Coming up with an investment idea or thesis is one of the core attributes of a great investor, but one of the more commonly overlooked skills is how to correctly express this view. Consider the following:

It is June 2014, and Lebron James is a free agent. It is widely believed he will return to the Miami Heat, but there are rumors of a small chance he will return to the Cleveland Cavaliers. Let’s say that the “market” believes the odds are 10:1 he joins the Cavs, but you believe the odds should be 5:1. How would you express your view to make money? [1]

Think about this for a few minutes before reading further…

I think the most common answer would be to bet that he goes to the Cavs, getting the 10:1 market rate odds. Let’s assume you bet $10, if you are right, you get $100, and wrong you lose $10. Assuming your 20% odds are correct, the expected outcome of this trade is $100*0.2 + -$10*0.8 or $12, which is a $2 return or 20%. However, there is a huge variance here, as 80% of the time you will lose 100% of your investment, which is not ideal. I would call this “the rookie trade.”

Let’s try to think of something better. What type of bet has longer (further out-of-the-money) initial odds and could move more on a Lebron return. Something that comes to mind are the odds of winning an NBA title. Odds that the Cavs win an NBA title were around 30:1, and you can assume if he doesn’t return this would fall to 60:1, maybe even a bit worse. Conservatively, if he does join the Cavs, these odds should improve at least to 10:1.

Let’s say you bet $10 at 30:1 that the Cavs win a title. There are two scenarios: A. He doesn’t join (80% chance based on your assumptions) and this would result in a -$10*(.5)*(.8) = $4 loss. B. He joins (20% chance), and odds improve to 10:1 which results in an expected value of 0.2*0.1*$300 = $6. You can improve the probability that this expected value will be achieved by selling the Cavs at 10:1 if you are correct.

This approach offers the same expected value as before, but with a much better vol distribution and no scenario where you lose everything assuming you exit the trade. You even retain some upside if championship odds are better than 10:1. This would be the “pro” trade, but let’s think, could we do better than this?

How can we really reduce our downside and retain upside optionality in multiple scenarios? Ticket prices for NBA games vary widely depending on if a superstar is playing. Tickets for Lakers games (Kobe) and Miami Heat Games (with Lebron) always command premium prices, whereas losing teams such as Orlando or Detroit usually have cheap tickets available for around $5. The Cavs had been horrible for the last four years, and tickets such as Cavs at Orlando were extremely cheap. Buying cheap tickets for Cavs road games against bad teams for $5 to $20 is the best investment in my opinion (or looking into Cavs season tickets).

For example, if you buy a ticket for $5, it is not going to go much lower as NBA tickets usually hold some value. Therefore, in the 80% chance he doesn’t join the Cavs, your loss is minimal. However, when Lebron is playing a team, $5 tickets usually turn into $25, $50 or potentially even $100+ tickets. Even assuming the lowest case scenario, $25 at a 20% probability, you still have an expected return of 100%. You also retain tremendous optionality that the ticket price can go even higher or that superstars join other teams, such as Orlando, or demand for their tickets increases. This is the “All-star” trade in my opinion: minimizing downside and retaining a tremendous amount of optionality while still expressing your trade idea effectively.

It is important to note that this last example is probably not transactable, as I am not sure single tickets are for sale that early before a season begins. Also, if you were 100% certain the “rookie trade” would work, then it would clearly be better than the “pro” trade (although if you are 100% certain about anything, you may want to rethink your understanding of risk). However, this is simply an example that I feel is helpful to demonstrate how to think creatively about expressing an investment thesis. You can protect downside significantly and retain upside optionality if you are creative, and that is what we try to do at Volmanac.

We attempt to translate an informational advantage (however big or small) acquired through data analysis into a small probability or timing advantage related to an important catalyst for an asset. We then construct a trade with an asymmetric risk distribution which leverages this small probability into high risk- adjusted returns.

[1] These market odds can be debated, but the point of this article is to think about risk, not debate historical odds