Prudent Value Wtih Options concentrates assets in its best ideas (subject to reasonable diversification) and generally maintains its investment positions for extended periods of time.
In selecting among investment opportunities, careful assessment must be made of the risk profile of the various alternatives. In equity and debt (through ETFs) investing, risk comes in basically two forms: bankruptcy/default risk and market risk, with the greatest risk coming from the substantial costs that are incurred through bankruptcy/default. Prudent Value believes that both of these risks are best mitigated by investing in high-quality assets at a discount price.
In addition, we believe that the Prudent Value With Options model can reduce risk further by writing covered calls, uncovered puts, and option spreads.
Writing covered calls is a moderately bullish options strategy to earn a premium (i.e., income) by selling out-of-the-money calls against a holding of the underlying shares while being able to participate in capital gains (albeit limited) if the underlying stock rallies.
Writing uncovered puts (aka naked put write or cash secured put) is a bullish options strategy that is executed to profit by earning a premium when a put option expires worthless (i.e., out-of-the-money). Also Prudent Value can benefit as a long-term investor if the stock price drops below the put strike and the put gets assigned, thus owning the stock at a lower desired price (i.e., discounted stock price - premiums collected).
Writing option spreads (Bull & Bear) are designed to profit from either a rise or decline in the price of an underlying security. A bull spread is a spread where profit is attained when the price of the underlying security goes up. Conversely, a bear spread is a spread where profit is attained when the price of the underlying security goes down. Based on our view of the market, Prudent Value may write bear call spreads during times of over-valuation and write bull put spreads during times of under-valuation.
Our principal research methodology is as follows: First, seek high-quality equity and/or debt investments within our circle of competence (real estate, insurance, and credit services, to name a few). Second, the underlying assets of these investments should possess strong balance sheets and generate free cash flows. Data sources include but are not limited to the following: 1) financial newspapers and magazines, 2) research materials prepared by others, 3) annual reports, and 4) company press releases.
Prudent Value's approach to diversification is to limit the size of each asset purchase (to approximately 5% of the portfolio) across the capital structure and asset class, then to sell a security if it becomes an uncomfortably large position (10% or greater) in the portfolio.
In addition, the Prudent Value With Options model may write covered calls on stocks we believe to be fully valued to reduce the effect of drawdowns.
Assets are generally sold when their share price reaches our intrinsic value or to minimize losses. Intrinsic value is an economic concept, estimating future cash flows discounted to present value.
In addition, the Prudent Value With Options model may write bear call spreads during times of over-valuation to reduce the effect of drawdowns during market turmoil.
During times of extreme market euphoria, the portfolio may hold large cash balances, buy puts, and/or sell deep-in-the-money covered calls.