a question about selling puts versus buying the stock

[valuecfa]

I can't wait to hear it.

 

I'm a big boy, please tell me what "volumes" it spoke.

 

That is a kind invitation, but I'll decline.

 

I've made my points, and I'm pleased to see most people get it. As for the rest well, I'll leave it to Warren: "If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is."

 

Bear in mind that in the recent past Buffett also has sold put options on stock indexes in the US, UK, Euro zone, and Japan. He has quite infamously bought silver, has speculated on the Brazilian real recently, sold put options on Burlington Northern less than a year ago.

[Myth465]

Sounds to me like you are picking and choosing which Buffett you know / like.

The Buffett I know thinks a mispriced asset is a mispriced asset.

[Uccmal]

I can't wait to hear it.

 

I'm a big boy, please tell me what "volumes" it spoke.

 

That is a kind invitation, but I'll decline.

 

I've made my points, and I'm pleased to see most people get it. As for the rest well, I'll leave it to Warren: "If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is."

 

Opihiman, What is this garbage.  You openly criticize at least two board members and then dont actually add any value yourself.  I too am confused by your comments.  Obviously I dont get it.  Damn shame. 

[bargainman]

Opihiman, What is this garbage.  You openly criticize at least two board members and then dont actually add any value yourself.  I too am confused by your comments.  Obviously I dont get it.  Damn shame. 

 

I'll second that.  Add to that the quoting of Buffett out of context, quoting random value investing platitudes, and all in your first 10 posts on this board!  I'd say.. that speaks volumes!

[maxprogram]

Maybe the discrepancy here is that -- yes, when flat-out purchasing a call, the intrinsic value of the underlying equity should be a major input into the decision. But, options themselves have value regardless of the underlying which can be exploited just like equities.

 

One example: In the recently updated edition of Security Analysis, David Abrams (Klarman protege) discusses his realization that options arbitrage is another form of value investing. He lays out an "options box" where you buy a call and sell a put at strike $x, then sell a call and buy a put at strike $y. The value of this box remains fixed -- I think it's $5 in the example. If option prices are not in line, you can buy the "box" for say $4.50, guaranteeing a 50 cent profit, regardless of underlying equity.

[Opihiman]

Despite the condescending tone to which I've been subject, and against my better judgment, I'll make the point again in simple colors.

 

Here is a simplified restatement of the OP's example:

 

Jan. 2012 $20 Puts

[ORCL est. current stock price: $22.0]

Put Premium: $2.95

Net Cost "If Put":$17.05

Margin of Safety: 22.5%

 

Note that margin of safety is referenced to an options strike price, the premium received, and ORCL's observed price in the market. Lots of Price, no Value. There is no stated or implied reference to intrinsic value of the underlying. Margin of Safety is a key, if not the key principle of value investing. When we see it bastardized in this way, we ought to point it out.

 

I would assert that the greatest threat any investor faces is the threat of his own muddled thinking. Apparently from this BB article (link below) from Tuesday, muddled thinking around options is rife right now. What I saw in the original post were the queries of a retail options trader who had haphazardly glommed on some veneer of value investing. Whitney Tilson from the BB article: "Trading options is one of the all-time suckers’ bets, most experienced professionals lose money doing it. It’s virtually certain that inexperienced, individual retail investors will lose money doing this.”

 

I was brusk with the OP - I suspect some here are reacting to my tone rather than to my message. I will just say that retail options investors receive deceptively positive results from many of their trades. This contributes to overconfidence, and oftentimes a closed mind. Overconfidence, a closed mind, and muddled thinking are rarely receptive to a coy response.

 

http://www.bloomberg.com/apps/news?pid=20601109&sid=apikSovE33hQ&pos=13

[ERICOPOLY]

Despite the condescending tone to which I've been subject

 

For a minute there I didn't think you had a sense of humor.  Good on you.

 

[Rabbitisrich]

The OPs usage is appropriate if you consider that a margin of safety aims to reduce your odds of loss in the face of uncertainty. Wouldn't you agree that a higher put premium relative to strike price increases your margin of safety given no change in the risk of the underlying?

 

The boardmembers are reacting to your tone more than you statements, which are otherwise fair. OP is clearly new to investing and to options, so a less aggressive response would have been more helpful.

[Opihiman]

The OPs usage is appropriate if you consider that a margin of safety aims to reduce your odds of loss in the face of uncertainty. Wouldn't you agree that a higher put premium relative to strike price increases your margin of safety given no change in the risk of the underlying?

