The previous post stirred the pot quite a bit. I received several comments, which I will try to respond via this post. I wrote about my general thought process without getting into the details of the strategy. I will try to explore some thoughts around that in this post.

Strategy not executable in India
Let me clarify something at the outset, namely that the strategy of buying deep out of the money puts to hedge against extreme events (or black swans), works well with long term options. As far as I know, we only have 1-3 month options in India. I think these options are quite fairly priced and any chances of making money on these options due to mispricing are lower than winning a lottery.

I bought some options once (miniscule amount) to just experiment a bit and I think it is very unlikely I will ever buy short term options to hedge or insure my portfolio.

The strategy in my previous post would work well with long term options with durations greater than 9 months. These kind of options are available in the US market and called as LEAPS. I don’t think such options are available in india yet, so I think my strategy would continue to remain on paper till we have such options.

Justifying an approach
I received several comments and more emails which implied that I wanted to dabble in options and I was justifying it by wrapping it up with the logic of value investing. That may very well be the case, though I consciously don’t think so.

Let me give you an analogy. When we buy a car or a house, don’t we buy earthquake or accident insurance? We don’t hope for an earthquake so that we can collect money on the insurance. The purpose of buying insurance is to protect our asset against extreme events. In order to have this peace of mind we end up paying 0.2% or higher of the asset value as insurance.

Long dated, deep out of the money put options can sometimes serve the same purpose. The trick would be to buy when the premiums are low and the market does not expect the crisis. Ofcourse this is hardly do able in India.

Investing for the thrill
I don’t think I am in for the thrill. I have invested in options a few times and you cannot believe the agony I have gone through during the holding period. Options lose value with time, which is called as time decay or Theta. So if you have a 3 month option, you will lose 20-25% of the value in the first month (with everything else remaining the same). As a result, it has pained me to see my options position lose value everyday.

So with options one has to get the timing right too. I am almost 100% sure that I can never get the timing right. So it is unlikely I will buy options repeatedly to try my luck in the market.

Short term hedge
I would rarely want to hedge my portfolio for the short term via options. My approach is to sell overvalued positions or hold on to it through a market drop if I am convinced about the company. As some of you commented on the previous post, buying short term options would just be a waste of money.

Learning
All of the above discussion does not mean one should not learn about options. I think it is a topic one should explore and learn. There are quite a few interesting possibilities with long term options, especially during extreme market peaks or bottoms. That ofcourse is a separate topic in itself.

There is a Chinese proverb – ‘May you live in interesting times’ which may be a curse in disguise. The essence of the proverb is that if you want to condemn a person, you would wish that the person encounters ‘interesting’ times or in other words a lot of change and turbulence.

I don’t think anyone has cursed us, but we are definitely living in interesting times. I think the really interesting times started from 2008 and there has been no letup in the excitement.

The Greek tragedy
If you have been following the news, we have quite a situation in Greece. If one leaves aside the nitty gritty of the situation, it can be simply described as living beyond the means. Greece as a country has been spending (the government that is) way beyond its means (tax revenue) and covering up the deficit by borrowing from the market.

They were able to do it for sometime, till things finally came to a head a few days back. The market decided, enough was enough and started hammering the euro and European bonds of countries such as Greece, Spain, Portugal etc. It became quite scary by Thursday when the US and other markets started dropping by 3% or higher and volatility spiked by more than 50%.

The EU and ECB (European central bank) came together over the weekend and have put together a financial package of 600 billion dollars to aid the countries in trouble. This package has calmed the markets for the time being and would give time to countries like Greece, Spain etc to set their house in order. It remains to be seen if they will bite the bullet and fix their deficits. If they do not, then the markets will force them to in due course time.

My reaction
I typically ignore market fluctuations and macroeconomic situations. In this case however, there was a real risk of a market meltdown in Europe and US and a corresponding crash in India.

As I have already stated, I have started liquidating stocks which I would not buy if they dropped by 20% or more. I have already exited my positions in stocks such as VST, Denso, Ingersoll rand and started reducing my positions in IT stocks such as Infosys, Patni and NIIT tech (see my portfolio disclosure here)

My decision to sell is not a macro call. I have no clue how the macro picture will play out in Europe and how it will impact us in India. There are a lot of moving parts to be able to predict and all the opinions in the papers and on the TV are just that – opinions and guesses.

My decision to sell is based purely on valuations and my view of the future prospects of these companies. I am not too optimistic about IT companies at current valuations (key word is current valuations – the companies may still do well in terms of performance).

Exploring options
I am exploring the idea of ‘Deep out of the money’ puts to take advantage of a possible crash in the market due to the European debt issues. There are multiple issues associated with this thought process.

The first issue would be the possible corruption of my value investing philosophy. The general wisdom is that value investors should not dabble in options. Options are more suited for a trading or quantitative approach to investing. I would disagree with that. Value investing is not some religion, where you are either a part of the cult or out of it. Value investing at its core is buying something for less than its value. The ‘something’ can be a stock, option, bond or even a TV. So if I can find an undervalued option, and can evaluate the risk intelligently then it is as much a value buy as a stock.

Options are priced based on a Gaussian distribution (difficult to explain in detail in this post) and hence underprice extreme events. So if a company in question is likely to show great performance in the next one year or crash completely, the options may be underpriced for such a scenario. Similarly, put options may be underpriced if the market crashes due to some extreme event. The risk is ofcourse that the extreme event may not happen and you will be out of the premium you paid for the option.

I have been studying derivatives for sometime and have been analyzing them. Although I still look at them as a hedge or insurance against extreme events, I have been exploring the idea of combining value investing with options.

The main risk I personally face with options is not monetary risk as my positions are very small. If I lose money, it is likely to be a small amount. The bigger risk is that I will look like a complete fool in my own eyes (that I will look like a fool to others is a lesser issue). In order to avoid the regret and learn from my experience, I have started maintaining a daily dairy of my options work and have started recording my thoughts, feelings, actions etc.

As an aside, I bought puts on ICICI bank and some other companies in late 2008 to hedge my portfolio and deposits with these institutions in the extreme event that one of them failed and took my savings down with them.

If you think a value investor should never touch options and I am being foolish to do it, please leave me a comment with your reasoning behind it.