Options, Weapon of Mass Destruction?

Most people will not associate The Oracle of Omaha with options. Because after all, options are derivatives – which derive their value from the underlying securities such as stocks.

And from Berkshire Hathaway 2002 annual letter Warren Buffett said:

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

So people do not often associate Warren with derivatives. However, in the same letter, Warren also said:

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

This means that while he acknowledges the risk associated with derivatives such as options, there are situations where derivates can make sense, even for an astute and logical investor like The Oracle of Omaha.

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Options As An Investment Tool

First off, he approaches options as an investment, not as a gamble.

“I believe each contract we own was mispriced at inception, sometimes dramatically so.” – Warren Buffett

Options are priced using The Black-Scholes Model. They take into account the implied volatility – which is based on how much the stock price has moved in recent times.

Buffett said that the Black-Scholes Model might work for a short time horizon but the value of the model decreases as time passes by. That is because recent stock volatility is not a good predictor of the long-run outcome of the security or stock.

So, how does Buffett leverage the limitations of The Black-Scholes Model?

Also read: Part 1 of 2: Here’s How to Use The Black-Scholes Model to Price Options

Buffett Sells Put

“Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indexes: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on Sept. 9, 2019, and our last on Jan., 24, 2028. We have received premiums of $4.9 billion, money we have invested.” – Warren Buffett

While retail investors normally sell put options in the listed market, Berkshire generally trades in the over-the-counter (OTC) market. Dealers trade directly with each other.

The Oracle’s Put Strategy

Warren sells options with a very long term time horizon of usually more than 15 years, which is overpriced in his view due to the limitations of the Black-Scholes Model.

Using the premium he receives from selling puts, he uses it to invest.

His options are also “European”. This means that they are only exercisable at expiry. So he does not have to worry about paying out the notional value before the expiry date.

For selling put options, Buffett says that “It’s only the price on the final day that counts.” An elegant way to put it, and an elegant options investing method that is characteristic of The Oracle of Omaha.

Can We Also Sell Puts?

Although most of us will not have the platform to write 20-year put options backed by our huge portfolio, we can still invest in relatively long-dated (around 2 years) options in the listed market.

We also have some advantages by selling puts in listed markets. For one, there is more liquidity for us to sell puts on individual stocks. And usually, those options generate much higher premiums than index options because of the company-specific risks associated with them.

In the OTC market, there are counterparty risks, By transacting in the listed options market, there are generally no counterparty risks as we are transacting with the OCC (Options Clearing Corporation).

OCC is the buyer to every seller and the seller to every buyer in the U.S. listed-options market.

Also read: Is Bitcoin Worth Investing in 2020? Here’s My Quick Thoughts

In Conclusion

Selling put options can be a useful strategy for investors to get paid while waiting to buy a stock they want to own at a certain price.

As with any investments, there are also risks with selling put options. And most of the risks are internal, fear, greed, not understanding the company and its valuation well enough, and being greedy by selling put options using money we do not have or at stock we do not want to own at that price.

If you are interested in exploring options as a part of your investment strategy, I encourage you to learn with Value Investing Mentorship Coaching.

Disclaimer:

The information provided is for educational and general information purposes only and is not intended to be personalized investment or financial advice. We make no promises as to the accuracy or usefulness of the information we present.

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