Know your Options
From time to time we are asked about option strategies. There are many different types of option strategy, and the merits of any given one depends very much on the particular strategy and the circumstances, but there are a few general principles that are worth keeping in mind. These include:-
– Buying or writing options is a zero sum game. This means that when one person sells an option to another, one of them will win and the other will lose. This is in contrast to ordinary shares where it’s reasonable for all long-term investors to expect a positive return
– Who wins and who loses will be determined by a combination of skill and luck. The skill component lies in correctly valuing the option (and to some extent the underlying asset). The luck component reflects the inherently random nature of share price movements in the short term
– Some investors believe they can predict short term share price movements. We don’t have this skill (and are yet to be convinced that others do) so this doesn’t feature in our analysis
If you accept these principles, there are some general conclusions that follow. These include:-
– It only makes sense to use option strategies as a way to increase profits if you are more skilled at valuing the option than the person taking the other side of the trade. If not, it’s like playing backgammon against a talented opponent: you may roll some double-sixes and win a few games, but continue playing long enough and your opponent will get the better of you
– You generally won’t know who is taking the other side of the trade. It’s probably best to assume they know what they’re doing
– On the other hand, it may well make sense to use options to manage risk. If you particularly want to avoid a loss that would result from a specific change in prices, options may provide the protection you need. Just be aware that there will be a price to pay for this protection
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
