How to profit from uncertainty itself

School was humiliating for me. Not at the time, but in hindsight. Everything I considered a complete waste of time back then has proven to be embarrassingly useful since. And most of what I considered useful has since been disproven altogether.

Most embarrassing of all is my ridicule of Australians learning Japanese in primary school. Having lived in various European countries until 2003, I considered learning Japanese about as useful as Finnish.

It was utterly incomprehensible to me that all Australian school children should learn Japanese. I refused to believe it – it made me laugh out loud. What use could it possibly be to any of us? Even Latin would’ve been better.

And I had no intention of ever travelling to Japan, either.

Ironically enough, I now live in Japan thanks to my Japanese wife…

My children wet themselves laughing when I try to read them Japanese children’s books.

Another memorable mistake is my dismissal of learning history. What use could it possibly have? Just a bunch of stuff that already happened…

These days, I write about history all the time. I use the rhyming nature of history to make my bizarre investment predictions seem more plausible.

My prediction of double-digit inflation in the UK in April 2021 was ridiculed…by those who didn’t know their history.

My prediction that the green energy bubble would burst in 2021, the same month that clean energy ETFs topped out, seemed just as absurd. But many readers remembered the tech bubble, the housing bubble, the Japan bubble and so many others.

The point is that history is like a bank of evidence that wild things really can happen. And that they will therefore continue to happen. Which makes history rather useful to investors.

Heck, the best investment strategist I can think of describes himself as a “market historian”.

But there is one exception to my embarrassing scholastic track record. Something I learned which has always stuck with me. And which could prove unusually useful to you in the next five years…

Meltdown or meltup?

Financial markets are full of people predicting either a meltup or a meltdown.

Usually, both sides are wrong, and we just muddle along.

That was the big prediction of newsletter publisher John Mauldin more than a decade ago. He was entirely aware of all the reasons to predict financial and economic disaster. But was a big believer in technology too.

Mauldin believed the bullish and bearish narratives would essentially cancel each other out.

He argued that any crash would be offset by government and central bank action. But true booms were unlikely to eventuate as government and central bank influence undermined the economy’s productivity.

The “muddle-through” thesis sounds a bit boring. But today, I’d like to show you how to profit from that exact environment. A world where people are inordinately optimistic or pessimistic about where the stock market is going, while it ends up going nowhere fast.

But I’ll need to take you back to my school days to do it…

And the first thing you need to know is this…

Risk is volatility, not the probability of a loss

Thousands of years before stock markets were invented, financial markets already featured futures. There’s even evidence of olive oil futures in Aristotle’s time.

The idea of the earliest futures was to bet on the price of a commodity. But this was a transfer of risk, not idle speculation. Consider a theoretical example…

An olive oil producer wants to lock in the price of his olive oil, which will be ready later that year. He can do this by selling what’s known as a futures contract. If the olive oil price falls by the time it is ready, the producer will receive money from the futures contract that offsets his loss on selling at the fallen market price.

But selling a future also caps the potential profit. If the price of olive oil rises, the olive oil producer will lose money on the future. The effect is to cancel out the higher profit from selling his olive oil on the market.

So, the olive oil producer is using futures to lock in a predictable price in the future. The future reduces the price risk of making olive oil.

That’s why the word “risk” isn’t synonymous with prices falling. Sometimes, falling prices is what you’re betting on.

Before we get to a better definition for risk than “falling prices,” consider the other half of the futures deal…

In my example, the buyer of the future is the one who takes on the speculative risk of olive oil prices. If the price falls, they lose money on the future. But if the price rises, they make money. So, the risk has been transferred from the olive oil producer to the speculator.

It was futures trading like this that allowed French wineries to produce such exceptional wine. Thanks to wine futures, the wineries stopped going broke during a bad harvest. Their futures deals protected them from the downside risk.

The wine merchants who bought the wine futures took on the risk of good and bad vintages. The wineries got on with the business of trying to improve their wine over time. Futures allowed them to do it.

The point is that the price of an investment going up isn’t inherently good. It can be good for one party and bad for another.

Out of this, we can establish that risk isn’t simply the chance of the price going down. It’s about uncertainty. How volatile the price is. How fast and far it could go up or down.

Volatility can be measured in several ways, such a variance, covariance and theta. But let’s keep it simple.

There is one asset that profits from uncertainty itself. An option…

How to make risk itself pay you

Buying an option gives you the right, but not the obligation, to buy or sell an asset at a specified time for a specified price.

You might buy an option to sell 100 BHP shares for $40 in three months’ time.

If the price crashes to $36 by then, the option becomes worth a lot of money. Because it gives you the right to sell 100 BHP shares that are only worth $36 for $40 instead.

It’s easy to see that the value of an option is impacted by the volatility of the share price. If BHP is regularly in the habit of plunging 10%, then the option is likely to pay off in three months’ time. If BHP doesn’t often drop that far that fast, the option is worth less.

What I’m getting at is that the value of an option benefits from expected levels pf volatility. So, if markets are expecting a large boom or bust, options are likely to be very valuable. Back to that in a moment…

An option isn’t a one-sided trade. Someone must sell the option to an investor. The seller’s position is a confusing one. But it’s your opportunity. So, let’s take a look.

In exchange for receiving an upfront cash payment from the option buyer, the option seller must promise to give the buyer their payout.

In our example of a $40 BHP option, if the price falls to $36, they have to buy the 100 BHP shares for $40. That’s painful when the price is just $36.

But the option seller receives an upfront cash payment in exchange for taking on this risk. This is called the premium – it’s the price of the option. And it’s what I want to tell you about today.

If you’re an investor who believes that neither the bulls nor the bears are right about the future, that we’re in for a muddle-through scenario instead, then you should be selling options. You would be betting that volatility is not going to be as bad as the bulls and bears are anticipating.

Options buyers would be paying you large premiums on options bets that are actually unlikely to ever pay out.

Because there is so much bullish and bearish sentiment out there, selling options is a highly profitable strategy. How profitable? Find out more, here, if you haven’t signed up already.