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By impliedvolatilty
January 7, 2002

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What is an option?
A bundle of rights

What is a stock?
A bundle of rights

What is a piece of Real Estate?
A bundle of rights

What is a bond?
A bundle of rights

What is a convertible?
A big complicated bundle of rights

After reading the first paragraph of Mr. Mann's treatise on options I was anticipating some thought provoking observations on how individual investors owe it to themselves to understand and utilize options. In his introduction we are treated to the obligatory homily to the oracle of Omaha, WEB seems to be gaining all sorts of newfound adherents nowadays, if I remember correctly the 50% drop in the share value of Berkshire between May of 1998 and March of 2000 exiled those archaic Berkshire types to the rest home of the hopelessly "un hip", condemned to suffer the obdurate stubbornness of an old codger revolting against the dawn of so many ventures, ventures with a universal promise for eye-catching wealth creation, after all isn't that what equities do? Just recently we see them venturing away from the shuffleboard and out on the dance floor. But my hopes were dashed as I delved further into a "random thought of the day"; it kind of reminded me of volatility as it was indeed random (as billed) exhibiting both non-normality and non-linear characteristics

Bill is no "fool" in my book and his writing and market knowledge are a delight to read, but in this case I remain perplexed as to his thesis, it appears his primary points are as follows, options have severe handicaps and are destined to fail because:
* Individual investors are little more than the fodder for the options market
* One of the two participants MUST be wrong
* In options it is possible for both participants to lose,
* There is no way for options writing to generate value

They fail to create value, due to... moral transgression?, an argument along the lines of "conversion of energy" a debate best suited to Carl Sagen. Now when Carl got cremated did the mass of the universe increase/decrease/or remain unchanged? Equities are the great cornucopia of wealth creation because they allow the "little guy" a piece of the action and so distribute the entre of entrepreneur to the masses, thus feeding a virtuous circle of rewarded venturesome ness, of course equities are never mis-priced, options on the other hand facilitate the pricing and laying off of concentrated risks- obviously there is no benefit to such an activity in excess of its friction and cost due to the fact that options are always priced for the benefit of the big boys.

* People "write" options against individual stocks. The theory is that if the buyer does not exercise the option, then the seller gets to keep the dividend and the purchase premium. If the option is exercised (meaning that the buyer chooses to either "Call" away the stock from the seller or "put" the shares to the seller), the theory is that the seller still comes out ahead from a combination of the dividend and premium.
If an owner of a stock(s) sells a call option, does that impact the volatility of his/her portfolio? What would it cost to achieve this result if options were not available? Why does "the invisible hand" of markets create such vehicles? Is this a benefit? By the way the exercise of a call is quite different from the exercise of a put.

* Once again, under this structure, one of the two principals MUST be wrong. There are even complex mathematical formulas showing how such a program gives an option seller a decided advantage over equity holders�. there are no value-creating events in options writing
Advantage-option seller or not?

*There are thousands of pros with the latest and greatest computers looking for the exact same thing.
* I would recommend that individual investors think very, very carefully before stepping into the options market.
* So what is making option buying and selling more attractive right now? I believe it has to do with the human tendency to place more weight on recent experiences than more distant ones.

The desire to take imprudent risk has always plagued our society, undoubtedly speculation takes form in the financial markets, however the relative popularity of options has less to do with the such shortcut heuristics mentioned. In professor Daniel Kaheman study of such cognitive difficulties he discovered that humans, when faced with complex problems heavily rely on mental shortcuts that factor significant events based on chronology. He discovered that such irrational behavior disproportionately effects the community of stock analysts, and moreover the dependence on information technologies (most notably the internet AKA TMF CNBC etc.) has "systematically impaired decision making and exacerbated cognitive bias".

* The process of buying the put also decreases the potential gains on the stock, in present, not future dollars. Naturally, I see why this would be attractive, but it seems like an awful distraction from simply hunkering down and making a determination as to whether the company represents a bargain at current prices or is fully valued.

Now I was under the impression that "there is no way for options to generate value", now how can that be consistent with an "attractive" attribute, anyone who obtains peace of mind from any insurance policy should therefore jettison such coverage hunker down and ride out the storm, unperturbed by the "awful distraction" of paying premiums, an activity that impairs the stock gains, which everyone agrees are as assured as the sunrise.

* It is one that has a fixed amount of value, an immense deal of efficiency, and a guaranteed net aggregate loss for all participants���.
* If I sell my Intel because I believe it will go up less than 10% per year, but someone else buys it because he thinks it is safe and it goes up 8%, we are both correct.


* The thing about options for most retail investors: It just makes something that is already so bloody complicated that much more so.

* Our goal here is to try to keep investing simple

* Options are a complex sideshow to investing in which the expected total return on invested capital is negative

* There is nothing inherently superior in strategies using options, and there is no options strategy that will provide a risk-free return.

