A thought experiment –
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.

If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).

The key objections to this strategy could be

· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases

A few other cases

· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)

I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.

Please feel free to comment on the above strategy or any better ones you may have tried.

If your first thought is – Options and value investing …what a combination? You are not alone. You will rarely find discussions on options and derivatives in books and articles on value investing. But then just because most value investors don’t talk about options, does not mean one should not even try to understand them.

That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.

Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t 🙂 !).

The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000

The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.

I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –

Options pricing is generally dependent on the following variables
– strike price
– time for expiration
– Interest rates
– Volatility

Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.

The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.

The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)

In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.

Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.