One of the most critical behavioral elements that we teach in our IOI 101 course is to thoughtfully approach any investment decision or opportunity. That means reading and thinking deeply about the idea and developing your own opinion based on the data you have collected. Indeed this kind of thinking inspires much of the academic and applied research we read here at IOI.
The use of options in a portfolio context starts many spirited debates and so I offer you this piece from Investment and Pensions, Europe in which Roni Isrealov and Lars Neilsen tackle the purchase of protective puts as downside protection while maintaining their upside participation.
What they find in terms of “return effects” from this strategy was surprising. The team also offers some other ideas for how to take better advantage of downside risks. This is not to say that puts aren’t a good tool for this problem, Israelov and Neilsen find that they are just an expensive tool because the market seems to do a better than average job of pricing those options consistent with the risk or even above the observed risk.
The authors offer that selling option premium into downside risk exposure generates better returns in a higher volatility regime. This is particularly easy to do when one understands the intrinsic value of an option’s underlying asset. IOI 102 and 103 can teach you how exactly to bound a company’s value and structure the very investments that Isrealov and Neilsen suggest. Have a read of this thought provoking article and then get to class with us!