Why Valuation Matters in Options Investing

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

In this segment from Motley Fool Live that first aired June 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss why valuation is so important when investing with options.

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Ellen Bowman: It goes back to what I was saying about wanting to layer these strategies on top of companies that I already know and understand. Tell me why you start with doing the math as though you were investing long and then turn to Options from there.

Jim Gillies: In my view, what I always brought to the service, what Jeff brought to the service, what Jim Mueller brings to the service is, look, Options are derivatives. That could be scary, and of course, we’ve all heard Warren Buffett talk about derivatives are weapons of financial mass destruction. They can be. I mentioned my personal experience with a friend who wasn’t mass destruction, but it was unpleasant for her, and I imagine for her husband at some point.

But no, they’re derivatives. They derive their value from something else. The something else being the underlying stock. In this stunning step of logic, we always thought, if their value derived from something else maybe you should pay attention to that something else. [laughs]

We’re not going for any great insights here, Fools. This is, I hope, fairly basic stuff. If you have a stock, we’ve said this before, but how do you know if a company you’re buying is a good price? A lot of people will characterize a value investor as someone paying say, 70 cents on the dollar than going to a dollar and they’ll sell. As a self described value investor, that’s not how I approach things at all, but that is the characterization sometimes.

Similarly, some people say, “Well, I don’t mind overpaying. Maybe I’m paying $1.30 for a dollar value, or $1.50. But the stock price is going to grow into that over time and this will be great.” Well, those are two very different attitudes, or even the value guidance as I’m going to try to buy at 70 cents on the dollar and then hold for a long time. These are different approaches and they’re both valid. But your approach to Options is going to change. Options, they have a finite life.

Bowman: Right.

Gillies: Whether that’s a week, whether that’s three months, whether that’s 2 1/2 years, they all die. You would prefer to not die with them. [laughs] Most of us would.

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

Gillies: Look, the sad fact of the matter is Options, not sad fact but, Options require a bit of a reset. I see Jim Mueller’s chirping us on the side here [laughs]

Bowman: He’s teasing us. [laughs]

Gillies: Jim, stop that, you’re distracting. But if you are approaching, you can be right on the direction of a stock movement, for example. But you could have chosen the exact wrong Options strategy for that stock, and so what could happen is the stock could move. Reward, in theory, reward the stockholder and would have rewarded you as an investor if you’d chosen a slightly different strategy. But in other words, it’s possible to be right and lose money with Options.

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