It is 5 A.M., and again, I can't sleep. I find myself locked into reading the book Tomorrow's Gold by Marc Faber. I find the book has an interesting thesis, many important historical examples, and engaging information about boom-and-bust cycles.
But there is a problem...
How on earth do I make use of all this? There isn't any applicable information for me to use.
This is what I believe the worst part about 95% of investment books are. They are expensive, the stories are overstretched, and it is usually the same as the others. If we're lucky, after reading 300 pages, there is a single page of investment "advice" at the end.
"Buy physical gold (GLD),"
"Buy real estate,"
"Buy and hold stocks,"
or, "Diversify stocks and bonds by 60/40."
I want actual practical advice. Taking the important theories and frameworks I find relevant and making them applicable for investing and everyday life.
That is why I am starting with this key topic...
We need to find the optionality of things. This concept is from Nassim Taleb and Mark Spitznagel.
After reading the tome, that is Taleb's book, Antifragile, I cherry-picked the important parts to apply towards my portfolio and life.
In summary: you need to always look for opportunities that offer favorable optionality and take advantage of them.
Optional - left to one's choice; not required or mandatory:
Ex: a formal dress is optional.
Ex: exercising an in-the-money option is optional if you want, but don't have to.
Just as the word optional means, it is something that is not mandatory. For instance, these are situations that offer a fixed low risk/cost and have substantial upside. Like buying out-of-the-money options. You pay a small amount upfront for the right, but not the obligation, to exercise the option in the future if you wish. Therefore, at worst, you can only lose your upfront capital. But at best, you can have significant upside. It is almost exactly like how insurance works.
One of my favorite stories of optionality is about Thales and the Olive Options. Thales lived in Greece during the 600 BC period and was a philosopher. He was a practical man and understood that writing philosophy wasn't profitable. So, he took advantage of the conditions offered to him about his speculations on the coming olive harvest...
Thales's reputation for wisdom is further enhanced in a story which was related by Aristotle. (Politics, 1259 a 6-23). Somehow, through observation of the heavenly bodies, Thales concluded that there would be a bumper crop of olives. He raised the money to put a deposit on the olive presses of Miletus and Chios, so that when the harvest was ready, he was able to let them out at a rate which brought him considerable profit. In this way, Thales answered those who reproached him for his poverty. As Aristotle points out, the scheme has universal application, being nothing more than a monopoly. There need not have been a bumper harvest for the scheme to have been successful. It is quite likely that Thales was involved in commercial ventures, possibly the export of olive oil, and Plutarch reported that Thales was said to have engaged in trade (Plut. Vit. Sol. II.4).
Simply, Thales expected a huge olive harvest. Therefore, he went out and paid small fees to lease many olive presses for a fixed period (as if he were buying call options - paying upfront premiums for a fixed time period), which was an indirect way to profit from olive oil. Thus, he had the right to use the presses if he chose, but it wasn't mandatory. Worst case scenario, he loses his downpayments, never uses the presses, or simply rented them out enough to recoup his money. As quoted above, "... Aristotle points out, the scheme has universal application, being nothing more than a monopoly. There need not have been a bumper harvest for the scheme to have been successful."
Thankfully, in his favor, there was a huge harvest. And, when others came to turn the olives into oil by using the pressers, they were forced to pay Thales a substantial profit to do so.
Thales basically made the first option...
Optionality can also be used in everyday life. For instance, when I took a job last year, I had to move to Baltimore from my sunny home in Scottsdale, Arizona. But my moving costs were more than covered. So, I weighed my options.
"It is a far move and what if I don't fit in," I thought to myself, "I also don't like the cold weather or Baltimore in particular."
I continued, "but at the very worst, I won't lose any money from moving. And, if I don't like it, I can always move back - costs covered. At least it would be an adventure with no real losses."
The risk/downside was that I didn't like the job and would simply move back home - with my costs paid for and experience gained from the opportunity.
My upside? I would love my new job, and it cost me nothing out of pocket to move there.
Therefore, taking the job was favorable optionality for myself. The cost/risk was fixed, the worst case scenario didn't leave me with serious losses, and the upside was enormous.
I concluded that the risk/reward was heavily in my favor, and I took the job.
This is just one of the many situations to deal with in everyday life. The prudent individual who understands optionality will position themselves appropriately to catch all upside with as little downside and risk as possible.
Now, to apply this idea to my portfolio...
Again, I am looking for speculations that offer asymmetry, i.e. high reward with low risk/cost. To find these, you have to be contrarian (otherwise the market would price it in), have an independent outlook/opinion, and be extremely cheap. Avis is just that for me.
(Link to the inputs for the chart)
This gives me roughly seven months from now for Avis's stock to collapse below $12, which is priced in as highly unlikely. But if it does, then the reward would be enormous.
Our maximum risk is only ever $500. Therefore, worst case scenario, if I hold them until expiration, I lose my initial $500. If that is what happens, then at that point, I will re-evaluate my thesis, and if I still believe Avis is headed down, I will simply buy another $500 worth of 1-2 year put options (aka LEAPS).
LEAPS - Long-term Equity Anticipation Securities - are publicly traded options contracts with expiration dates that are longer than one year.
The optionality is favorable in my view. Because I get substantial gains if the economy suffers or Avis has business trouble, and it has low/fixed costs with enough time to let my thesis play out.
Here is another example from my own portfolio...
Today, I can buy 50 call contracts for Jan/2019 with a $7.00 strike price for $450...
This gives me a long period of time for any tail events (rare sudden events) to hopefully affect the price of gold and send it higher. And, if not, I won't suffer.
Again, worst case scenario I lose $450 in 18 months. But compared to what the market is pricing in, I believe that gold will rise substantially before then. If it doesn't and they expire worthless, I will simply re-analyze my thesis and re-buy the Yamana call options for another 18 months again.
The upside is unparalleled. And, the risk for reward more than subsidizes the unlikeliness of it happening. The best part is I don't even really care about Yamana. I just know that if gold/silver rises substantially, so will their stock. If they were to go bankrupt, or the company shut down mines, I would simply lose $450 and move on. But if the gold price tops above $2,000 and Yamana stock goes back above $20 (AUY's stock was over $20 in Nov/2012), the gains for the options would be insane.
These events are priced in as nearly impossible to happen. But in 2008, Avis stock fell below $1. Imagine if you had bought one-year puts six months before. Those would have made a killing.
My objective is to take the theory of optionality and develop it into a tool we can actually apply as speculators.
Do I know the future? No. Am I smarter than the quants on Wall Street? No. Are these tail events likely? Not really.
But I am positioning myself to take advantage of any sudden volatility and catching the upside, all while understanding my fixed risks and costs. Pairing the knowledge of Benjamin Graham's "Margin of Safety" with Taleb's work on optionality, you are left with actual practical tools for speculating.
Margin of safety - a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.
With what I believe about the market and where the economy is heading, I feel good about risking less than $1,000 annually to hold these positions (the Avis puts and Yamana calls). I spend a small amount upfront (premium of buying the options) in order to secure a long time period to catch all upside from any unforeseen, random, events.
The weakness for focusing on optionality in my your portfolio, of course, is risk losing the premium up front, is constrained within a time-limit, and requires your highly unlikely prediction to play out. Sometimes the market is priced in pretty efficiently, leaving not enough room for error.
I can't see the future. No one can. But that is why I am buying these out-of-the-money options. It is my profit insurance. Therefore, we need to take advantage of such favorable risk/reward scenarios and position ourselves.
Optionality is key.
Disclosure: I am/we are long AUY, GLD, SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.