* Man, there is just no need

Is it just me, or did I miss a chapter in finance theory, as far as the preceding direct quotes these equivocating absolutes are really just cheap shots. How about a guest interview with Espen Gaarder Haug on models and why they matter, or DO derivatives "create value"? Such information would be far more useful in answering the question of how the insurance characteristics of options can serve the equity investor to:
A) Reduce volatility
B) Mitigate the "risk of ruin",
C) Replicate exposure while reducing VaR.

This wholesale dismissal of complexity tosses the entire universe of convertible investing into the dustbin. Convertibles represent a fixed income vehicle with an equity kicker in the form of an imbedded call option. These hybrids provide exceptional risk/reward profiles offering a compelling albeit complex profile. Mr. Mann rejects the garden variety of plain vanilla options as instruments that turn average investors into "fodder". I wonder if Mr. Mann is one of the millions of Americans who have an adjustable rate mortgage? I wonder if Mr. Mann is one of the millions of Americans who have seen their pension assets transform from defined benefit to defined contribution, if so he is an uninformed unwitting counter party to even more complex exotic options than he seems willing to admit. Just what exactly is the total notational/theoretical exposure of Americans to a shift higher in mortgage rates?

Remember when Billy Beer was a hot item? Remember when Paul Volker had Alan's gig, remember when T-Bonds were yielding 15%. Fixed rate mortgages provided an "option" (one factor term structure option) that got exercised, a downside cushion against violent short term volatility, a great many Americans were insulated from this storm due to this imbedded option in those dull fixed rate mortgages, as interest rates advanced to unthinkable levels this risk was borne by large institutions able to hedge such risk, or by the government itself (for those institutions unprepared). We may postulate on the systematic risk but thanks to options it's just an academic exercise, protection that proved inherently superior�to be sure. I sincerely doubt those who sign up for ARMs imagine a future that might result from such contingencies (the macro of advancing interest rates, on housing prices considering the national adoption level of ARMs). If such circumstances would occur today the correlating impact on housing values would negatively impact household wealth on both the balance sheet and income statement, the whole "trade" has the potential for an arbitrage gone sour as increasing monthly mortgage outlay moves in tandem with a declining asset value- collateral, a potential outcome Americans gladly shoulder with little consideration for the contingent nature (and it's yet to be determined scope) of the liability, after all ARMs are "cheaper" however my Rendlemann/Bartter model suggests otherwise. In a similar vein Defined Benefit plans so too carried an imbedded option (ratchet option) that continuously protected pensioners accumulated wealth from outlier events, with the near universal adoption of Defined Contribution plans we are now getting a dose of gruesome systematic risk as we witness 401K getting deep sixed. As Dick Chaney (of Halliburton) might say "Big Time". If memory serves me Mr. Mann just recently spoke on the Hill flanked by pensioners who were sadly bawling their eyes out, they jettisoned any downside protection and instead accumulated concentrated directional positions in stocks. I sincerely doubt they imagined such a future either. This massive destruction in household wealth is yet another factor in the declining economy. There is measurable correlation here folks! Risk managers and those at the helm of our economy recognize how important it is to keep the market propped up, a consequence of the unprecedented level of Americans faith in LTBH, the real problem: What happens when that faith gets tested in today's unhedged equity centric casino? When the Dow went from 969 in 1965 to 776 in 1882, almost unbelievably the economy continued expanding robustly with GDP increasing 400% during this period. I cannot even conceive that such stable economic circumstances, all in the face of a 17-year equity decline, could repeat themselves today.

The future arrives as a surprise and options prepare you for exigencies. Is the initial rate on a fixed rate the same as an adjustable�of course not, uncertainty has a price tag so either you can shoulder it or your counter party can, it is simply a case of you can pay me now, or you can pay me later. The systematic risk of market decline has been now borne by pensioners, and if you want a taste of it, turn on the tube and see grandma eating Alpo, the bitter fruit of that once prized 401K.

The "advantages" for options trading:

*It's a highly valuable line of business for the brokers
* Some people who have figured out how to do it
* I can see how someone who is nearing retirement would want to do this: big losses could, at that point, be catastrophic. But the process of buying the put also decreases the potential gains on the stock

Quite amazingly enough we are inculcated to go forth and identify winning equity, with the implication that this task is user friendly, undoubtedly there are thousands of pros with the latest and greatest computers looking for the exact same thing, moreover "big losses" are catastrophes for the oldster only? The data suggests that big losses are simply a catastrophe whether you are 2 or 92. Moreover the catastrophic loss that gets shrugged off as "tuition" dramatically impairs decision making and fosters a compulsion to "win it back", finally such embracing of risk ends very, very badly when habitually adhered to, and as we are all aware its got loads of adherents. When the Japanese invaded Manchuria they would perform medical experiments on the local population, and they would do so without administering anesthesia. When a Japanese physician was interviewed regarding this practice he commented: "At first they would make a lot of noise, but after a while they would get real quiet"

I believe that there are many ways for investors to get to the promised land of superior investment returns�The Motley Fool's mission is to show people what strategies offer the best chance of long-term success -- ��If you like a company and think the price is good, buy it. This is why we suggest you � seek to buy companies for the long term

Not only do options get categorized as "crackpot" but identifying short term trends also gets painted by the same brush, so in the absence of these tools we are left with just one avenue, a road we have heard time and time and time and time again, buy for the long term. From a kindly constituency that is known as brokers, feeling only compassion towards investors, and driven by pure selflessness when touting stock.

