Thread by @bauhiniacapital

Within a portfolio (and a portfolio construction method), thinking about optionality and opportunity is important: a counter-thread.

https://twitter.com/lsvalue/status/1256596084530569216

There is no free lunch.

I could go on but that is pretty much it. If you THINK you have discovered something you can do without paying for it, you are ignoring the cost. There is ALWAYS a trade-off.

1) Option spreads are quite literally, “paying for optionality.”

Example: buy a $1500 Jun21 TSLA call at $43. Sell $1520 Jun21 at $40. Net pay $3 for spread. Stock drops $100 next wk, call px drop to $35 and 32.50. Buy back $32.50, own $35 outright.

The underlying moved against you, you lost a little money. You bought back your far out option and now you are outright long.

No optionality was ‘created’. Optionality was purchased. Explicitly.

Portfolio optionality Rule 1: wanna buy an option? Buy an option.

2) Closing a position. This is the closest of the five to “optionality”. But not the way it is described here.

In a standard portfolio long 96.5% stocks 3.5% cash and divs receivable for execs, redemptions, etc, if you trim $1 off your $5 position in AMZN, you will reinvest it.

If you sell $1 of AMZN to buy $1 of Francis Underwood’s Cupcake Kingdom ($FU... oh heck you get it) you do so b/c you think FU will outperform AMZN.

If you think AMZN will fall 50%, that’s a portfolio decision. I’d sell more than 20% of my AMZN position.

But there IS optionality here. If you are aggressive (and in a non-taxable fund) and have high confidence in likely relative performance.

If two stocks will go from $50 to $250 over next 5-10yrs and you’re not sure whether it’s 5 or 10 but both will outperform benchmark soundly

then you are long both stocks at say 5% (or 10% or whatever) of your portfolio. If Stock A rises to $100 in Year 1, and Stock B only goes to $60, does that change the likely 10yr return? Of either? Both? Or of relative return of two? If you now think Stock A is likely to get to

$250 closer to Yr5 than Yr10 and Stock B is likely to get there later, look at relative expected return to target. On a log normal basis, Stock A has just made 40+% of the path return you expected. Stock B a lot less. Stock B is still a 4-bagger. Stock A is a 1.5-bagger.

Portfolio sizing should reflect confidence in relative return potential (if you want to get wonkier about it, there is a volatility and portfolio intracorrelation aspect in there too) so you might sell some Stock A and buy more Stock B.

Sounds easy enough. You are harvesting noise.

What if you rebalanced your entire portfolio like that once a month, or any time one stock got out of whack of its expected relative trajectory vs benchmark or expectation?

“But I’m an investor not a trader”

Yeah... about that...

You are a portfolio constructionist. You don’t care what goes in. If Francis Underwood’s Cupcake Kingdom merges with highly overvalued Medicinal Enhancements Inc in 2018 b/c they see value in offering edibles, and then underperform because of the complexity of licensing issues

and the fact that they haven’t managed cross-border inventories/production well, you might sell that stock $FCKME because it isn’t doing it for you. So now you reinvest the proceeds.

People change their minds on portfolio constituency from time to time. They should change their

minds on portfolio construction less often. But the market moves even more frequently than you change portfolio constituents. If you recognise this to be the case, you have noise you can harvest.

If it’s a taxable account, timing matters. And cost comes into the equation.

3) Cash/margin. Hmmm.... this is more complex.

If you are a long only investor with 96.5 stocks and 3.5 cash, raising cash to say 10% so as to take advantage of the possibility some things you like will go down in price and you can buy more, that’s called being bearish.

You only do it when you think the probability-adjusted return of doing so is better than the return of not doing so.

If you are meant to be ~100% invested all the time, that’s what the 3.5% is for. Make it 4% or 5% and raise the beta of your 95 or 96 slightly. Or just tilt a

little bearish at 95/5. If market is up 10% in your face in a quarter and you are 10% in cash, you just underperformed by 60bp.

But guess what. You don’t have to. Your entire portfolio is cash. Along the lines of #2, if FU and ME decide to merge and FU sells off hard b/c

everyone sees the problem of cross-state licensing of edibles, but you figure out that if they make edible cupcake flour in one state and ship that, it all works [no idea on this myself] then it all works, you might be a big buyer of the dip. Sell some AMZN, buy some FCKME.

It’s all relative all the time.

Always.

If you have your entire portfolio on margined swap so have 100% exposure but 50% cash and 50% margin maintenance against the swap, FU goes down, you put 5% of your NAV in. Great. Are you 105 long now?

If you raised leverage, or

portfolio volatility, you just paid a cost. There is, in most constructs, no free optionality in linear (log-normal) equity portfolio price space.

4) Selling puts to enter positions. This IS optionality. Selling puts is selling optionality, not gaining it.

Time for some game theory:

You like AMZN. You want to buy more if it drops 10%. You sell a put on it at 90. You get $1 of premium for every $100 of underlying.

But you like all your stocks. That’s why they are in your portfolio and sized the way they are. Because they are all equal on a relative expectations/volatility-adjusted basis. (If not, see #2).

So do you sell puts on everything? That’s like selling puts on the market.

No, no, no you misunderstand. I want to buy Stock C, which I don’t own. But only if it goes down 10%.

So you are saying if Stock C went down 10% you’d buy it? Yes.

But what if your portfolio fell 10% at the same time? Ah. But that’s not the bet I want to make.

Sorry cupcake. That’s the bet you are making unless you look at conditional outperformance options (Stock C has to go down 10% to trigger it but only if any one of Stock A, B, or n is not down during the period). Then you get exercised on C and sell A, B, or n to finance it.

That’s a bit like #2.

You could do that, but it would be quite complex if you wanted to do that on more than 1 stock at a time - Far more complex than you’d want.

If you replace below-market GTC orders (because you are lazy) with puts, you get what is coming. It could be higher leverage, it could be dumb luck (Stock C down, Stock A up 30% hitting price/sell target at the same time, and you earned the premium at the same time).

But you pay for the possibility of dumb luck by obligating yourself to do something you might now want to do. Sell 90 put for small size on Stock C on Feb 28 and watch portfolio melt 20% so now you need to sell something 20% down to raise cash to buy Stock C down 10%, even tho

it may be trading -30%.

Put selling may hv value but it is much harder for long-onlies to use than they think (they give up more optionality than just the put).

Optionality is not free. It is a relative value choice. It is part and parcel of the portfolio construction process.

And please forgive me the mild implied profanity...

I was only one coffee in when I saw the original thread and exclaimed to myself...

Francis Underwood Cupcake Kingdom Medicinal Enhancements!