“Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.”
That’s right, Warren Buffett is a big user of these weapons of mass destruction.
Jest aside, options can be a great tool to complement investing when used appropriately.
Buffett’s Thoughts on Options
In Berkshire’s 2008 and 2010 annual letter, after highlighting the dangers of derivatives, Buffett explained in detail why he uses options to generate float for investing:
“Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options. We put our money where our mouth was by entering into our equity put contracts. By doing so, we implicitly asserted that the Black-Scholes calculations used by our counterparties or their customers were faulty.”
Like the efficient market hypothesis, and many other financial concepts taught in business school, the Black-Scholes model isn’t perfect.
Key inputs to the calculation of options value include:
A contract’s maturity/expiration date
Analysts’ expectations for volatility
In 2008, he gave the example of selling a 100-year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level in 2008).
Applying the key inputs to the calculation of options value, the Black-Scholes premium for this contract would be $2.5 million. In other words, Buffett would collect $2.5 million upfront for a put option that would expire in 2108.
What is the likelihood of the S&P 500 being lower in 2108?
In the 20th century, the DJI increased 175 times as companies within the index reinvested and grew.
The probability that the S&P 500 will be valued lower than its 2008 level after a hundred years is far less than 1%—an extremely unlikely scenario.
Even if this scenario were to happen, Buffett would only need to get a return of 6.2% CAGR on the $2.5 million premium collected to make up for the total loss of $1 billion.
Selling Puts on Coca-Cola (KO)
In Apr 1993, Buffett sold 50,000 put options (equivalent of 5 million shares) for $1.50 worth of premiums per option.
This comes up to a total of $7.5 million in premiums collected. These options expire on 17 Dec 1993 with an exercise price of $35.
KO shares were trading at $39 back in Apr 1993.
Let’s dissect Buffett’s rationale for selling put options on KO.
Lowering KO’s Purchase Price
Buffett wasn’t willing to pay $39 for KO shares back in April 1993 and was waiting for KO to hit his target price of $33.50.
If KO fell from $39 to $35, Buffett would effectively be buying KO shares at $33.50. The premium of $1.50 collected would have lowered his purchase price ($35 – $1.50).
Buffett’s method shows us how selling puts on stocks on your watchlist is a good way to generate income while waiting for it to hit your target price.
Buffett was able to collect premiums of $7.5 million upfront and invest them immediately. The concept of premiums collected from selling options is similar to underwriting insurance.
Much of Buffett’s wealth has come from insurance float, such as collecting premiums from car insurance upfront and paying out claims subsequently.
The time between collecting the premiums and paying out claims (if any), allows Buffett to put these monies to work!
This is akin to borrowing money, except that this is ‘permanent capital’. During economic crises like we saw in 2008, the credit market froze up and financial institutions were unwilling to lend capital.
However, even in an economic downturn, premiums from insurance would still be paid and you would not be at the mercy of creditors.
Another difference is that Berkshire has an underwriting profit almost every year! This means that Buffett has been borrowing money and he was getting paid to do so.
Buffett frequently uses options and other derivatives to build up his portfolio. While the majority of his strategy is buy and hold, derivatives can allow for otherworldly gains or a steady stream of passive income that protects you from some of the potential downsides.
Two Risks of this Strategy:
Firstly, If the stock goes below $35, you are still obliged to buy it at the agreed strike price and will “miss the opportunity” to buy it cheaper. This isn’t a problem if you planned on buying the stock and holding it for the long-term anyway.
Secondly, if the stock never hits your strike price and you may miss your chance of owning a potential winner. This isn’t entirely bad as you still get to keep all of your premiums and you can keep doing it all over again until the stock hits your desired price target.
My Options Journey
Since I started investing more than a decade ago, I have brushed options aside, thinking that they were just ‘noise’ or otherwise, ‘weapons of mass destruction’.
I’m glad some friends of mine helped change my thinking last year. Options can actually be used to complement sound, rational investing by increasing my returns or generating cash flow (i.e. income).
This year, I’m making it a priority to master this tool and I will be sharing what I learned publicly.
I believe the best way to learn is by teaching and writing, in plain simple English.