Lottery Tickets

I don’t know about you, but I really enjoy buying lottery tickets. I have some money, but not so much that $150 million wouldn’t change my life. Hell, $1.5 million would change my life—I could pay off the rest of my mortgage, which I have been diligently paying off over the last year. I could buy that condo in Miami that I’ve always wanted. I could buy a really cool car. I could donate a bunch of it to my high school. I could invest the balance of it and grow it even more. There are a ton of things you can do with that money.

Some people say, “You shouldn’t buy lottery tickets, it is negative expectation, neener neener,” but the reason the multistate lotteries work is because you’re paying an inconsequential amount of money, money that you won’t miss, for the small but real likelihood that you could get a life-changing amount of money. And like they used to say, if you don’t play, you definitely won’t win. 

I’m not a degenerate about it, but whenever I stop at the gas station, I pick up $20–$50 of tickets. I’m not going to miss it, and the mental masturbation that you do about what you are going to do with the money when you win is pure entertainment value—it’s fun to think about and well worth the $20. I get more entertainment value out of that than going to a movie. I actually talked about this in No Worries.

Optionality in Everything

There are lottery tickets in the markets too. You can buy deep out-of-the-money options and hope that a stock crashes down or crashes up. I did this one—around the pandemic. In November of 2019, I bought some crash puts in the S&P 500, and then when the pandemic happened, I made over 30X my money. Obviously, I did not have advance knowledge of the pandemic—I just thought that the stock market was a little hot and was betting on a steep pullback. 

Now, having said that, that is the only time in my trading career that has worked. If you know anything about options, you know that the deep out-of-the-money ones tend to be very overpriced—nobody wants to sell those for cheap. But occasionally, implied volatility comes down to the point where they are worthwhile.

I like to think about these situations where you can risk a little to make a lot. I certainly like this better than risking a lot to make a little. But these situations are not specifically confined to options—there is implied optionality in everything. You might be looking at a cheap stock that does not have a lot of downside and has the potential to go up a lot. That is like buying a cheap option. That is where small-cap value is at the moment—it really is a basket of cheap options.  The danger with buying cheap options is that they expire out of the money, but I would argue that buying the Magnificent 7 stocks here is like selling options—you are risking a lot to make a little. This was a recurring theme in the Options Masterclass, and once you see it, you can’t unsee it. There is optionality in everything we do.

Two Types of Risk

Insurance is an option, too, but a different sort of option. There are two types of risk: speculative risk and pure risk. With speculative risk, you can win or lose. With pure risk, you can only lose. 

If you have a big fancy house, you want to protect that big fancy house from loss. Hence, an insurance policy. You are on the hook for a deductible, and insurance picks up the rest. Now, I have owned houses since 1999, have spent probably close to $200,000 in homeowners insurance premiums since then, and I have never made a claim. 

Does that mean the insurance was a bad idea? Absolutely not. If you cannot bear the financial risk, you pass it along to someone who can. There are some people who self-insure their houses, meaning they don’t buy homeowners insurance, and that is usually in situations where the house is paid off and they have the cash to cover the loss if something happens. Given the frequency and severity of hurricanes in South Carolina, I don’t see myself doing that anytime soon.

I, for the most part, am a buyer of options. That’s not to say that I have never sold options, but I do it sparingly. Some people make a living out of selling options. Some people buy yachts from selling options. I have never had that kind of skill. But I want to get you thinking about optionality in all your investing activities, which is another way of saying risk/reward. If you buy a stock, and you expect to make 20%, you have to think about the potential downside. If the potential downside is 50%, then you are selling options.  

There are two payoff profiles in finance: You can risk a little to make a lot or risk a lot to make a little. I would argue that there are some corners of the market these days where you can risk a little to make a lot, which is what my analyst Adam Crawford is trying to do in his new newsletter, Heartland Investor. I hope you will jump on board.

Jared Dillian, MFA