LTBH (Lightheaded Today, But Hopeful)

Allied Chemical 
Allied Can
American Smelting
American Tobacco B.
Bethlehem Steel
Corn Products Refining
Eastman Kodak (IMHO headed for BK)
International Harvester
International Nickel
National Distillers
National Steel
Texas Corporation
Union Carbide
United Aircraft
U.S. Steel
Westinghouse Electric

30 years ago these 18 companies were the "Berkshires" of their day all DJ Industrial components, What happened?� CHANGE, and the "Delta" rate of change- of change itself- is accelerating (apologies I slipped in an option term). And it is change that is driving the adoption of options, change in the behavior of underlying stocks, change in technology, change in the degree of volatility, change in the publics appetite for speculation. Professor John Campbell's empirical exploration of volatility expression in financial markets, ascribes the fact that current market volatility resides in the top 10% of historical volatility due to the rise of institutional ownership and the attendant herd mentality of that reality, leverage, additionally dependence on information technology which feeds group think and hair trigger heuristics in the worst ways. Markets are becoming very, very volatile, and the unthinkable is happening with terrifying regularity

"Investing is about TWO things: Buying and selling
James Bittman

Those struggling with the new realities of current financial markets dream of "making things simple" unfortunately this is not possible. I also much prefer the stable world of pensions guaranteed, lifelong employment at a predictable company, conventional fixed rate mortgages requiring 50% down and ten year amortization, but we live in far, far different world. A world where people check stock quotes every 20 minutes on weekdays every half hour on Saturdays, and hourly on Sundays. A world where the expectations on what risk is supposed to deliver is quite pronounced and therefore mispriced. If you think the inputs to option pricing models are useful only to theoreticians, you are mistaken. . There is one universal element in all models, the risk free rate of return, from the touchstone of- cost of carry- we can begin crucial mathematical calculations.

The more you understand about the behavior of options the more you realize that they are indistinguishable from stocks.

I realize that this statement is quite revolutionary and that many of you may take exception to it, nevertheless I welcome the debate. You don't need to be reading academic studies of volatility to recognize that stocks have become options. Option premiums are calculated from 5 "known" variables (underlying price, strike, time to expiration, dividend, the risk free interest rate and then there is the implied volatility which reflects assumptions about the future), Every element that makes itself known in options makes itself known in equities. For example Theta, if your stock fails to perform at a hurdle rate exceeding the risk free rate of return, are you not subject to a decay of value over time? Now if your selected management produces positive results greater than generally anticipated by the relative richness or equity premium above historical/market trend. Does not your gamma curvature reflect such as the conditions of these two opposing forces? (if exceeding theta, thus a positive outcome) All stocks have imbedded within them positive expectations, no functioning stock is priced for bankruptcy. The implied growth rate of a stock is no arcane imaginings of some nutty professor, stocks are priced for success� all of em,� yes every single last one therefore we can conclude that with such universally held unrealistic expectations a great, great many will disappear (worthless at expiration). How many parents wipe the chins of their adorable offspring convinced that the little darlings will become President?,�all of em. Does not Discounted Cash Flow simply act as a "square root of time" whereby one is required to pay for an infinite stream of profit, in essence an option with no anticipated expiration, (it's too bad those eighteen stocks above didn't get stamped with an expiration date, though in all fairness some were acquired or merged etc.)

Indeed stocks are options with no agreed expiration and the risks they advertise are only a shadow of the risk you are saddled with� Hey this is not the hotel room in the brochure!! Options are hags from the time you make the reservation, respected as real, requiring difficult sober mathematical analysis. Stocks however are cloaked in the garb of respectability not ever to be seen on the "derivative" side of the tracks, at least not in daylight hours, but come happy hour�the bars are full.

Once maligned for humdrum businesses run by humdrum faded oldsters Berkshire seems quite the candidate for "best of show", that abysmal performance noted above is a faded memory of times when nobody gave a damn for the insurance (apologies for an options term) business a predictable equity now reborn and ripe for lifelong LTBH. So lets take a moment to "focus on what's under the hood" in this �currently- universally respected admired and loved company. My, my; this Berkshire outfit has collected 20 Billion in premium (apologies an option term), and holds contingent liability, for which it is reserved, ... sound familiar� geeze and I thought the laying off and pricing of risk was not a wealth creating venture, ... maybe somebody should tell Warren

"Never daunted by any risk if premiums are high Berkshire has emerged as a big re-insurer. Case in point the company collected $1.25 Billion in premium for incurring up to $2.5 Billion in claims for White Mountain in the CGNU deal. That followed a similar deal with Ace last year and various other transactions this year. These policies will involve losses- in excess of the premium- but Buffet pays claims slowly enough that Berkshire actually earns returns, even on claims resulting policies"
BARRONS Nov. 6, 2000


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