35 lines
2.4 KiB
Plaintext
35 lines
2.4 KiB
Plaintext
Risk and the Intelligent Option Investor • 265
|
||
For an intelligent option investor who has a long-term worst-case
|
||
valuation that is now 20 percent higher than the market price, there is a
|
||
wonderful opportunity to sell a put and receive a fat premium (with the
|
||
possibility of owning the stock at an attractive discount to the likely fair
|
||
value), sell a put and use the proceeds to buy an OTM call LEAPS, or sim-
|
||
ply buy the stock to open a position.
|
||
Indeed, this strategy is perfectly in keeping with the dictum, “Be fear-
|
||
ful when others are greedy and greedy when others are fearful. ” This strat-
|
||
egy is also perfectly reasonable but obviously rests on the ability of the
|
||
investor to accurately estimate the actual intrinsic value of a stock. This
|
||
brings us to the next form of risk—valuation risk.
|
||
Valuation Risk
|
||
Although valuation is not a difficult process, it is one that necessarily in-
|
||
cludes unknowable elements. In our own best- and worst-case valuation
|
||
methodology, we have allowed for these unknowns by focusing on plausi-
|
||
ble ranges rather than precise point estimates. Of course, our best- or worst-
|
||
case estimates might be wrong. This could be due to our misunderstanding
|
||
of the economic dynamics of the business in which we have invested or
|
||
may even come about because of the way we originally framed the problem.
|
||
Thinking back to how we defined our ranges, recall that we were focusing
|
||
on one-standard-deviation probabilities—in other words, scenarios that
|
||
might plausibly be expected to materialize two times out of three. Obvi-
|
||
ously, even if we understand the dynamics of the business very well, one
|
||
time out of three, our valuation process will generate a fair value range that
|
||
is, in fact, materially different from the actual intrinsic value of the stock.
|
||
In contrast to market risk, which most often is a nonmaterial and tem-
|
||
porary issue, misestimating the fair value of a stock represents a material
|
||
risk to capital, whether our valuation range is too low or too high. If we esti-
|
||
mate a valuation range that is too low, we are likely to end up not allocating
|
||
enough capital to the investment or using inappropriately light leverage.
|
||
This means that we will have missed the opportunity to generate as much
|
||
return on this investment as we may have. If we estimate a valuation range
|
||
that is too high, we are likely to end up allocating too much capital to the
|