Theory A is a financial tool that empowers individuals to ground their financial decisions in contextual understanding rather than trend following the latest meme. While meme stocks and similar can provide a lot of excitement and short term gains, they almost always end in financial ruin when applied consistently. Just like russian roulette, the chance of death increases towards 100% the longer you play.
This page breaks down the basic concepts of value investing as well as options trading so that investors understand why prices are the way they are and how to use our tools to manage a long term portfolio.
What is a Good Price?
Let's say a company spends 1M every year to run a business, paying cost of goods, insurance, rent, employee salaries, etc... and at the end of the year makes 1.2M in revenue. The total earnings or profit of the company is 200k.
How much would you pay for this company?
200k seems like a steal. After all you'd make that money back in just a year. 400k? 2 years. And so on. The price you are willing to pay relative to the earnings is the amount of years you are willing to wait until you pay off your initial purchase.
This ratio is the Price to Earnings Ratio. As a rule thumb, many value investors consider a P/E ratio of 15 or lower to be a good price. So the above business would be worth 15 * 200k = 3M.
However the real world is not so simple. Companies have different growth rates and different burn rates. How do you value a company that is growing earnings at 50% per year? How do you value a company that has no earnings but is doubling its user base each year?
For the former, Peter Lynch popularized the idea that for fast growing companies, a fair P/E ratio is a ratio that is equivalent to its growth rate. So if a company is growing earnings at 20% per year, a P/E ratio of 20 would be a fair price.
The market price is always right because it is the price that buyers are willing to transact at. However, when you multiply this by the number of shares outstanding, you get the market cap. And the market cap often does not make sense.
By using the market cap instead of the price, and then overlaying it over earnings, we can get an intuitive view of how a company is being priced.
For example, AAPL here has a historical P/E of around 20x average over the last 10 years. But in the last year, its P/E ratio has almost doubled to 40x. You can see this in the chart below. When AAPL's marketcap moves towards 20x its earnings, it bounces up as value investors recognize the deal and buy it. (Even during the COVID panic!)
The current price would seem too high for value investors because the rate of earnings growth doesn't justify its P/E ratio. When AAPL was smaller it could grow quickly by selling iPhones to new countries. But with a saturated market and more competition, it is unlikely that it can continue its historical growth rate.
Note however that the light green area is just analyst estimates. It is very possible that analysts are wrong and that the green area will actually be much higher. Perhaps they are underestimating demand for Apple's new VR headset.
However the more likely scenario is that many retail investors don't understand how valuations work. They don't see the green area and only see the line. So they buy and sell purely based on how much Apple is in the news or what their friends are buying. The most they can do is draw a line up and to the right.
This combined with the automated buying of many 401ks and passive index funds that buy the SP500 means that the price can stay high for a long time because there is so much price insensitive buying.
Understanding Options
Options are a zero sum game. You cannot buy an option without a seller willing to sell it. Many retail investors for example buy cheap out of the money call options in hopes that the price goes up. The seller of these options often is making a business similar to selling lottery tickets.
There are a small percentage of winners, but mathematically the business makes money just like a casino. Similarly, sellers of put options are like insurance companies. They collect a small premium from many people which offsets their payouts.
When using options to invest, it is important to understand whether or not you are in it for the thrill or if you can actually leverage them to manage your portfolio to suit your risk tolerance.
Options are priced using a formula called the Black-Scholes model. It is a very complex formula that takes into account the stock price, the strike price, the time to expiration, the risk free interest rate, and the volatility of the stock.
The key takeaway though is that they model prices movements as a random walk with differing amounts of volatility. The more volatile the stock, the more likely it is to move up or down.
The most important type of option to understand is the straddle, which is an at-the-money call combined with an at-the-money put. When you buy a straddle, you are betting that the price will move outside the straddle range and when you sell a straddle you are betting that it will stay within a range.
The image below shows all the option contracts around the ATM strike for TSLA plotted at their breakeven prices. The highlighted PUT shows that the $325 strike put at 4/17/2025 has a market value or premium of around $37. This means a seller was willing to see this insurance and a buyer was willing to buy it. For the buyer of the put to make money (assuming held to expiry) the stock has to fall more than $37 to make up for the premium paid.
By plotting all the breakeven prices, we can get a sense of the market's expectations for price movements. All these points are traders and investors putting money where their mouths are. When the volatility of a stock increases, such as prior to an election, the cone widens as sellers expect more movement and increase their premiums. Thus the cone acts as a real time prediction market for price movements.
(Note that the cone dynamically adjusts as volatility changes. When you buy a straddle, you're hoping that the code widens faster than your theta decay. When you sell one, you're hoping that the cone stays the same or gets narrower while benefitting from theta decay.)
Hybrid Investing
One of the reasons that value investing is not very popular is that it feels very slow compared to the overnight millionaires that meme stocks and crypto creates. After all, we don't want to finally be able to buy a house and afford a wedding in our 80s. It's useful to see how the SPY is in a bubble, but if it's a bubble that lasts multiple decades... then does it really matter?
When Theory A was first built at first we rejected integrating options since it felt like zero sum gambling and the antithesis to value investing. However we realized that by combining both worlds we would be able garner insights that both sides miss.
Volatility cones tend to be symmetrical because of how options pricing and the Black-Scholes formula works. They model a random walk and the prices adjust dynamically as volatility changes.
However, by combining options with an earnings overlay, we can express long term value sentiments through options and add leverage to our portfolio in a calculated manner.
For example let's say we want to bet on AI somehow and look at NVDA. Looking at is as just a line, it feels too high. We might want to "wait for it come down" and some other naive outlook.
However by using our platform, we can see that it is actually growing real earnings at 50%. We can play with the P/E multiplier and realize that that at 47x there is decent buying support. By overlaying the options, we can express a long term bullish view by buying a far expiry option or even do something more complicated like a calendar spread, selling the short term call to buy the long.
Instead of holding say $5000 in NVDA, we can hold $1000 in LEAP options which provide equivalent leveraged exposure. If we are right, we benefit from the upside while only risking 1/5 of the initial capital outlay.
Obviously there are risks. NVDA relies heavily on factories in Taiwan. Geopolitical tensions might disrupt operations there. The U.S. might encourage new companies. AI might hit a wall in improvement. Maybe new AI chips will not be GPU based. Etc...
Using our suite of tools we can model the world more effectively and make decisions based on our own understanding and predictions of the world rather than being swept along by viral momentum and the social pressure of memes.
We can choose to leverage the wisdom of crowds. Or go contrarian against their madness.
The information on this website is for informational purposes only and should not be construed as financial or legal advice. The content on this site is provided "as is" and we make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability or availability of any information, products, services, or related graphics contained on the website for any purpose. Past performance is not necessarily indicative of future results. There can be no assurance that any investment strategies will achieve their objectives. Investment return and principal value will fluctuate so that investors' shares when redeemed may be worth more or less than their original cost; current performance may be lower of higher than the performance quoted herein.