Mr. Market is a helpful tool value investors use to rationalize price swings away from what they believe to be intrinsic value. Mr. Market is presumed to be an erratic character and serves as a useful anthropic metaphor for value investors to explain share price variance away from intrinsic company value.
Inherent in the value thinking framework is the assumption of value or intrinsic worth at a share price point. My own opinion is that 80% of firms don’t operate in value markets or industries as they lack moats and other Value attributes. We will leave that aside for now.
To introduce Oscar Option, we will assume you have found Mark’s Moat Maker inc., a nice company spewing free cash flow and earnings in such a manner that our appetite says intrinsic value rests at $30 per share. Like good value investors we base this on 5 years worth of historical figures and believe it to be sustainable into the future.
One of the problems investors have with Mr. Market is that he talks a good game. For months at a time Mr. Market may whisper into the ear $20,$25,$19,$45 or any such number for Mark’s Moat Maker inc.
After a while it is easy to anchor our new price point to whatever we recently “heard” Mr. Market say. This is standard behavioral anchoring bias and a response to social expectations, a confirmational bias. The over “heard” Mr. Market mentality can become the “herd” reality.
To paraphrase Ben Graham, just because people agree or disagree with you doesn’t make you right or wrong. Being right early or in the middle of you position doesn’t count, investing is an end game, although a smooth comfortable ride constantly up would be nice, it is probably the exception rather than the rule.
The problem is the noise in the middle. All that price chatter from Mr. Market while you hold your position can be disturbing. Picking an entry or exit point for an idea is difficult.
Many people ask, “Should I get out of X?” Answering this is a fool's errand as standard attributional bias means that unless you help pick the “best” exit you are either a genius or fool and typically the latter.
The most helpful thing one can do is aid someone’s mental framework. For a position holder considering selling, I put forward the following question. “Would you like to own more of X today?” If they aren’t willing to buy more then they are probably better off exiting as they believe there is negative intrinsic value relative to the current price.
An interesting way to get around the chatterbox stress of Mr. Market is to preplan a strategy. You can even get paid to do so. If you believe that you understand a firm’s long term intrinsic value then why not preset your entries and exits and get paid to do so. The noise of day to day events and vapid CNBC/FoxBusiness commentary shouldn’t affect intrinsic value.
Mr. Market’s cousin Oscar Option pays you to plan around your intrinsic value price estimate. Assuming you have done your homework on Mark’s Moat Maker inc. and believe its long term intrinsic worth is $30 a share which is north of the $20 it trades for today . You are interested in partnering up with this firm as a shareholder for the long haul. Before purchasing a share you come up with a game plan involving Oscar Option.
You plan on buying a share of Mark’s Moat Maker today at $20 a 33% discount to your intrinsic value estimate. You determine that $45 per share is a bit steep for Mark’s Moat Maker inc. so you tell Oscar to CALL you when it hits $45 and sell the position.
You also decide that $10 per share is cheap for Mark’s Moat Maker inc. as it is 66% below your $30 intrinsic value estimate and quite a deal. You would like Oscar Option to PUT a share of Mark’s Moat Maker in your account at $10 per share.
Think about that for a moment. Value investing is psychologically uncomfortable and counter intuitive which is why so few do it well. You are selling options to your friend Oscar Option. If the price goes up 125% you are asking him to CALL you to exit the position. If the price goes down you are asking Oscar to PUT another share in your account. This might feel strange, but it could be considered a value investing strategy.
In this situation you are an option seller which is something usually considered risky. If you believe you understand the underlying companies intrinsic value and are willing to own it, then you are already bearing risk. Oscar Option pays you for the favor of exercising your orders, which is a better bargain than you get with a standing stop order.
The nice thing about Oscar Option is that he pays you for the privilege of executing your game plan. If you own the underlying share and you truly believe that $30 is the fair intrinsic price, it makes sense that you would want more at a 66% discount and that you would want out at a 50% premium. What you are doing is selling options to your friend Oscar Option who has some of the manic depressive attributes of his cousin Mr. Market.
On the long side you get CALLed to unwind your top heavy shares and on the short side you get to PUT a little more in your account. As an option seller you collect premium which means you get paid for both of these orders whether executed or not.
You can sell these options 3-6 or months in advance. If you truly believe intrinsic value moves slowly then this should comfortable not only in bolstering you income, but in managing your position.
Please don’t undertake options positions unless you fully understand the, mechanics, tax issues and other risks inherent. If it isn’t in your circle of competence avoid it. Better a simple plan failed that you can learn from, than a complicated one that works which you don’t understand and may lead to bigger trouble down the road.
Regardless of working with Oscar Option, do consider the psychology of pre-planning your exits and entries. The daily News to Noise ratio is probably 1:99, most of it is there to sell ads, not teach or inform. Mr. Market’s chatter is intoxicating, entertaining, time consuming and potentially dangerous.
Once you own a share of a company, every grain of information illicits an emotional response over time it will affect you. If you get quotes on your blackberry you may be stimulated and stressed, but are you winning? Thin slicing your time ever more doesn’t make it more productive, quite the opposite actually.
For the experienced options trader, Oscar Option may be more interesting as an exercise in psychology and equity position management. As a risk fan, former runner in a bond futures options pit and quant there is lots to be said for Gamma risk, black swans and Black Schole’s myriad flaws so Oscar Option can be characterized as a naïve strategy, but may serve as a useful thought exercise for many.
With current volatility high and a lot firms trading near cash, selling puts and collecting premium while potentially getting a company at a bargain may not be such a bad deal. The caveat of course is to correctly identify intrinsic value.
No, I am not an armchair theoretician, I work with a small hedge fund, and yes I am up double digits for the year with a 1.10 Sharpe ratio. Maybe it’s luck, maybe it’s not. If you work for a fund and would like to talk strategy or collaboration send me a message.
On a side note, Charlie Munger (Warren Buffet's partner) is in my opinion the most financially successful anthropologist alive today. Read his book, it is easily worth more than 5% of what you are currently investing in educational payback.