VALUE INVESTING VS. RULE #1 AND OPTIONS

Tom had a great question about Rule #1 and Options. Read on:

Phil,

Ok, ok, ok, you said, "The answer is this: Buy only wonderful businesses at attractive prices. "

Now, when it comes to stocks that answer makes perfect sense and I can deal with it.

But what about when a guy (or gal) wants to trade Options? How does our value investing philosophy carry over to this unique form of investing?

The reason I ask is twofold. First of all, these quality companies we're looking for generally have relatively low volatility - and since we're only in an option for a few months we need the thing to move! Correct?

Second, my wife and I are attending Success Magazine's Investools Options seminar here in Grand Rapids on Oct. 18th. So I figure it'd be good to arrive loaded for bear!

Any insight would be greatly appreciated!

Regards,

Tom Vanden Bosch
Grand Rapids, MI

My response:

Tom,

We don't do 'value' investing.  Value investing is very Ben Graham type stuff.  Buy cigar butt businesses at very low prices and very low PEs in the hopes that there are one or two puffs in there still. Graham owned around 200 of these at a time and dumped them mercilessly if they didn't rebound quickly.  We've moved along with Mr. Buffett toward the idea of buying a mis-priced but very GOOD businesses.

A very good business tends to be a growth business with a high degree of predictability. That means, as long as I understand the business, I'm okay with Dell or Google or Whole Foods or any other number of high flying, high PE growth businesses as long as I can get a good deal. 

Therefore, the high quality businesses we are looking for are often quite volatile.  It's the ponderous overpriced Dow stocks which we avoid... because, while they are quite good businesses, they are usually quite bad deals -- and therefore the price doesn't move much. 

 

The beauty of Rule #1 for Options Traders is the joy of finding a business that doesn't seem like it's going to move much... buy the option cheap... and then the thing takes off.  SCORE!!!!  Believe me, 50% moves in 6 months are quite enough volatility to make you very rich if you are on the right side of the move with an option.  And, since you are going to get some wonderful advanced training, I'll add that volatility can move both ways.  Find the opposite of a Rule #1 business that is massively overpriced a la GM in 2000 and you can just KILL it with a judicious Put.

 

Now go play!

 

Phil