Buying out of the money options

I have read both of Nassim Taleb's books and his ideas regarding investment make a lot of sense to me. For those who aren't familiar with his approach, he puts the majority of his holdings into risk free or nearly risk free assets and puts a small amount into holdings that he believes will generate outsized returns but which generally tend to be underpriced, e.g. out of the money options.

I was wondering whether any practicable books exist that discuss this strategy: how to evaluate whether an out of the money option truly is underpriced, selecting which options to buy in terms of expiration and such, capital management, etc.

Specifically, I am interested in hedging inflation risk by buying out of the money options in gold, etc. Suggestions?

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Comments (15)

Oct 30, 2010 - 9:58am

Hedging crash risk makes sense if you have a ton of skin (money) in the market and want to give some balance to your profile, but this is a very difficult strategy to make any real alpha. Additionally, buying options that will expire 49 times out of 50 is the classic example of a negative carry trade -- it gets very expensive to run. Even out of the money premiums aren't cheap for retail investors. Taleb actually uses the strategy you describe as an overlay on a rates/currency macro-looking book.

Your last sentence is your investment theses but i don't think options are necessarily the best instrument choice to express your view.

Oct 30, 2010 - 2:46pm

Out-of-the-money options? (Originally Posted: 04/14/2010)

How are out-of-the-money options treated at the close of a transaction?

For example: XYZ company has a current stock price of $20 per share. XYZ company has various tranches of options outstanding. One tranche of options has a strike price of $30. A PE firm offers to take XYZ company private for $28 per share. If the deal closes, the options are worthless.

Is that it? Do the option holders receive nothing? Do they receive similar options in NewCo?

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Oct 30, 2010 - 2:49pm
If a deal goes though at $28 and you own options with a $30 strike, you must have seriously overvalued the company.

Or, more likely, are an employee who got said options as part of his/her comp.
Oct 30, 2010 - 2:50pm
If a deal goes though at $28 and you own options with a $30 strike, you must have seriously overvalued the company.

Ummm... what are you talking about?

If you've got options expiring 6 months, a year out, 2 years... what does what the company is being bought for today have to do with that? Also... buying an option isn't necessarily a value play, its often a volatility play or a hedge... so the strike price you're willing to buy at may have absolutely nothing to do with what you think the company is worth.

Oct 30, 2010 - 2:51pm

First of all, the owner of an option doesn't "get" anything when the option nears expiration. Upon purchase, he already has all he will ever have. The OPTION to make a sale or a purchase of a certain security at a certain price. If a company goes private before the option holder has a chance to exercise, then after the transaction is closed, since there aren't any more public shares, there's nothing for the option holder to do. So the option expires worthless. Tough shit.

And no one "values" a company in order to choose a strike price. The strike can be whatever the heck you want. The deeper in or out of the money will have profound effects on the price of the derivative, though. There are numerous strikes and maturites out there, and the assumption is that at all strikes the option is fairly priced.

Oct 30, 2010 - 2:54pm

As long as there's delta there's hope...
Oct 30, 2010 - 2:57pm

There's probably something in the original contract that deals with this type of thing. Although, in reality, like everything else in this life, it's To Be Negotiated. Bottom line, if the top guys hold a lot of them and they're crying about it, then they'll work something out, if the options are mainly held by lower level employees, they will get fucked. Most likely, both scenarios will occur simultaneously.

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