 

Interesting question. I think the logic is very dangerous, and I'll use an illustration to show why. Follow me - it's important.

 

For illustrative purposes I will use WCOM circa August 1999 trading in the $55-50 range.

 

On Monday I sell a put at the the $50 strike for $1.00

On Tuesday I sell another put at the same strike for $1.25

 

By your logic Rabbit, the Tuesday sale offers greater 'margin of safety' because it offers greater protection against downside risk. This is not what Ben Graham taught. From Security Analysis (3rd ed. p. 45): Margin of safety on common stock exposure "should be represented either by the excess of calculated intrinsic value over the price paid, or else by the excess of expected earnings and dividends for a period of years above a normal interest rate."

 

As stated, the OP's original question was about the mechanics of pure speculation, with some value-related terms casually sprinkled in.

 

I'll just reiterate a simple point: unless an equity option position is anchored to some measured estimate of intrinsic value, it is, in essence, a purely speculative position. Speculation has its place, as long as one goes in with their eyes wide open.

 

 

 

 

[ERICOPOLY]

Rabbitisrich wouldn't start out by selling puts on WCOM. 

 

The running insult here is that you assume we are all stupid, and that you must enlighten us.

 

[twacowfca]

Maybe the discrepancy here is that -- yes, when flat-out purchasing a call, the intrinsic value of the underlying equity should be a major input into the decision. But, options themselves have value regardless of the underlying which can be exploited just like equities.

 

One example: In the recently updated edition of Security Analysis, David Abrams (Klarman protege) discusses his realization that options arbitrage is another form of value investing. He lays out an "options box" where you buy a call and sell a put at strike $x, then sell a call and buy a put at strike $y. The value of this box remains fixed -- I think it's $5 in the example. If option prices are not in line, you can buy the "box" for say $4.50, guaranteeing a 50 cent profit, regardless of underlying equity.

 

 

Agreed.  Tuesday AM there was a huge mispricing in the June $120 SPY strike puts vs the July $120 strike puts. At one point the June puts apparently were priced higher than the July puts.  By the time we shorted the June puts and bought the same number of July puts there was a small difference amounting to about 1% of the price of either put.  The implied vol on the June put was about 45, but the implied vol on the July put was about 26.  This trade could lose money, but the risk/reward profile is asymetric-- much more upside than downside.

[Rabbitisrich]

Opihiman, I don't really follow your example. The two put premiums result in different losses for the same return.

 

Take the example to its logical extreme: You wait until the third day to sell the put and the underlying falls to near zero. You would then require a premium in which your ultimate loss will be much smaller than it would have been in the prior days. The premium received changes your risk profile.

 

The example is meaningless if you are using a hindsight bias, since in that case you are presuming losses before the case. I don't think the OP intended to sell options with no consideration of the underlying. In fact, he explicitly states that the opportunity cost is the purchase of the underlying.

[calonego]

hpmst3 (Hugh),

 

Thanks for posting a fair question. I'll attempt to add to it in another post.

 

Opihiman,

 

Could you please re-examine "hpmst3"'s original post, then look at his follow-up explaining that the part you have been arguing about was a quote from another message board and the explanation confused him. It would be more helpful to explain to him that the answer he received elsewhere was flawed, rather than to attach him and his purported error (maybe the discussion can be re-focused on the errors of the unknown party's explanation). He made no such error in logic or analysis, he merely asked a question. And good on him for doing so.

 

 

 

[calonego]

Hugh,

 

I really liked your other questions on the board as well, they are some of the better ones posted over the past year so please do not take what happened here as a personal insult -

 

How is Hamblin Watsa paid to manage FFH float?  (no one here really knows exactly)

What else does Li Liu own other than BYD?  (no one could answer this, the lecture includes great former holdings though)

Wells's cost of funding... a very important tidbit and a key in researching banks.

The info on Keynes and the detailed biography. I should read this, but I'm behind, have a few books on him I already need to read before attacking a huge bio.

[calonego]

Hugh,

 

I'm going to start at the beginning.

I know you know this stuff, but I don't want anyone thinking I have a flawed basis and make a flawed assumption.

 

So, you've found a company... you like the business and find that it's worth "X", but trading at "0.3X".

