Kobayashi-Solomon - The intelligent option investor applying value investing to the world of options

Copyright 2015 by Erik Kobayashi-Solomon. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher.

ISBN: 978-0-07-183366-0

MHID: 0-07-183366-8

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To Fred Solomon

(19302013)

To my family and my tribe

M any thanks to all the people who have been part of the process during the writing of this book. I am indebted to three people in particular, Mr. Brent Farler, Mr. Ben Louviere, and Mr. Neil Kozarsky, who have graciously offered their time, help, and business expertise in bringing this project to fruition. Certainly this book would be much different and of not nearly the quality without Brents guidance, thorough reading, and insightful, helpful suggestions, starting with the very first draft in late 2012.

In the literary world, I cannot say enough good things about Mr. Sam Fleishman, of Literary Arts Representatives, and Mr. Knox Huston and Ms. Daina Penikas, my editors at McGraw-Hill, all of whom have allowed this work to move from conception to completion and whose advice and support have made all the hard work worthwhile.

In the investment-management world, I am indebted to Mr. Steve Silverman, owner and portfolio manager of Ironbound Capital Management, who taught me important lessons about the business of investing and about how to critically assess the value of a company, and to Mr. Deepinder Bhatia, Founding Partner of Bayard Asset Management LLC, a true expert in the art and science of equity research and analysis.

In addition, I thank Mr. Rafael Garcia, of the International Financial Corporation; Mr. Joe Miramonti, of Fedora Investment Partners; Mr. Franco Dal Pont, of Batalha Capital Management; and Mr. Paul Neff, of the Federal Reserve Bank of Chicago, for the excellent discussions about valuation, option theory, and bringing the touchstone of valuation into the realm of option investments.

When I began work on this book, I did not realize just what an enormous process it would be. Truly, without the help and support of all the people mentioned here and all my friends and family around the world, I would have had a much more difficult time completing this work.

Y ou have a tremendous advantage over algorithmic trading models, investment bank trading desks, hedge funds, and anyone who appears on or pays attention to cable business news shows. This book is written to show where that advantage lies and how to exploit it to make confident and successful investment choices. In doing so, it explains how options work and what they can tell you about the markets estimation of the value of stocks.

Even if, after reading it, you decide to stick with straight stock investing and never make an option transaction, understanding how options work will give you a tremendous advantage as an investor. The reason for this is simple: by understanding options, you can understand what the rest of the market is expecting the future price of a stock to be. Understanding what future stock prices are implied by the market is like playing cards with an opponent who always leaves his or her hand face up on the table. You can look at the cards you are dealt, compare them with your opponents, and play the round only when you are sure that you have the winning hand.

By incorporating options into your portfolio, you will enjoy an even greater advantage because of a peculiarity about how option prices are determined. Option prices are set by market participants making transactions, but those market participants all base their sale and purchase decisions on the same statistical models. These models are like sausage grinders. They contain no intelligence or insight but rather take in a few simple inputs, grind them up in a mechanical way, and spit out an option price of a specific form.

An option model does not, for instance, care about the operational details of a company. This oversight can lead to situations that seem to be too good to be true. For instance, I have seen a case in which an investor could commit to buy a strong, profitable company for less than the amount of cash it heldin effect, allowing the investor to pay $0.90 to receive a dollar plus a share of the companys future profits! Although it is true that these kinds of opportunities do not come along every day, they do indeed come along for patient, insightful investors.

This example lies at the heart of intelligent option investing, the essence of which can be expressed as a three-step process: