Palisade Research - Tue, Nov 6, 2018

Part 2: Understanding Optionality, an Ancient Philosopher, and Olive Oil

picture of    a thinking man sitting on a stone with his head on his right hand

For the second-part of our Palisade Strategy & Fundamental Series - I'm going to go over important tools that speculators can use to maximize reward while limiting risk (if you haven't read Part One - you can do so here)

Above all else - as speculators - we need practical theories and practical ways to apply it towards our investing.

Think of it as if you have a 'mental toolbox'. And the more you learn - the more important theories, frameworks, and strategies you have to use.

Soon - after building up a strong toolbox - you can then stack these tools you've gathered and create your own investing frameworks.

All this is why I'm going to add this key concept to your 'mental toolbox'. . .

That is: Make Sure To Always Find the Favorable Optionality.

What does this mean? Well just as the word optional means - it's something that's not mandatory.

The dictionary describes it this way: Optional - left to one's choice; not required or mandatory.

For example - paying your car insurance is optional. You don't have to do it. But it's probably a good idea if you do. By paying small monthly premiums, you're financially protected from a sudden rare event (a car accident) that could end up costing you a fortune.

Another example - buying stock options. You can always exercise the option contract if you want - but never have to.

So what's Favorable Optionality?

This means finding optional situations that offer you significant upside with little-to-zero risk/costs - meaning the reward far outweighs the small risks.. . .

And Unfavorable Optionality?

This is the exact opposite - this is finding situations that offer you significant risk/costs with little-to-zero upside - meaning the risks far outweigh the small rewards. . .

Using the car insurance example again - I make small monthly payments for the right - but not the obligation - to call upon my insurer if something happens to my car or myself.

If I get rear-ended and my tail light busts - I can check if I would rather pay out-of-pocket. Or instead call my insurance company and have them fix it if the damage is too much.

It's important to realize that I have the option to call my insurer. I don't have to - but I can if it's too expensive.

And one thing I've learned in life is that having multiple options is always better.

You can visualize Favorable Optionality like this. . .

line diagram of favorable optionality visualized

One of my favorite examples of optionality is the epic tale of Thales and his Olive Presses. . .

We first learn of Thales Miletus - a philosopher and the 'father of geometry' - from Aristotle's book, Politics.

We know that Thales lived during 600 B.C. and was an aspiring philosopher. But - of course - was mocked for his uselessness and poverty.

Of course - Thales was a practical man. So what did he do? He decided to make a fortune using his creativity and knowledge.

He reasoned that once he gained wealth, he could then dedicate his life to philosophy - or whatever he wanted - without worrying about money ever again (while also showing his doubters off).

Since he didn't have much money - he looked for which ways gave him huge upside with little downside/costs.

And after a while - the perfect opportunity appeared. . .

image of seven people at harvest time

Thales studied the weather and other conditions and soon decided that he expected a huge olive harvest (expecting a glut of olives). This was contrary to the public's perception - which expected a light harvest.

Thus - he took advantage of the market's one-sided expectations and found the Favorable Optionality to exploit. . .

Instead of betting directly on an olive glut itself (which would be shorting olives today) - he went out and paid small fees to lease multiple olive presses for a fixed period of time (sound familiar? It should - this is roughly what an option contract is).

He reasoned that this was an indirect way of profiting from olive oil. And - even better - he didn't even need that large of a harvest for him to still profit.

As Aristotle noted - ". . .the scheme has universal application, being nothing more than a monopoly. There need not have been a bumper harvest for the scheme to have been successful."

Thus - after locking in all these leases - he now had the right to use these oil presses if he chose. But wasn't obligated to.

The worst-case scenario? There would be a poor olive harvest and he would simply lose the small down payments he made on the un-used olive presses.

But the best-case scenario? There would be a much larger olive harvest, and the olive presses he leased would see huge demand. He could then ask request higher payments from the entrepreneurs wishing to use his presses to make olive oil.

So putting it simply: the best-case scenario far outweighed the worst-case scenario. Which equals Favorable Optionality.

Luck be it that there was a massive harvest. Much more than the market had expected. And when entrepreneurs showed up at the presses with several bags of olives - Thales was standing there with his hand out. Forcing them to pay higher prices - and reaping him a substantial profit.

In speculator terms - he more-or-less cornered the olive press market. . .

"Thales's reputation for wisdom is further enhanced in a story which was related by Aristotle. (Politics, 1259 a 6-23). Somehow, through observation of the heavenly bodies, Thales concluded that there would be a bumper crop of olives. He raised the money to put a deposit on the olive presses of Miletus and Chios, so that when the harvest was ready, he was able to let them out at a rate which brought him considerable profit. In this way, Thales answered those who reproached him for his poverty. As Aristotle points out, the scheme has universal application, being nothing more than a monopoly. There need not have been a bumper harvest for the scheme to have been successful. . .(Plut. Vit. Sol. II.4)."

Thales soon retired rich and simply focused on the good life.

I imagine him sitting up late at night - writing philosophy in his luxurious home - without worrying about bills or a care in the 600 B.C. world. . .

So - in hindsight - we can say that Thales made the first call option.

He understood the risk-reward and where the Favorable Optionality was. He could bet small amounts with little downside - yet which offered huge upside.

That's what I call good speculating.

Another person who learned from Thales was the trader-turned-philosopher - Nassim Taleb.

In his book Antifragile - an absolute must read in our Palisade Reading List - Taleb wrote how he loathed working. And how he longed to simply write all day without worrying about bills.

Thus - when he was younger - he went into trading because he noticed how he could make large amounts of money via commissions in a relatively short period.

This is compared with careers like salaried desk workers and dentists. Where income's fixed and there's a very small chance of ever making sudden, huge, monetary gains. No matter how much more or harder you work.

Taleb realized that jobs such as trading and writing - if done correctly - could yield vast wealth all while sitting in his bathtub.

He just had to be patient. Find the Favorable Optionality when it appeared. And bet big (as Thales did).

So in wrapping all this up. Remember - as speculators - we need to focus on finding the Favorable Optionality in opportunities. And always avoid the unfavorable.

I would rather lose small amounts of money nine-out-of-ten times and win a large amount once. Than make small amounts of money nine-out-of-ten times and lose it all once (known as blowing up).

This is how Modern Portfolio Theory (MPT) is designed - as I wrote in Part One (read here if you haven't yet). Financiers today aim for making small gains at the risk of losing large amounts of capital.

Imagine your money-manager buying stocks that are already at record highs and with markets extremely overvalued (which I've already shown - click here).

True - it's rare to suffer a large loss. But it does happen more often than many realize.

And much more often than the 'financial elites' tell us. . .

Thus each time traders buy at such high prices - their Unfavorable Optionality increases.

Why not rotate from overvalued markets and into undervalued markets? Where the downside/costs are much less?

So - in conclusion - make sure to always identify and align yourself with Favorable Optionality. In both everyday life events (such as car insurance or careers) and in your investment portfolio.

Avoid situations that tether you to huge loses with small upside.

In the next issue - Part Three of the Palisade Strategy & Fundamental Series - I will go over Cycle Theory and how we can use favorable optionality and Minsky's Financial Instability Hypothesis (Part One) with it to better our framework for speculation. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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