"Rule 1 is don't lose, your option holdings are not consistent with your strategy, unless you changed from value investing to gambling..."
A reader posted this comment, and as someone who considers himself a value investor it's something I wrestled with - afterall, in the world of value investing buying options basically amounts to heresy.
So what is value investing? IMHO it's simply buying something at a discount to it's real, or intrinsic, value. Normally, when people think value investing they think stocks - but really value investing can be applied to real estate, private equity, bonds, commodities, etc. However, options are a different story because, while a share of stock represents partial ownership of a business, an option has no such claim. In the world of engineering an option would be akin to a 2nd derivative, i.e. the operations of a business drives the price of the stock, and the price of the stock drives the price of the option.
So does it ever make sense for a value investor to buy options? Obviously I think the answer is yes, but only in certain situations - maybe the underlying stock is highly leveraged, or maybe there's some future event that could dramatically change the value of the underlying company. Rarely, an option is just plain cheap and the risk/reward profile is really attractive.
Also, the world of options is quite interesting. First, just about everyone is a trader and they view stocks as pieces of paper (not partial ownership of a business). Second, just about everyone uses the Black-Scholes model to price options (B-S uses volatility, interest rates, time to expiration, etc. to price the option, but doesn't considers the real intrinsic value of the underlying stock b/c it assumes the market is efficient). So in the world of common stocks there are plenty of value investors bidding up the prices on undervalued stocks, but in the world of options this simply isn't the case.
Anyway, just off the top of my head I can name several value investors who've purchased options (or warrants) - Warren Buffet, Joel Greenblatt, and Francis Chou - so while I can pretty much guarantee I won't be as successful as them at least I'll be in good company!
