July 4, 2008

Bet against the crowd

The best returns can be achieved, sometimes, by taking the out of favour odds. Taking a long bet on the stock market right now is an out favour bet. Although it may have a low probability of occurring the expected returns can be high. US markets dropped from their peak by more than 20% while international and emerging markets dropped by more than that. The pessimism and low expectation of earning growth and uncertainty about the economic health are very rampant among investors. Given that back drop any positive event can light a match underneath equity prices.

Reading through the option figures on the S&P 500 (SPY) indicate that a 15% move to the upside have lower probability of occurring than a 15% decline. Therefore the put options are more expensive than the call options. Taking a position in deep out of the money calls may prove to be lucrative bet. So let me run the numbers on SPY Call Option Dec 2008 with strike price of 167 (current SPY price is 126):

Payoff $ (Price at expiry- cost) % Probability
SPY to go up 15% .14-.01= .13 1,300% 20%
SPY flat 0 (.01) -100% 20%
SPY to decline -15% (.01) -100% 60%
If the market stays the same or declines obviously you are out your premium on the option and if it rallies by 15% your returns are 1300%. If I assigned a low probability of 20% to a market rally by year end the expected pay off from the bet is 180%.

Now, I do not think there will be a rally, but if I want to take a directional bet I will take the bet on rally with low probability as its expected pay off far out gains any bearish bet.

Would I take a position like this? the answer is no. It is out from my style and process. There are a lot of investors and traders who implement strategies like these very successfully and earn exceptional returns. I like to stay focused on my process and earn my returns by finding good businesses. However, I like to run scenarios and see how out of favour odds can translate to excellent returns.

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