In my case, most of these instances are discovered in small, nano-cap companies. So really the only option is to attempt to buy enough common that it makes a dent on your net-worth when the thing triples to a fair intrinsic value. Rarely these companies may have a somewhat more complicated capital structure and you may be able to buy a really interesting convertible bond, quoted warrant, or do a PIPE with them on favorable terms, otherwise, just be in the market daily bidding the stock and you may get some.

 

In rare occurrences I've found small-to-mid capitalization companies (say $500mln-$5bln market caps, which generally have options) trading at a very favorable valuation. Historically FFH in '06 at $89 comes to mind, WEN before the Tim Horton's spinoff was discussed publicly (in the $20s); and recently Telefonica (TEF) and Transocean (RIG) may be in this ballpark (ideas I'm looking at).

 

So, the company has some options outstanding if it's large enough, and you think it's cheap. You must, as a favor to yourself, examine what's available. Morningstar.com is really good for this as it lays out what's out there on a security and the relevant info/data points, plus it's free.

 

In the calls, you could purchase a deep in the money call, giving up dividends,etc, but you would have less capital tied up (you save on the opportunity cost of this cash) and still participate in most of the favorable parts of being a shareholder in a public company.

If you purchase an out of the money call, you are speculating on the timing of the company trading up to your valuation or a catalyst playing out. In the event that a large company is really trading at 30% of what it's worth (based on really good analysis) this may not be a bad speculation for a small portion of a portfolio, the main unknown is the timing of the market and the individual company. The writer of the option is writing it based on the assumption that the company can go up or down, and almost in a equal probability, so you may do alright in time betting against that if your valuation is correct and you do this with small sums of money.

 

In the puts you can write something out of the money or near the money. As you point out, you have a sum of capital you will receive for writing the put (think of it as an insurance premium) in return you are telling the counter-party that you will be there for them to sell the security to in the event it goes below the strike price. I like to think of it as:

 

a) buy the company's shares for $25 (even though they are worth $75)

b) sell a Nov $20 put for say $2, locking in a purchase price of $18... less the time value of the $25 being invested in short-term bonds

 

If you were looking to buy a 20% position, the company is that cheap, selling the $20 put for $2 may be a viable choice for a portion of the position, it'll lock in a buy at $18 in the event it is exercised. However, as you rightly stated, you may give up on the upside from $25-$50, the move to intrinsic value, in the event the shares do not fall below $20, and at the right time, for the holder to exercise their option.

 

I like to think of it this way, if I'm going to buy shares in the company at $25 for 10% of my equity (at a 66% discount to my IV), I would likely buy more at a 75% discount, say 20% of my equity. This $17-18 cost is below a 75% discount and a great forced entry point if the shares get that low.

 

If you are considering doing this to make $2 every few months selling options, you are selling insurance policies. You better know what you are insuring and price accordingly (I have friends that do this very well).

If you are doing so thinking the shares will go higher and based on the volatility going down so the price declining (etc, etc), you are speculating...

If you are doing this with the knowledge that your valuation is entirely correct and that if the shares fell that low you would love to have the option exercised on you, you may be doing this per what I think Warren did with KO a number of years ago. A second reason may be due to his requirement (personally and to the insurance regulators) to hold only a certain amount of float in equities. He may have been forced to write the puts based on a need to hold cash and short-term bonds, although there was a great opportunity to invest in KO. But my recollection is that the use was for the former reason.

In the event the shares do not decline and you are not forced upon more wonderfully undervalued securities, the profit will augment your returns somewhat, but much less so than having purchased more common.

 

In a combination, you can write a put and buy a call in a synthetic long position, but this stuff gets a little complicated.  

 

So the basis of the investment is entirely founded on valuation - caveat venditor - as Uccmal has said, you may get a margin call, as the common declines and if the value of the option spikes, plus you better be willing and able to buy the common that is put on you.

 

You better be right on your valuation. You can loose a lot of dough doing this if you are very wrong.

 

The original info you quoted is a little odd - I'm note sure what he meant with his reference to margin of safety, but I can tell you this much, it wasn't something Ben Graham intended when he coined the term.

[calonego]

I'd add that as someone that has done this before, you should be inclined to just buy the common. Selling puts is really scary and risky.

 

But, if the person on the other end is willing to really pay up for a put (like the volatility they are using in their formula (blah blah) is really high) it is usually because the stock is hard to borrow to short and buying the put is the only way most people can attempt to participate in the company's failure. So you writing the put at a high premium, compounded with a great discount to IV may be very profitable... but it's not advisable to write options for most people (say anyone without over 10yrs of experience, a good understanding of derivatives and the math, and have lots of cash).

