Why valuation is important in options investing

Investing using options is very different from building a classic long-term buy and hold portfolio.

In this segment of Motley Fool Live this first broadcast on June 7Motley Fool Canada Analyst Jim Gillies and Fool.com Editor / Analyst Ellen Bowman explain why valuation is so important when investing with options.


Ellen Bowman: It goes back to what I was saying about wanting to overlay these strategies on the companies that I already know and understand. Tell me why you start by doing the math like you’re investing for a long time and then move on to options from there.

Jim Gillies: In my opinion, what I’ve always brought to service, what Jeff brought to service, what Jim Mueller brings to service is, look, options are derivatives. It could be scary, and of course we’ve all heard Warren Buffett say that derivatives are weapons of financial mass destruction. They can be. I brought up my personal experience with a friend who wasn’t mass destruction, but it was unpleasant for her, and I imagine for her husband at one point.

But no, these are derivatives. They get their value from something else. The other thing being the underlying stock. In this amazing logical step, we always thought that if their value derives from something else, maybe you should pay attention to that other thing. [laughs]

We’re not going for big ideas here, you fools. This is, I hope, pretty basic stuff. If you have stocks, we’ve said this before, but how do you know if a business you’re buying is worth a good price? A lot of people will characterize a value investor as someone who pays, say, 70 cents on the dollar rather than going for a dollar and they will sell. As a value investor, it’s not my way of approaching things at all, but sometimes it’s characterization.

Likewise, some people say, “Well, I don’t mind paying too much. Maybe I pay $ 1.30 for dollar value, or $ 1.50. Well, they’re two very different attitudes, or even indications of value because I’m going to try to buy at 70 cents on the dollar and then hold on for a long time. They are different approaches and they are both valid. But your approach to options will change. Options, they have a finite life.

Archer: Right.

Gilles: Whether it is a week, whether it is three months, whether it is two and a half years, they all die. You would rather not die with them. [laughs] Most of us would.

Archer: I find it poetic and memorable, I think it’s a good thing to keep in mind.

Gilles: Look, the sad fact of the matter is Options, not sad fact though, the options require a bit of resetting. I see Jim Mueller tweeting us on the side here [laughs]

Archer: He teases us. [laughs]

Gilles: Jim, stop it, you’re distracting. But if you get close, you may be right in the direction of a stock market move, for example. But you could have chosen exactly the wrong options strategy for this stock, and what could happen is that the stock could move. The reward, in theory, rewards the shareholder and would have rewarded you as an investor if you had chosen a slightly different strategy. But in other words, it is possible to be right and lose money with Options.

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