Can options explain strategy?
Gridiron quarterback option play. Source: Wikimedia. Public Domain.
Options are choices. Strategy is acting on our choices. When a company decides to lay off workers and focus on an online platform, they’re exercising a real, strategic option. When the market falls and investors exercise protective puts on S&P 500 futures, they’re exercising financial options. When professionals “dress for success” and choose between flats and heels, they’re exercising personal options.
Investment strategies can be explained with options, too. Two of the most common approaches to the stock market are growth investing and value investing. Growth investors seek to hold stocks in companies whose revenue is increasing at a faster rate than the overall economy. Value investors look for companies whose prices relative to their fundamentals seem inexpensive. Growth investors search for new approaches to economic reality; value investors focus on companies that have been beaten down by the market, who may have untapped resources that other investors either don’t know about or don’t care. Growth investors look for a new world; value investors expect the world to come back to normal.
In terms of options, growth investing is a long call strategy. Growth companies expect the world to change and try to position themselves in front of those changes to grow their revenue and earnings. Many consider today’s data giants – Facebook, Google, Amazon – to be growth stocks, and that’s accurate. But growth can be a theme for any sector of the economy. Walmart revolutionized retail in the ‘90s; Amgen permanently changed drug development in the ‘80s; Boeing’s jet airliners permanently altered business and vacation travel in ‘60s and ‘70s. Every day has its disruptors. When they buy growth companies, investors purchase call options on a volatile future.
Source: Options Playbook
By contrast, value investing is a short put strategy. Value investors looks for ordinary companies that look extraordinarily cheap. Whether it was tobacco stocks in the ‘90s or homebuilders after the Financial Crisis or retail stocks in the wake of the “Retail Apocalypse”, value investors search for firms where the rumors of a company’s death become greatly exaggerated. They want to find firms where the market expects management to put a worthless corporate hulk back onto equity holders. When the world doesn’t end and those puts expire worthless, value investors collect their premium and go look for new overvalued puts to sell.
Source: Options Playbook
Growth investing works best when the world changes; value investing is profitable when it doesn’t change as quickly as folks think it will. The thing to remember about being long calls is that most calls expire worthless. Growth investing underperforms much of the time. Time doesn’t work in your favor; you usually don’t collect a dividend while you’re waiting for a growth stock to take off. But when it wins, it really wins, as Wal-mart and Amgen and Microsoft and Nike can attest. Each of these companies started growing and created a revolution in their markets that just fed upon itself, and their shares rode the wave. But this strategy requires patience and diversification. When you sow your seeds to the wind, you never know which of them will take root and bear fruit a hundred-fold.
Wal-mart, Microsoft, Amgen, Nike share prices. Source: Bloomberg
Value investing works because the world has a funny way of not ending, and management – especially management with skin in the game – can be awfully resourceful at finding ways to adapt and survive. A short put strategy usually works, if you do your homework. The market looks at the outward appearance, but a value investor tries to get to the heart of things. Time is on your side. All you need is for things to keep going. The thing to remember about being short puts, though, is that when stuff goes wrong, it really goes wrong. Sometimes, even with the right incentives and a great business plan, management can’t pull a rabbit out of a hat and the shares go to zero. It’s important for value investors to diversify to manage risk and limit their downside. Stop-loss orders can be helpful, as well, in case there’s something out there that we missed.
Option-based thinking is a powerful tool for understanding investment strategies. Whether it’s options on futures or option plays on the gridiron or growth vs value investing, understanding strike prices, time decay, volatility, and diversification gives us insight into what choices we can make and how we might do better.
Thinking about options is a good way to understand different ways to invest. As with any mental model, it has strengths, weaknesses, costs, and benefits – both in time and money. Understanding how options work is a critical part of investing today.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”