[Uccmal]

Calonego, Well said... Thanks.

[biaggio]

Calonego,

 

":I'd add that as someone that has done this before, you should be inclined to just buy the common. Selling puts is really scary and risky"

 

I am so happy to read this.

 

I have thought of using options in past. It  gives me a headache. I think my poor brain is too small. I feel much more comfortable purchasing common like a business owner. Agree for most best to keep things simple.

[ERICOPOLY]

It has been suggested that retail investors nearly always lose with options.  This suggests that if you take the other side of the trade you will nearly always win.  I've also read that 70% of options expire worthless -- this suggests that if you write options you win 70% of the time.

 

I'm just having a little bit of fun with this.  Seriously, I think if you feel like you simply must use leverage then writing deep-in-the-money is probably a better way to go for most retail investors because you are effectively getting an interest free margin loan, and margin loan rates are typically very high at retail brokerages.

[calonego]

biaggio,

 

If you find something at 30-40% of IV, a double or triple should make you happy in the common...

If you start doing these complicated things and leveraging up, you have to babysit your holdings incase there is a problem and you could miss the return due to a dividend/cap structure change or timing.

And even then, an intraday blip like on May 6th could wipe you out on a very bad margin call.

 

Getting a little leverage on a good idea by augmenting your common with some cheap calls is low risk...

 

ericopoly,

 

if the writer of the put is wrong on the valuation of the security and something happens with the market or their portfolio, it could end poorly. But your premise was that the individual just had to use leverage... the problems with this strategy are due to the leverage, rather than the actual put selling.

[twacowfca]

It has been suggested that retail investors nearly always lose with options.  This suggests that if you take the other side of the trade you will nearly always win.  I've also read that 70% of options expire worthless -- this suggests that if you write options you win 70% of the time.

 

I'm just having a little bit of fun with this.  Seriously, I think if you feel like you simply must use leverage then writing deep-in-the-money is probably a better way to go for most retail investors because you are effectively getting an interest free margin loan, and margin loan rates are typically very high at retail brokerages.

 

 

Excellent points.  Most options probably do expire worthless, but occasionally you can lose your shirt if you write a put; or you may hit a grand slam home run if you buy a put or call.  Volatility is generally  much more extreme on the downside than the upside.  However the long term trend in equity markets is generally up.  Thus, buying a long term put may be a difficult way to make money, compared to buying a short term put that may result in an occasional grand slam home run, especially when the implied volatility (a measure of how cheap or expensive an option is) on the short term put is low.  A contango with the long term put being more expensive compared to the short term put is the usual situation. However, the contango may mostly  disappear in volatile, bearish markets and sometimes briefly even become a backwardation with near dated puts becoming relatively pricey compared to the next month out.  Buying puts a few days ago when the implied volatility was very high, especially for short dated puts, could pay off well in a crash, but on average buying puts when the volatility is high is a bad bet, considering that crashes are rare events, even when  markets turn down.

 

 

Eric's second point is excellent advice,  Buying a deep in the money option is generally a much better alternative to using margin.  The potential loss on the option is definite, while using margin can wipe you out.  And the cost of the time value decay of the option may sometimes be no more than the interest forgone on the money tied up in the trade.  :)

 

 

 

 

[twacowfca]

I'd add that as someone that has done this before, you should be inclined to just buy the common. Selling puts is really scary and risky.

 

But, if the person on the other end is willing to really pay up for a put (like the volatility they are using in their formula (blah blah) is really high) it is usually because the stock is hard to borrow to short and buying the put is the only way most people can attempt to participate in the company's failure. So you writing the put at a high premium, compounded with a great discount to IV may be very profitable... but it's not advisable to write options for most people (say anyone without over 10yrs of experience, a good understanding of derivatives and the math, and have lots of cash).

 

 

Good advice.  Interestingly, according to Jim Chanos, aka The Sith Lord, one way to tell if a heavily shorted stock, like SHLD several months ago, may be about to break upwards, is when the premium short sellers are paying to borrow the stock evaporates. This often means that the shorts are unwinding their trade.

[twacowfca]

Hugh, I don't think Warren would do such a complicated analysis because that would lead to a false sense of precision, but he would give much weight to the worst things that could happen, referencing the historical record going back at least a century.  Here's what he might find:

 

Expropriation as with Russian Imperial bonds and enterprises.  If that should happen he probably wouldn't have to fulfill the contract and we would have worse things to worry about than how BRK was doing.  Nuclear war? Forget BRK. Where's food and shelter?

