In the last article, I briefly discussed holding your wealth in something other than dollars and said that I was planning to hold mine in No Lose Stocks and “possibly some long shot calls and puts”.
I’ve been rereading Taleb’s “The Black Swan” lately and have been formulating some ideas for a new investment strategy I’m calling Long Shot Options.
The idea in a nutshell is to find the options that have to rise or fall the smallest amount over the longest time for the smallest price, and then buy them and wait. Most often these options will expire worthless. But my hunch is that maybe once a decade or maybe even more often, they will hit. And because they are so cheap, like $0.05 per share, when I buy them, I can buy lots of them for very little money and profit exponentially if they go up.
So let’s get into the specifics of why I think this might work.
One of the things that we find difficult to take is losing money, so I plan to only buy these options with the interest earned each month on my core capital. If I use only the interest from my account each month to buy whatever options are cheap that month, then the balance of my account will never drop. Occasionally it will jump up to a new higher level when I make gains or deposits, but it will never fall.
Avoiding losses can also be a relative gain. Consider that over the last couple months the S&P 500 has dropped 25%. Since I have been using the No Lose Stocks strategy, my own investments have returned 0% over that same period, meaning I haven’t lost any money. But compared to someone that rode the S&P 500 down to where it is, I have a relative 33% gain.
So we’re avoiding losses while still being exposed to the possibility of gains.
One of the things Taleb discusses in his book is our tendency to overestimate how much we know. He talks about a psychology experiment where the participants are asked, for example, how many lovers Catherine II of Russia had. The participants are supposed to guess a range where they are 98% certain the answer is within the range.
If the participants set their ranges correctly, then only 2% of the participants should be wrong when the results are tallied. But when the answers are checked the percentages turn out to be 15% to 30% wrong. The participants are overestimating how much they know. They were given the opportunity to set the ranges as wide as they liked, and yet they still missed the mark.
What I take from this is that option sellers are doing the same experiment. The option seller is being asked to pick a range that the stock will not go to. Since the option seller is picking the range, I can then bet against that range with the knowledge that the option seller probably picked too small of a range.
So we’re able to use the option seller’s overconfidence against him.
Bad at predicting
Next consider that the option seller is predicting what the stock price will be in the future. He’s looking at the past and making predictions about how high or low the stock price will go from here and in how much time.
But he’s basing his decisions on past data and looking for occurrences that happen very infrequently. The more infrequently something happens, the worse we are at accurately predicting it. The reason being that we don’t have a large enough sample to accurately gauge the likelihood that it will happen again.
Consider if you saw something happen once in the last 30 years. You might believe that the thing happens once every 30 years. But if it then happened again the next day, the rate would be twice every 30 years or on average once every 15 years. And if it then happened again the day after that, the rate would be 3 times every 30 years or on average once every 10 years. Over a very long time, assuming the real rate stayed constant, any bunching of occurrences would eventually average out. That’s the affect of the law of large numbers.
But it means that for things with longer times between occurrences, or a low chance of happening, we are really bad at accurately predicting the real rate of the phenomena. So if we let the option seller pick what he thinks the rate is, and bet against him, he will probably underestimated the rate.
So we’re able to use the option seller’s weakness at predicting against him.
Picking on the most optimistic
The market bidding process means that when I buy my option, I’m buying it from the person that was willing to take the smallest amount of money for taking on the risk that the stock will go to that price. This means that I get to buy from the guy who is the most optimistic and thus the one who is most likely to be wrong.
So we’re able to pick the option seller most likely to be wrong in his prediction.
We have a bias towards frequent rewards. This means we would prefer to get lots of small rewards rather than one large reward. Logically, we can reason that one large reward is better than a bunch of small rewards that don’t add up to the large reward, but psychologically we crave the constant positive feedback. So it makes it even more likely that the person selling the way out of the money options (which is a way to get constant positive income) is doing so irrationally and probably mispricing the risk he is taking in order to feed his need for a constant gain.
So we’re able to bet against the option seller’s weakness for frequent rewards.
If we look at history we see that rather than being a smooth even progression, history often moves in leaps. A new discovery is made and then everyone quickly shuffles and readjusts to accommodate the new reality. This same thing happens in the stock market. When new information is discovered the price of the stock quickly reacts, moving either up or down depending on the information. These leaps are fundamentally unpredictable, so by looking for the longest option expiration we can get the highest chance of hitting one and profiting from it.
So we’re able to take advantage of history’s tendency to surprise us with new information.
With Long Shot Options we’re attempting to take advantage of the weaknesses of the option seller and the tendency of history to surprise us, all while avoiding losses to our core capital.
If you’d be interested in subscribing to the Long Shot Options service when it becomes available, drop me an email at email@example.com.