Earlier this week, The Wall Street Journalhighlighted my strategy of buying long-dated put options on two tech-heavy indices: the Nasdaq 100 tracking stock
However, I do expect these investments will be highly profitable. So allow me to give you some background and take you through my thought process so you can see how I arrived at my current strategy.
Since loading up on numerous cheap stocks last March, I've becomeincreasinglyconcerned that the market has risen too far, too fast. I fear that stocks are priced for perfection, and there could be a nasty pullback if the economy doesn't deliver perfection. I'm especially shocked that speculative froth has returned to so many sectors such as nanotechnology, biotech, anything having to do with China, not to mention most tech stocks.
Given these concerns, my initial strategy was to short the most overvalued stocks I could find -- for example, the Chinese Internet stocks, Sina
Essentially, I was short volatility -- which is a very dangerous game. So-called 100-year storms seem to occur every few years in the financial markets, and investors who are short volatility can be put out of business in such situations. Just ask the Nobel laureates at Long Term Capital Management.
I therefore decided to cover most of my shorts, but I still wanted to profit from the decline I expected in the frothiest, most overvalued sectors of the market. So I looked at buying put options instead. Puts offer numerous advantages relative to shorts:
- When shorting, gains cannot exceed the amount invested and losses are potentially unlimited. With puts, you cannot lose more than your initial investment and, if you're right, you can make many times your investment.
- When shorting, one must risk the entire stock price, whereas with puts one typically only has to risk a small fraction of the stock price of the underlying security.
- When shorting, mistakes (e.g., stocks that move against you) grow as a percentage of the portfolio, precisely the opposite of put positions.
So why would anyone short a stock rather than buying a put on it? First, the best shorts are often small companies for which no options are available. Good luck trying to buy a put on Taser
This is why I decided to short the iShares Nasdaq Biotechnology Index Fund
The high cost of puts
A final disadvantage of puts is that they can be expensive. Options are typically priced using the Black-Scholes model, which uses volatility as one of its inputs, so the more volatile a stock is, the more expensive are its options, all other things being equal. This generally means that puts are very expensive on the most overvalued stocks, since they tend to be the most volatile.
As an illustration, let's look at put pricing today for three stocks that are, in my opinion, wildly overvalued: Juniper Networks
- Juniper (current price: $25.95) -- To buy January 2006 puts with a $25 strike, the cost is $5.90, meaning that the stock has to fall 26% to break even.
- Sirius (current price: $2.90) -- To buy January 2006 puts with a $2.50 strike, the cost is $1, meaning that the stock has to fall 48% to break even.
- Research in Motion (current price: $91.39) -- To buy January 2006 puts with a $90 strike, the cost is $22, meaning that the stock has to fall 26% to break even.
Changing the strike price and expiration date will affect these figures, of course, but any way you look at it, buying puts on high-volatility stocks such as these is very expensive.
Unwilling to bear the risk of having too much short exposure or to pay the high prices for puts on individual stocks, I hit upon my current strategy (with the help of my friend David Eigen of Lego Capital, who gave me this idea): Buy puts on baskets of overvalued stocks such as the Nasdaq 100 and semiconductor companies. While these baskets are not as overvalued as certain individual stocks, it is highly likely, I believe, that the laws of valuation gravity will eventually catch up with them. The Nasdaq 100, for example, trades today at 51 times trailing earnings and 34 times this year's estimates. I cannot predict when the decline will happen, however, so I'm prepared to be patient.
Because the Nasdaq 100 and the Semiconductor Holdrs Trust have marched steadily upward for almost a year, volatility is low and even long-dated options are remarkably inexpensive. It is madness that at-the-money put options on these indices were expensive when the market bottomed last March and tech stocks were arguably cheap, and now they're cheap when the same stocks are richly valued. But I'm happy to take advantage of this senselessness.
Case study of my latest purchase
A few weeks ago I paid only $4.30 a share for January 2006 puts on the Nasdaq 100 with an at-the-money $38 strike price, meaning that the Nasdaq 100 only has to fall 11% at some point in the next two years (even excluding the time value that might be remaining) for the investment to break even. The returns beyond that point increase rapidly.
To understand the leverage in this position, let's assume that instead of buying puts, I shorted the Nasdaq 100, which was then trading at the strike price of $38. In this case, I would have invested $38 per share and exposed myself to unlimited losses on this amount. In contrast, I invested 89% less capital for the puts ($4.30 vs. $38).
To see how these two alternatives might play out, if the Nasdaq 100 falls to $30 by the time the puts expire in two years, I would make $8/share on a short position (a 21% return). By owning the puts, however, I would make the same $8, though I would have to subtract the $4.30 I paid, yielding $3.70 of profit, or an 86% return. By buying puts, I tie up far less capital and am not exposed to unlimited losses.
The downside of options, as noted above, is that time is working against me. If the Nasdaq 100 stays above $38 for the next two years and then plunges shortly thereafter, I will lose 100% of my investment in puts, whereas if I maintained a short position, I would profit. Despite this risk, I have chosen to buy puts because I think two years is ample time for my investment thesis to play out. If I'm wrong, my losses will be relatively small and, more importantly, capped.
Whitney Tilson is a longtime guest columnist for The Motley Fool. He is short the iShares Nasdaq Biotechnology Index Fund and owned puts on the Nasdaq 100 tracking stock and the Semiconductor Holdrs Trust at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.