Sometimes we overdo “option value”. We do things that have a small possibility of a big upside, and big possibility of no or very minimal downside, in the belief that “nothing can go wrong in trying”.
My father used to term this “pulling a mountain with a string”, with the reasoning being that if you actually manage to pull, then you have moved a mountain. If not, all that you have lost is a string.
There is one kind of situation, however, where I think we might overindex on option value – these are what I call “one shot events” or “brahmastras”.
Going into a little bit of mythology, there is the story of the Brahmastra in the Mahabharata. Famously, Karna possesses it. It is an incredibly powerful weapon with the feature (or bug, rather) that it can be used only once. Karna would have set it aside to use on Arjuna, but the Pandavas decide to send Ghatotkacha to create havoc during the night fight when Karna is forced to use up his brahmastra on Ghatotkacha – meaning he didn’t have access to it in his battle with Arjuna, where he (Karna) ultimately got killed.
Because the Brahmastra could be used only once, Karna wanted to maximise the impact of the weapon. His initial plan was to use it on what he thought might be a decisive battle with Arjuna. The Pandavas’ counterplan was to force him to use it earlier.
Actually, thinking about it – the Brahmastra can be thought of as another kind of option. The problem here being one of optimal exercise. Actually, there is a very stud paper written by economist Avinash Dixit on this topic – regarding Elaine’s sponges.
Read the whole paper. It is surely worth it. To quickly summarise, Elaine has a limited number of “contraceptive sponges”, and wants to maximise her “utility” of using them. When a guy comes along, she needs to decide whether it is worth expending a sponge on him. Dixit derives a nice equation to determine a function for this.
Basically, Brahmastra occurs when you have only one sponge left, and you need to use it at an “optimal time”. There is another problem in economics called the “secretary problem” (nothing to do with secretary birds) that deals with this.
Recently I’ve been thinking – these kind of Brahmastra / sponge / secretary problems are important to solve when you are thinking of talking to someone.
Let’s say you have what you think is a studmax application of GenAI and want to talk to VCs about it. If you go too early, the VC will only see a half-baked version of your idea, and even if you go to them later once you have fully formed it, the half-baked idea you had showed them will influence them enough to discount your later fully formed idea.
And if you go too late, the idea may not be that studmax any more, and the VC might dismiss it. So it’s a problem of “optimal exercise” (note that this is an issue only with American options, not European).
It is similar with asking someone out (or so I think – I’ve been out of this business for 14 years now). You approach them “too early” (before they know you), they will dismiss you then and then forever. You approach too late and the option would have expired.
In the world of finance, we focus too much on the PRICE of options and (based on my now limited knowledge) too little on optimal expiry of the said options. In the real world, the latter is also important.