Tag: Options

How Joel Greenblatt Uses Options

How Joel Greenblatt Uses Options

Joel Greenblatt was previously a fund manager at Gotham Capital and delivered an annualized return of 50% from 1985 to 1994, before returning all capital to its partners in 1995.

In his book You Can Be a Stock Market Genius, Greenblatt shares his secret to generating parabolic returns with a long-term options contract—Long-Term Equity Anticipation Security (LEAPS).

(On using LEAPS) “There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and as generously.” — Joel Greenblatt

Greenblatt would purchase a call option—which is the right to buy a stock at a predetermined price for a period of time. For example, we could buy a call option on Facebook that gave us the right to buy its stock at $300 per share by Jan 2023, approximately 2 years away.

How Does A Call Option Work?

Typically, when we buy a call, we are bullish that Facebook’s stock price will go beyond $300. To buy this call option, we need to pay a premium of $45.

If Facebook’s share price goes up to $390 in Jan 2023, we would make 100% on our investment within 2 years. With an initial capital outlay of $45, we would reap a profit of $90 by exercising our call option, buying Facebook at a strike price of $300 and selling at a market price of $390.

But of course, risking $1 for $2 in returns is never a good investment from a risk-reward perspective.

If Facebook’s stock price trades below $300 in Jan 2023, the call option will expire worthless. For example, if it trades at $250, you would rather purchase from the market as opposed to exercising your right to buy at $300. You would rather let the call option lapse and lose the $45.

For Greenblatt, buying LEAPS call options makes sense only when there is a good chance of an event that will propel the stock price upwards significantly.

You can subscribe to my learnings on options here.

Wells Fargo Thesis

In Dec 1992, California was caught in one of the worst real estate recessions and Wells Fargo had the largest concentration of real estate loans in California.

During that period, many doubted if Wells would survive the real estate downturn and as a result, its stock price fell to $77.

Greenblatt’s thesis was simple_—_adjusting for cash earnings and one-time expenses, Wells was earning $36 per share before taxes. If things weren’t as bad as they seemed and returned to normalized levels, Wells’ loan-loss provisions would probably be $6 per share annually. This would translate to a normalized pre-tax earnings of $30 per share, or $18 after tax (assuming a 40% tax rate).

Conservatively giving it a price to earnings (P/E) multiple of 9 to 10 times, Wells could be trading at $160 to $180 per share (versus its price of $77 at the time).

Understanding the Downside

“Non-Performing” Loans

Greenblatt determined that while Wells was embroiled in one of the worst real estate downturns, its financial position was actually quite strong. At first glance, Wells’ non-performing loans were huge, coming up to approximately 6% of Well’s total loan portfolio.

But lo and behold, these “non-performing” loans were actually bringing in a yield of 6.2%.

This was when the bank’s prime rate (the interest rate paid by the bank’s best customers) was 6% and the cost of Wells’ money (the interest paid to depositors) was 3%.

Non-performing loans are loans that are substandard. These include (1) loans that do not pay interest, (2) loans in which the full interest obligation is not paid and (3) loans for which it is anticipated that future interest charges and principal payments might not be paid on time.

Wells was being so conservative that 50% of its non-performing loans were still paying all the required interest and principal payments on time.

In other words, the most worrisome part of Wells’s loan portfolio was still earning a return of 6%. There was a good chance Wells would be able to recover a good portion of these non-performing loans’ value.

Well Capitalized

Even after provisioning for potentially large loan losses, Wells still had higher capital ratios (e.g. tangible equity to total assets) than its competitors.

140-Year Track Record

In its 140-year history, Wells never had a loss in any year. Despite going through the worst real estate environment for California since the great depression, they still eked out a profit in 1991.

Few industrial companies demonstrated the predictability of Wells’ earnings. It was reasonable to assume that Wells would trade at a P/E multiple of 9 to 10 times normalized earnings (most industrial companies were trading above this).

Why Use LEAPS?

Banks are a different animal from most companies. It’s difficult to assess what makes up its loan portfolio. The financial statements only provide a very general overview of the bank’s assets.

Although Wells had been conservative and their financial strength certainly looked strong enough to withstand this recession, there was still a small chance that the bank’s loan portfolio could make the investment go south.

Investing in LEAPS is a great idea when the risk/reward ratios are in your favor. LEAPS lowers the capital outlay and magnifies your returns.

For Wells, there were two likely outcomes:

(1) Things were not as bad as they seemed, and Wells would trade above $160, or

(2) The housing crisis would worsen and Wells would trade significantly lower than $77.

Based on Greenblatt’s assessment, (1) was significantly likelier than (2).

And two years was sufficient for Greenblatt’s assessment to prevail—if things weren’t as bad as they seemed, Wells was likely to trade above $160 within two years.

Table comparing between buying LEAPS and stock

Buying LEAPS

In Dec 1992, Greenblatt purchased Jan 1995 calls at a strike price of $80 and paid a premium of $14. This meant that Greenblatt would have the right to buy shares of Wells at $80 in Jan 1995.

In two years, if Wells survived the California real estate crisis, and traded at $160, the value of these LEAPS would skyrocket to $80. This is because Greenblatt could buy shares of Wells at $80 and sell them immediately at $160.

On an investment of $14, this would mean a profit of $66 or a gain representing almost 5 times the original investment.

On the other hand, if Wells didn’t survive the real estate crisis, the total loss would just be $14. Investing in LEAPS set up a risk/reward ratio of 1 down to almost 5 up.

How About Investing in the Stock Directly?

Instead of using LEAPS, we could invest in the stock directly. However, this would not offer as good a risk/reward ratio, since Wells was either going to skyrocket or crash.

If the stock skyrocketed to $160, stockholders would have made a profit of $83 by having purchased in Dec 1992 at $77 per share.

On the other hand, if Wells didn’t make it, the stockholder could lose the entire $77. This offers a risk/reward ratio of approximately 1 up to 1 down, which would be significantly inferior using LEAPS.

Conclusion

Things played out according to Greenblatt’s thesis. By Sep 1994, Wells had more than doubled to $160 per share. Applying LEAPS in this case provided a much better risk/reward ratio. Options, when combined with sound fundamental analysis, can significantly increase your upside while reducing your downside.

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If you enjoyed today’s article, I’m sure you would enjoy the following:

How Warren Buffett uses options

How Warren Buffett uses options

“Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.”

Warren Buffett

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.

You can subscribe to my learnings on options here.

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:

  1. A contract’s maturity/expiration date
  2. Strike price
  3. Analysts’ expectations for volatility
  4. Interest rates
  5. Dividends

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 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.

Generating float

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.

You can subscribe to my learnings on options here.

P.S. I have previously written down my thoughts on Facebook’s valuation and how I used options to lower my purchase price.


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