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How options can spice up investment – with Erik Kobayashi-Solomon

For most investors, the worlds of value and options may as well be oil and water but, as valuation expert Erik Kobayashi-Solomon’s career progressed, he became convinced the two could be successfully mixed

23/05/2021

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

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Benjamin Graham’s classic The Intelligent Investor is widely viewed as the founding text of value investing so it is perhaps only to be expected that when a financial expert tips his hat in that direction – as Erik Kobayashi-Solomon does with his 2014 book, The Intelligent Option Investor: Applying Value Investing to the World of Options – we would extend an invitation for them to join us on The Value Perspective podcast.

Not that a visit to the world of options is something we take lightly. This is a highly technical area, but might Kobayashi-Solomon – who, before writing his book, spent 15 years or so working in investment banking, learning how options work; in hedge funds, learning about valuation; and then third-party research, where he “figured out how to combine the two” – be the ideal person to offer a beginners’ guide?

An option is a simple directional instrument that allows an investor exposure to either the upside potential or the downside potential of an asset’s price,” is how he begins his answer – not, we suspect for the first time in his life. “A ‘call’ option is a special flavour of option that allows an investor exposure to the upside potential while a ‘put’ option allows an investor exposure to the downside potential.”

Simultaneous exposure

For its part, a share may also be a simple directional instrument but it does require an investor be exposed simultaneously to both the upside and downside potential of the market price of a company. “So, as a stock investor,” adds Kobayashi-Solomon, “if you want to gain exposure to a company’s potential upside, you must implicitly pay for that upside exposure by accepting the risk of a downside move in the stock’s price.”

To put it another way, then, an option disconnects the requirement to invest in both the upside and the downside potential of a business. If an option investor wants to gain exposure only to a company’s upside, they can choose to do that – however, because that linkage between upside and downside exposure is broken, they explicitly have to pay a monetary premium to do so.

“If you want to gain exposure to any upside in the way a ‘long’ stock investor would, you need to pay a premium but, in return, you do not have to pay the implicit price of accepting downside risk,” explains Kobayashi-Solomon. “Conversely, there are reasons an option investor might want to accept just the risk of a downside loss – and, if they do so, they get to receive that premium payment.”LongStrangle.png

This diagram shows an option investor that has gained both upside and downside exposure on ABC’s share price. If ABC’s share price either rises or falls, the option investor may be able to realize a gain on the position. Options allow investors to tailor their exposure to the price of an underlying asset in ways that simply cannot be done using only stocks.

Never the twain?

All that being so, then, for most investors, value is value and options are options and never the twain shall meet. As his career progressed, however, Kobayashi-Solomon concluded the two could be melded together. “I prefer to think about investing as a meal,” he tell us. “The meat-and-potatoes part of the meal is the stock and then the options provide some spice that accentuates the flavour of the underlying investment.”

Kobayashi-Solomon illustrates his point with the idea of a company that looks attractive over the longer term but appears to offer no immediate upside. “In that case, maybe you buy a smaller position in the stock and then accept that downside exposure,” he adds. “You know the stock has been beaten down and you do not particularly like the upside – but you also know the downside is not as worrisome as everybody thinks.

“Maybe you want that gain three to five years away and, in the meantime, you do not mind taking a little bit more risk on the downside. That is a perfect example of using options to spice up a ‘meat and potatoes’ stock position.” Rather than risk indigestion after this meal, however, we will save until next time an explanation of how options contracts are priced and how value investors might make that work to their advantage.

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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