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As macro speculators – we need practical theories and practical concepts to apply in our investments.

Therefore – make sure you remember this key concept and add it to your own ‘mental toolbox’. . .

Ready? Here it is:

Make sure you always look for the favorable optionality with anything that has risk-reward. 

What does all this mean? Let me break it down. . .

For starters – 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). 

Thus – 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.

That’s what optionality means.

So then – what’s favorable optionality?

This means finding optional situations that offer significant upside with little-to-zero risk/costs.

Or – said otherwise – the potential reward far outweighs the fixed downside.. . .

(Keep in mind – unfavorable optionality is the exact opposite – these are the situations that offer significant risk/costs with little-to-zero upside – meaning the risks far outweigh the potential reward). . .

Now – going back to the car insurance example again – I’ll 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 things get too expensive.

And one thing I’ve learned in life is that having multiple options is always better than not.

You can visualize favorable optionality like this. . .

(Some of you may recognize optionality as when I’ve described asymmetry – that’s because they’re roughly the same thing).

Now – one of my real life 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 useless writings and poverty.

Yet – 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).

But since he didn’t have much money – he looked for the ways that gave him huge upside with little risk (just like a true speculator).

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

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 yield a 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 was under no obligation to do so. 

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 upside-case scenario? There’d be a larger than expected olive harvest and the presses he leased would see higher demand. He could then charge higher prices for the entrepreneurs wishing to use his presses to make their olives into olive oil.

So – putting it simply – the upside-case scenario far outweighed the worst-case scenario. Which means – it offered 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. . .

Thus – in hindsight – we can say that Thales effectively made the first call option.

He understood risk-reward and how to find the favorable optionality.

He could bet small amounts – risking little (small downside) – but at the same time capture the significant upside (massive potential reward).

This is what I call good speculating. . .

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

In his book Antifragile – an absolute must read in our Speculators Anonymous Comprehensive 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 their income is fixed and there’s a very small chance of ever making sudden, huge, monetary gains. No matter how much more or harder they work.

Taleb realized that jobs such as trading and writing – if done correctly (the big word here is correctly)  – could yield vast wealth all while sitting in his bathtub.

He just needed patience – to find the favorable optionality when it appeared – and bet big (just as Thales did).

So – in wrapping all this up – remember: as speculators – we need to focus on finding the favorable optionality in risk-reward 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 (aka blowing up).

This is how Modern Portfolio Theory (MPT) is set up as –  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 – with valuations extremely overvalued and crowd sentiment very optimistic.

True – it is rare to suffer a sudden large loss. But it does happen more often than many realize.

And much more often than the mainstream financial media lets on. . .

Thus – each time traders buy at such high prices – their unfavorable optionality increases (larger downside risks with less potential upside). 

Why not rotate from overvalued markets and into undervalued markets? Where the downside/costs are much less? Makes much more sense looking at it from an optionality standpoint.

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. . .