Buying deep OTM call options on value stocks

ironchef · May 28, 2016

1245 said:
One other think to consider with the topic,"Buying deep OTM call options on value stocks."

Everyone can have their own description of a value stock, but I think we can all agree they tend to have lower growth and pay higher dividends. The advantage to buying "value" stocks are their expected dividend flows and lower volatility than the market. Buying OTM calls means you lose the dividend flow. The OTM calls will likely be low priced, dollar-wise, because there is a low expectation of going in the money. There is also the expectation that the stock will move less. I would think I'd be more interested in buying OTM calls on volatile stocks, because a stock portfolio would have added risk, while the OTM options have a defined risk.

That was what McMillan said in his book.

Sig · May 30, 2016

ironchef said:
As a non economist and one without formal finance training, I have the same question on volatility vs risk of an asset. To me, initiatively, modern portfolio theory make a lot of sense but I question if volatility can represent risk as you mentioned?

I often thought about what you said: When an asset/asset class is more volatile, it is usually defined as more "risky" because in a down market, it drops more than a non volatile asset. But for someone with a long view perhaps it is really not as risky (e.g., small cap index) as volatility indicated. Might it then make sense to purchase it during those down markets?
May I ask: how then does MPT define risk? I saw a lot of write ups using the Beta of the stock to calculate risk vs return. Isn't Beta a measure of volatility?

In any case, Scrooge, thanks for providing me some foods for thoughts. On a side note, I agree with the others that ATM may appear expensive but from a probability and statistically sense it is not necessarily so. Intuitively, as I go higher and higher in strike (more OTM), I will reach a point where the strike is so high that the probability of the stock reaching that strike is zero and the option will expire worthless every time. There must be an optimum strike price for risk vs return for each situation but I am not smart enough to know what that is.

Regards,

To answer one of your questions, Beta is not a measure of volatility, although that is a common misperception. It is a measure of how correlated the return is to the index, generally the S&P 500. A stock with a Beta of 1 goes up and down 1% for every 1% the S&P goes up or down, in other words it moves the same direction and same amount as the market. A Beta of -1 would mean the stock moves an equal and opposite direction, .5 would mean half as much, 0 means it's movements are unrelated to the market. A Beta of 0 definitely does not mean low risk, for example GPRO has a Beta of .6 but gyrates wildly more than the market. It just does so in a manner uncorrelated with the market. In MPT terms most of its risk is idiosyncratic, or related specifically to the company rather than to the market.

ironchef · May 30, 2016

Thanks Sig for clearing up my misunderstanding.

Then, how do I define the riskiness of an asset like stock? Would standard deviation or volatility be a good surrogate, if not, how do I define risk in MPT?

Thanks.

1245 · May 31, 2016

IVOL would be the current markets view of risk and VAR would represent the past.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/VAR.pdf

1245

ironchef · May 31, 2016

1245 said:
IVOL would be the current markets view of risk and VAR would represent the past.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/VAR.pdf

1245

Very helpful especially the link. Thanks.

Another question for you and Sig: Short term with options, intuitively I can equate IVOL with riskiness of the investment. But if I look at long term investment and remove individual stock risks by going to index funds, the small cap index over a long period out perform SPY on most all 30 year windows. So, as an investor saving for retirement it should not be any riskier to invest in small cap index but it has a higher return. How does MPT account for that?

1245 · May 31, 2016

What is MPT?

newwurldmn · May 31, 2016

ironchef said:
Very helpful especially the link. Thanks.

Another question for you and Sig: Short term with options, intuitively I can equate IVOL with riskiness of the investment. But if I look at long term investment and remove individual stock risks by going to index funds, the small cap index over a long period out perform SPY on most all 30 year windows. So, as an investor saving for retirement it should not be any riskier to invest in small cap index but it has a higher return. How does MPT account for that?

I don't believe you can be a speculator or an alpha seeking investor and believe in Modern Portfolio Theory. It's like derivatives guys believing in Efficent Market Hypothesis (when it comes to stock picking) while at the same time believing they can find edge in volatility.

Sig · May 31, 2016

ironchef said:
Very helpful especially the link. Thanks.

Another question for you and Sig: Short term with options, intuitively I can equate IVOL with riskiness of the investment. But if I look at long term investment and remove individual stock risks by going to index funds, the small cap index over a long period out perform SPY on most all 30 year windows. So, as an investor saving for retirement it should not be any riskier to invest in small cap index but it has a higher return. How does MPT account for that?

This is a gross oversimplification, but part of MPT says you demand a higher return for higher volatility. While small cap indexes outperform SPY over most long-term horizons, they are also more volatile.

ironchef · May 31, 2016

1245 said:
What is MPT?

Sorry, that was my shorthand for Modern Portfolio Theory: Investors demand a higher premium/return to hold riskier assets, so looking at small cap index, it consistently outperformed SP500 in a long time horizon, so why is it riskier and why not one prefers that if one's time horizon is long?

1245 · May 31, 2016

ironchef said:
so why is it riskier and why not one prefers that if one's time horizon is long?

RUT vs SPX. RUT includes small caps and are riskier because they move more on a daily basis, so their is more uncertainly about future returns. Right now, ATM calls in June RUT vs SPX calls are about 14.06 vs 9.9 implied vol.

Time horizon. You are making the assumption that if your time horizon is 30 years, that RUT will out perform SPX because it has in the past. I have no idea. Maybe it will, maybe it won't. Maybe there will be opportunities in the middle to switch back and forth based on what the world is like in the future. Remember, of the 2000 stocks in the RUT 25% are the S&P 500. Do you really want to stock pick small cap stocks with a 30 year time horizon?

If I'm trader not an investor, I'm looking for opportunities today. Maybe the right think to do based on your thesis, is to have an IRA and 529 account invested in a small cap funds, and trade my other assets however I can find an edge. I hope your timing of when you need the money makes you right. If you need the money during a recession or depression, you might have made a different choice.