options?  (Read 11859 times)

compoundinglife

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How to think about options?
« on: April 20, 2013, 11:18:54 AM »
Moving this discussion over from the AAPL thread.

Quote from: compoundinglife
What do you guys think about the LEAPs?

Apple right now looks insanely cheap if you back out the cash.  The P/E ratio is insane and Apple's growth is insane (very very few small caps have grown faster).  The LEAPs are reasonably priced and look like a safer way to play this.  Usually technology companies grow really quickly or die really quickly.  This should mean that the options should be a little more expensive than what historical volatility might suggest.  (Or I could be wrong.)

Interesting.  I had the opposite thought -- that LEAPS would be a little dangerous. 

I suppose that's because I've modeled very, very conservatively, with ASP and GM decline every year, pretty good slow down in unit growth for iPad and iPhone, declining Mac unit sales, modest software/services growth, and giving no value to potential new products such as a watch or TV.  And then taking a haircut on the cash position, of course, both for taxes and possible acquisitions/partnerships that will be necessary for a transition to more software/services revenue.

That puts me at a declining EPS, which is something the market won't like one bit.  Granted, I'm being pretty conservative, but this is a tech company after all. 

Just a thought on whether to go with LEAPS versus common.

The way I am thinking about it is 100 shares of AAPL costs your $39,000 today. A 2015 $400 LEAP costs you $5600. Instead of buying of the common, buy the LEAP and take the remaining $33,400 and put it in a compounding machine that you want to hold. Let's say you put that $33,400 in FFH. In the case that your LEAP goes to zero and FFH is able to compound over time at %15 per anum the first %15 almost covers your cost of the LEAP.

Value Line estimates 44.50 for 2013 and 52 for 2014 earnings, a PE of 12 on 44.50 is 534. Let's call it $500. So if at expiration (Jan. 15) AAPL is $500 and you at some point get your %15 growth per anum on FFH you wind up  $48,410 vs 100 AAPL common at 500 which would be $50,000.

Of course the simplest explanation is you invest $5600 and if AAPL is below $456 at expiration you lose it all.

But for whatever reason in the context of buying the common vs spending the same $$ and buying the LEAP plus FFH the second seems like a better option to me. Maybe I am just over thinking it.

Umm... I think options are a little complicated and difficult to grasp.

I would try to understand the basics of options first.  e.g. put-call parity
Then try to understand the Black-Scholes model.  This is a little unintuitive at first, but the direction of the stock mostly doesn't matter if delta hedging works.
Then try to understand areas where the Black-Scholes model should be modified.
Then you will understand why many options traders use BS by fudging the volatility parameter in it.  Pricing options is an art, not an exact science.

Taleb's book was helpful for me.

Or maybe take a step back and look at it like this.

The options market is a zero-sum game.
Suppose for a second that there were no transaction costs.  And suppose that taxes don't matter.
In a frictionless world... then there would be some "correct" price for every option.

If the call (or put) option is too cheap, then I would have to say that it's less risky than the common.  A put option is like insurance.  (And because of put-call parity, you can usually turn calls into puts and vice versa.)  If you get paid to own insurance, then that's awesome and not very risky.  If the put/call options are too cheap, then it's like you are getting paid to own insurance.

2- The options markets give you access to a lot of leverage.  Increasing leverage increases your risk.

BUT, you don't have to increase your leverage.  You can buy 1 option contract instead of 100 shares.

3- In practice:
a- There are transaction costs, sometimes the options market is slightly stacked against investors, there are taxes, etc.
b- Options are complicated.
c- It's really hard to value options.  (So, you know... look for a margin of safety.  Otherwise, nobody is forcing you to swing at any pitch.)


GrizzlyRock

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Re: How to think about options?
« Reply #1 on: April 20, 2013, 12:50:43 PM »
If Apple realizes that allocating their massive FCF to repurchases (as opposed to increasing the dividend) the Apple LEAPS could be very interesting

compoundinglife

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Re: How to think about options?
« Reply #2 on: April 20, 2013, 01:08:59 PM »
ValueTrap,

I think I get what you are saying which is basically that trading options is trading volatility. In a world of no transaction costs where you think the future volatility is going be greater than the implied volatility you can delta hedge and capture a gain a regardless of the markets direction.

But does that mean that viewing a long a call as a proxy for being long the stock is a flawed view? I don't think it is but I think that is your message. I am misunderstanding you?

no_free_lunch

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Re: How to think about options?
« Reply #3 on: April 20, 2013, 01:11:23 PM »
I normally am not a big fan of options but they seem more appropriate for apple.  The stock is at a crossroads, it is unclear if earnings will be maintained, we don't know what future products they will release and if they will be successful.  We do know that the market thinks earnings are in for a slow decline.  If they are wrong the stock will have to move up and sharply.  With the 2015 options you have a reasonable amount of time.

Compounding life, you use very conservative estimates to come up with $500.  It makes sense to be conservative, but I would also look at the more aggressive side of conservative.  If they can do $56 earnings and the market thinks that is maintainable you could easily see $700 again.  Not something to bank on but it gives reasonable upper and lower bounds if the roof doesn't collapse.