 

Hyperinflation as in the Weimar Republic.  No problem.  Simply scoop up a wheelbarrow full of worthless dollars and dump them at the counterparty's door to pay off the contract.  

 

The Great Depression in the US.  If he had sold a 20 year put at the peak of the market in 1929, the market would have been back to about the same level 20 years later.  Fifteen year puts might have been a little under water two or three times, but significantly so maybe only once. These scenarios are less likely going forward because the puts were sold before the recent market peak, and this gives an extra margin of safety.

 

 

Japan's two decade bear market.  This one could bite a little more, but it may not be as relevant because the Japanese market was extremely inflated in 1989, more so than the US in 1929 or 2007.  Even so, his earnings on the float likely would have made up the difference.

 

 

All in all, Warren might conclude that it's about a .98 probability that his combined ratio on the deal would be zero, and he would get to compound the earnings from investing the premium forever.  One percent of the time his cost of float might be less than 5% and 1% of the time his cost of float might be between 5% and 10% per annum.  There would be overconfidence in this analysis, but almost all of the very bad unknowns or "unknown unknowns" that might occur would be in situations so bad that what happened to BRK or other financial assets would be irrelevant.

 

 

 

This is not meant to be a definitive answer about how Warren evaluated the odds before writing the puts.  It is merely meant to be illustrative of the way he may have approached his decision.

[ericd1]

I never played "Buffett" before, but here's how I would look at the 15 year option napkin-analysis.

 

I would ask someone to figure the 15-year rolling returns for the index in question for the last 50 to 100 years. Knowing that would provide a "rough estimate" of the percentage of times the index ended below it's starting point after 15 years. Actually I know the number is very low so I'll just use 95% and that's my level of confidence I won't pay out anything.

 

Next average the 5% rolling 15 year losses...actually don't bother, I'll say 10%...That's my estimate of downside risk.

 

Then calculate the estimated return for investing the premium for 15 years (using BRK's last 15 year book value returns) I'll use 15%.

 

So I have 95%(+) confidence of a zero payout, and earning $813M, or a 5% potential of losing 10% on the option or $100M.

 

What's the worst case?  Estimated worst case would be the total loss of the $100M premium (not very likely) and lowest historic 15 year index loss payout $500M (let's say a 50% decline after 15 years - damn black swan!) = net loss of $600M (pretax, which provides a margin of safety ~ BRK's tax rate).

 

Appears the option risk is actually lower than making a 15 year stock purchase!

 

 

 

 

 

 

 

 

 

Note - I couldn't find rolling 15 year returns, but rolling 10 year losses (total return) 1900-2008 only occurred in 1914, 1921, 1932, 1938, 1974 and 1977. My guess is rolling 15 year losses are fewer...

 

 

 

 

 

 

 

 

 

 

 

[twacowfca]

I never played "Buffett" before, but here's how I would look at the 15 year option napkin-analysis.

 

I would ask someone to figure the 15-year rolling returns for the index in question for the last 50 to 100 years. Knowing that would provide a "rough estimate" of the percentage of times the index ended below it's starting point after 15 years. Actually I know the number is very low so I'll just use 95% and that's my level of confidence I won't pay out anything.

 

Next average the 5% rolling 15 year losses...actually don't bother, I'll say 10%...That's my estimate of downside risk.

 

Then calculate the estimated return for investing the premium for 15 years (using BRK's last 15 year book value returns) I'll use 15%.

 

So I have 95%(+) confidence of a zero payout, and earning $813M, or a 5% potential of losing 10% on the option or $100M.

 

What's the worst case?  Estimated worst case would be the total loss of the $100M premium (not very likely) and lowest historic 15 year index loss payout $500M (let's say a 50% decline after 15 years - damn black swan!) = net loss of $600M (pretax, which provides a margin of safety ~ BRK's tax rate).

 

Appears the option risk is actually lower than making a 15 year stock purchase!

 

 

 

 

 

 

 

 

 

Note - I couldn't find rolling 15 year returns, but rolling 10 year losses (total return) 1900-2008 only occurred in 1914, 1921, 1932, 1938, 1974 and 1977. My guess is rolling 15 year losses are fewer...

 

 

 

Yup.  And most of the puts he wrote were 20 year term, I think, until some were reset at much lower strikes with shorter durations.  :)