Warren Buffett, Derivatives and Option Selling

Warren Buffett is one of the most successful investors of our era. He has been among the richest men in the world for many years.

Warren Buffet entrepeneur

He is known to be a follower of value investing, which a long-term investing strategy in businesses with solid fundamentals and interesting prices.

His fortune is due, in part, to his extreme frugality.

He started saving from a very young age, and accumulated 100.000 $ rapidly, which he invested very well from the beginning.

He bought the insurance company Berkshire Hathaway. The company had around 20% average annual return for 40 years. Last 15 have been more modest, with a 5,3 average return. Nevertheless, this is quite normal considering the difficulty for a company to maintain its growth rate once it has grown so much.

Warren Buffet options

But, in reality, I am not writing this to talk about Buffett´s success as a long term investor and entrepreneur. But to talk about the fact, that some multi-millionaires, like him and Soros, join the populist ranks, in a typical case of “do what I say and not what I do”. And also to talk about one of the less known trading strategies that exist, but which well applied, could be one of the best: selling options.

Some years ago, Buffet said that derivatives (derivatives are derivatives and not only LTCM ones) are weapons of mass destruction for the economy. However, he has no problem in using them since long time ago.

Like in the nineties with Coke (one of his most long term investments), when he made some risky bets (1) selling options of Coke. With the intention that if the company fell 1.5$ by the maturity of those bets, he could buy those stocks without losing money. And if the stock did not fall, he would earn a nice premium.

The trade, of course, went well.

This type of trading is very dangerous – although in the proper hands it is one of the best trading strategies out there (and Buffett has those proper hands) – and he repeated it more times the following years.

Buffett put options

In one of his famous letters in 2008, he declared that Berkshire had sold put options with a notional value of 37.1 billion $ between four major indexes: Euro Stoxx 50, FTSE 100, SP 500 and Nikkei.

Those puts would mature from 2019 to 2028, and its risk in case that the stocks went to 0 would be those 37.1 billion (although if stocks went to 0, Berkshire would probably not exist). According to Buffett, in case the indexes fell a 25% by the time of maturity, Berkshire would face a 9 billion loss, but the company would receive 4.9 billion, plus the interest earned.

It seems that those puts were sold in the period of 2004 to 2008. So it is likely that the price would vary significantly, from an SP at 1150 (2004) or 1500 (2007) or 800 (end of 2008). The average could well be close to 130 (1300 SP 500) SPY (SP options).

In this light, it seems that Buffett´s bet has been a masterpiece (the SP quoting 2075 today in December 2014).

 

Although I want to point out that depending on when the majority of those puts were made, things could be quite different. If the puts were sold at the end of 2008 (800 points for the SP), the trade was fantastic. For it equals having bought the stocks in the middle of that vicious 50% bear market, just when many investors were selling (at the worst moment). In that case, for that bet to be wrong, the markets should fall close to 80 or 90% from 2007 heights. And it seems that the likelihood of the SP quoting 200 points by 2019 or 2028 is not very high (yet not impossible).

On the other hand, if the trade had taken place at the beginning of 2008, close to market heights, it would be more dangerous.

When you sell long-term puts at 1400 is not the same as selling them at 700.

If there is a huge bear market in the years to come (a scenario that increasingly fewer citizens believe in), we will see how the bet plays out.

As it seems that those bets were made mostly in the period 2004 to 2007, we might consider that the average price exercised for them was quite high, perhaps something like a 1300 SP 500 price.

Let´s see an entertaining speculative exercise (which has not necessarily be close to the truth).

Warren Buffet investing versus speculating

Scenario 1: Imagine an SP 500 (2) quoting an average of 2700 points in the years 2019-2026. In that case Buffett would make 4.9 billions of premiums and also the return of that money, which was supposedly invested in stocks: another 4.9 approximately (100% market rise).

Scenario 2: Imagine the SP trading at approximately 500 those years. In that case, from 33 billion $ of maximum loss (it seems that 10% of initial puts were rearranged and “eliminated” in a way in 2009), and supposing a original selling price of 130 SPY, the loss would be close to 20 billion $ ((800/1300)*33). But the worst would be the fact that Buffett´s investments would not be worth 60 billion dollars with a market trading at those levels, but perhaps they would be close to those 20 billion. And the fact that 4.9 billion were invested do not mean much if those stocks trade 70 or 80% down. So, when we analyze the bet, it does not seem out of risk. Moreover, it is possible that the bets on the European markets could be worse.

We will see what the future brings the “Oracle of Omaha”, and his speculative long-term derivatives bet.

It is the truth that the fundamentals of the trade can be good; since it has a limited risk (selling call options has no limit in risk). But the bet is not absent of it since it is no clear that we will not have a major bear market next years. Maybe there could be one as bad as that of 1929.

What will happen? Time will tell.

However, and considering that as for today those are winning bets, an options trader could well pocket in some profits today, by buying protection puts for the same maturity and securities.

 

  • In the, on the other hand, almost impossible case that Coke stocks went to zero in a few months, Buffett could have had some problems facing losses of about 167 million dollars. Since he received only 7.5 million $ of premiums.
  • For this example we do not consider Euro, Nikkei or FTSE indexes.