When you look at it like that you are looking at 2X-6X your investment if things work out, say 0x if they don't.  Sounds like good odds to me.  If you are being conservative and only putting a fraction of your portfolio at risk, especially if you were going with hedged FFH, that sounds like an interesting strategy to me.

compoundinglife

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Re: How to think about options?
« Reply #4 on: April 20, 2013, 01:28:58 PM »
I normally am not a big fan of options but they seem more appropriate for apple.  The stock is at a crossroads, it is unclear if earnings will be maintained, we don't know what future products they will release and if they will be successful.  We do know that the market thinks earnings are in for a slow decline.  If they are wrong the stock will have to move up and sharply.  With the 2015 options you have a reasonable amount of time.

Agreed. Part of the reason why I like the options in this case is because I feel that if by 2015 the stock has not appreciated or has depreciated further it is *likely*  because I was wrong about Apple and there is some big deterioration in their business in which case if I was holding the common I would probably not want hold it any more anyways. As apposed to say a BRK or FFH where I would keep holding regardless of price and price is probably not indicative of any long term fundamental problems.

Compounding life, you use very conservative estimates to come up with $500.  It makes sense to be conservative, but I would also look at the more aggressive side of conservative.  If they can do $56 earnings and the market thinks that is maintainable you could easily see $700 again.  Not something to bank on but it gives reasonable upper and lower bounds if the roof doesn't collapse.

When you look at it like that you are looking at 2X-6X your investment if things work out, say 0x if they don't.  Sounds like good odds to me.  If you are being conservative and only putting a fraction of your portfolio at risk, especially if you were going with hedged FFH, that sounds like an interesting strategy to me.

Yeah when I looked at I did take into account much more optimistic outcomes :) I just chose to post something conservative in the example.

Packer16

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Re: How to think about options?
« Reply #5 on: April 20, 2013, 01:45:10 PM »
One question I have always had about Apple and other widely held stocks is what do I know that others do not.  It may appear cheap but given the number of folks following this stock, I think there is a reason why it is trading where it is versus say some smaller less known names.  If had a moat like Coke then it would clearly be a bargain but the question is how long can they maintain their competitive advantage (esp. with other mee-too device flooding the market).

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compoundinglife

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Re: How to think about options?
« Reply #6 on: April 20, 2013, 02:01:15 PM »
One question I have always had about Apple and other widely held stocks is what do I know that others do not.  It may appear cheap but given the number of folks following this stock, I think there is a reason why it is trading where it is versus say some smaller less known names.  If had a moat like Coke then it would clearly be a bargain but the question is how long can they maintain their competitive advantage (esp. with other mee-too device flooding the market).

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That is a good question and definitely something that needs to be considered. Going to attempt to flip the question around a bit. When you have a stock that is very widely held, a ex-darling of retail investors and mutual funds whose to say that they are selling because they know something you don't. Or maybe they know what we know which is that there are probably some road bumps in the near future and they don't want to go along for that part of the ride.

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Re: How to think about options?
« Reply #7 on: April 20, 2013, 02:34:19 PM »
You have a good point but the competition for a stock like apple is alot different than for a smaller firm like OSTK, AIQ or TVL.  Investing is like a competitive sport with the competition for well known like AAPL being like playing a professional tennis player and investing in less well known names playing against your middle aged a little overweight neighbor.  That is why I am always skeptical of getting a good bargain with large cap stocks.  Look a Longleaf as an example.  They for the most part invest in large caps using a concentrated value approach but have failed to beat the S&P?  Why?  Not because they are poor value investors but because with large caps you have keen competition.   In AAPL's case what has happened to every large cap tech company that has reached AAPL's market cap?  I can think of IBM and MSFT.  They have stagnated or declined.  Again due to keen competition and the IBM and MSFT not being able to grow.  Based upon my understanding, AAPL's model is not as robust as either IBM's or MSFT's, so why would they be able to have different results.  Another aspect that is more technical who else is there to buy AAPL?  Just some thoughts.

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ItsAValueTrap

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Re: How to think about options?
« Reply #8 on: April 20, 2013, 02:35:31 PM »
Quote
But does that mean that viewing a long a call as a proxy for being long the stock is a flawed view? I don't think it is but I think that is your message. I am misunderstanding you?

Here's how I look at it.  You can bet on the underlying stock and throw an additional bet on volatility on top of that.

#1- If I like the stock, I might look at the options too since they might be even better than the common stock.

#2- Determine whether the options are overpriced or underpriced, regardless of the direction of the stock.  Is volatility over or underpriced?

#3- Let's say the options are fairly priced or underpriced.
Buy the options and don't hedge.  Maybe the stock is good but the options are even better.

If the options are really overpriced, then maybe you want to sell volatility.  (Buffett did this for BNI.)  Again, don't hedge if you want to bet on the direction of the stock.

Maybe I can't figure out if the options are over/underpriced.  (I like obvious stuff.)  There's nothing wrong with avoiding the options altogether and just sticking with the common.
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ItsAValueTrap

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Re: How to think about options?
« Reply #9 on: April 20, 2013, 02:42:36 PM »
Quote
One question I have always had about Apple and other widely held stocks is what do I know that others do not.

I think misvaluations can occur with large caps.  Berkshire Hathaway is sometimes mispriced.  The various Malone/Liberty companies have definitely been mispriced often.

Many large caps during the tech bubble and 08/09 crash were mispriced.  Anything in the S&P 500 will often fall 50% from its 52wk high.

A long time ago, Warren put most of his investment partnership's money into a large cap called American Express.

2- Look in the small cap space and try to find a company that grows faster than Apple and trades at a low P/E.  It's really, really hard.
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. " -Buffett

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