Buying Equities for their Option Value

Commenter dWj makes a good point about stocks: they are naturally going to be more richly valued than bonds, because of their option value. "Stockholders are long volatility," he writes, "at least relative to bondholders" — and he’s quite right, even if shellshocked stockholders right now are wishing they’d never seen the volatility of 2008.

The important thing to remember is that if you have a fixed-income asset, broadly defined — it might be credit, or Treasuries, or even cash — your downside is nearly always much bigger than your upside. No matter how safe you think you are, you can always be wiped out in some freak financial tsunami. Stocks can go to zero too, of course, but they have unlimited upside, and a small probability of a huge gain is something worth paying good money for.

John Cassidy, then, for all his protestations of optimism, doesn’t actually need to be an optimist for his move into equities to make sense:

Recently, I moved some of my savings from cash into stocks… In venturing into the stock market, I am taking out a long-term call option on the possibility that the doomsayers, my normal self included, are mistaken.

Indeed, the probability the doomsayers are mistaken can be quite low, and equities might still be attractive.

Nassim Taleb likes to talk about the difference between volatility and risk: equities are volatile, bonds are risky. The bursting of an equity bubble, as we saw in 2000, is reasonably benign; a debt bubble, as we saw in 2008, can be devastating when it bursts.

Donald Trump’s real-estate projects have a habit of going belly-up, but he has equity, not debt: when they do so, it’s his lenders who lose billions of dollars. Meanwhile, if he has a success, then he gets all the upside. It’s a nice job if you can get it (or persuade banks to fund it) — even if your projects lose money in aggregate, you can still end up making a fortune.

So it’s perfectly reasonable to move some savings — with the emphasis on the "some" — into equities right now, even if you believe, as I do, that they are ripe for another fall. I doubt that volatility is going to go away any time soon, and as dWj says, owning equities makes you long volatility.

On the other hand, most of us are overweight equities already, and have all the exposure we need to them and then some. Options are a form of leverage, remember, so if you’re buying equities for their option value, consider that a leveraged bet which should be based on a strong foundation of cash, TIPS, or other risk-free assets.