A question about call options and valuation on stocks …
First of all I would like to thank you for sharing your knowledge and experience on a variety of important subjects through your website and articles in about.com.
I have read your articles about case studies in long term investment in various stocks and how it can be a model for long-term investing. I’m about to begin the journey.
Do you think buying Apple stock would be a good investment? They had great earnings but stock is being beaten down 10%. It must be a good entry point. I’m looking at buying long term call spreads, just for example: Jan 2014 500-550 call spread for $13.50. If you would buy apple stock synthetically using call options what would you do?
I will never tell you which stocks you should buy or sell. That’s not my role. That’s your job to figure out by looking at the earnings and assets. I will just help you understand what those figures mean and try to give you a framework to put the numbers in context.
If I were looking at a company like Apple, I would be examining the source of the underlying earnings. In the case of Apple, approximately 50% of the stock price and valuation comes from the iPhone. That means that if I were going to try and decide if the current valuation were reasonable, I would be obsessively focused on iPhone shipments, margins, market share, and costs. If you can’t give me a reasonable estimate for iPhone sales 5 years from now, you are gambling, not investing.
[mainbodyad]Going one step further: Call options, as you described using them, are a form of extreme leverage. This is more than gambling. This is speculation on steroids. Even if you are correct about your underlying thesis on Apple’s valuation, you have no control over when the market (read: other people acting collectively) will recognize that value. Even if you find a cheap company, there is no guarantee it won’t stay cheap for an extended period of time. There have been several periods in the past century when great companies sold for a tiny fraction of their intrinsic value, and the situation persisted for months or years. Witness the 1973-1974 crash. Great businesses fell by 75% of their valuation and sat there, doing nothing. If you owned the stock outright, you would have survived and thrived. If you owned call options, you lost everything.
What you described is not investing. It is gambling. It is how people lose everything, even if it comes at the end of a period when they made a lot of money. This is the very embodiment of wipe-out decision making.
You Are Dealing with a Security You Do Not Fully Understand
Speculation can have its place. During the meltdown, I held derivatives on a a wide number of securities and made quite a bit of money doing it in some cases through my personal portfolios. However, the cost of being wrong is almost always a total wipeout if you aren’t careful.
Given your level of experience, and what you have described, you are playing with an instrument you do not understand. At your age, the opportunity cost of making a mistake is enormous. Even if it turned out well, if I were examining your record and listening to your explanation as to why you made the position, I would put the paper down and back away slowly.
[mainbodyad]Maybe someday I’ll write about the rare situations in which I would consider taking a speculative position. But if I thought Apple were cheap, I wouldn’t be buying the call options. I’d be making more money, writing checks, avoiding debt, and owning them for along period of time.
Think of the General Mills case study you read. There were multiple times in that holding period when the stock fell substantially, and stayed low for an extended period of time. If you had bought the stock, you turned $100,000 into $2,098,086. If you had bought call options, you would have probably lost everything at least somewhere along the line. That’s just the math.
Respectfully, for those reasons, I refuse to answer your question. If you don’t buy the call options, you’re likely to look at the newspaper and say, “See! I should have done it”. If you do, and they collapse (as most end up doing by the very nature of the security), you lose your money. There is no winning here for me to address the issue. You can read into that what you want.