Trading Put Options With Warren Buffett - Part Two
Constructing the Position
Just as value investors perennially look for ways to mimic Buffettísequity moves - and frequently end up frustrated - so any attempt tocopy this bullish (if comparatively straightforward) options play willtake a little effort.
First we need to get clear about which underlying indexes weíll use. Weknow that the only U.S.-based index is the S&P 500, so thatís easyenough, but since we donít know which three foreign indexes Berkshireis following, weíll have to do a little guesswork. Weíll look at Europefor stability or ìvalue,î and the BRIC countries (Brazil, Russia,India, China) for growth. Since weíll be using ETFs for these foreignholdings, we donít have to tie ourselves to individual national orregional indexes, and that added diversification means we should beable to get by with just two foreign holdings. Weíll use EFA as a proxyfor Europe/Japan, and EEM since its holdings represent the BRICcountries quite well.
Perhaps the first concern is early exercise. Buffett & Munger doníthave to worry about where equity indexes are in 2015, because theoptions theyíve sold canít be exercised until expiration in 2022 or2027. To duplicate that feature, we need to trade European-styleoptions. Thatís not a problem as far as the U.S. underlying goes, sinceSPX options are European-style. But options on ETFs are American-style,so we might need to be a little more watchful if we want to avoid earlyexercise.
As far the time horizons themselves, we simply canít duplicateBuffettís derivative contracts. LEAPs only go out so far in time, andthey donít even get close to the 15-20 year horizon that Buffett isworking with. The longest dated options on SPX/SPY expire in December2010. Thatís less than three years away, and the volume in that listingis still relatively light. EFA and EEM are listed through January 2010.This means weíll simply have to roll these positions forward every yearor two, which obviously increases transaction costs and forces us tobook profits/losses more frequently.
Another important issue is liquidity. Since weíll have to roll our soldputs every few years or so, we want our options to be liquid enough tomake those trades simple. This wonít be a problem with SPX (or SPY, ifyou want the dollar-denominated ETF), since these are some of thosemost liquid options in existence. As for EFA and EEM, current volume inthe LEAPs isnít huge, but it should be workable. (Note that for stockinvestors, neither of these funds is ideal under normal circumstances,since they have higher expenses than their competitors: Vanguardís VWO,for instance, is nearly identical to EEM, and at half the cost. But thealternatives to EFA and EEM just donít have listed options that aresufficiently liquid.)
The Trade: Naked Put Sales
With all of those parameters in place, this is how we would attempt to duplicate Buffettís options positions:
* Sell the SPY December 2010 105 puts for $9.30 per contract
* Sell the EFA January 2010 60 puts for $5.00 per contract
* Sell the EEM January 2010 100 puts for $11.50 per contract
Position sizing matters here: if you want to even out your exposure,youíll clearly need to sell about twice as many EFA contracts as you doin the other underlying issues. Weíve selected strike prices that arecurrently a couple strikes out of the money, because we will have toroll these positions forward so we want to price in a little bit ofdownside into the trades. As for the adjustments themselves, when andhow to roll these contracts forward will depend somewhat on how severethe U.S. recession gets.
There are some important disadvantages to actually entering thesepositions. For one, youíre tying up quite a lot of capital for quite along time, and because so much of the value of these contracts is timevalue (not intrinsic value), any major moves in your favor in theunderlying indexes wonít translate into quick gains. Additionally,although thereís technically a limit on any potential losses (a stockcanít drop any lower than zero), for practical purposes these areunhedged positions, which will not only expose you to more risk, butwill tie up more margin than would a hedged trade.
One purpose of this little exercise is to show how difficult it is toduplicate the moves of institutional investors on a retail level. Butthat disconnect need not be seen as a negative thing: retail tradersactually have far more flexibility and can use that advantage to avoidmany of the risks that large institutions must face, such ascounterparty risk. In fact, several of the features of Berkshireísposition may simply be ramifications of the size and relativeinflexibility of their situation: it is much harder to deploy fourbillion dollars than it is to deploy four hundred thousand.
To take advantage of their flexibility and reduce risk, ordinarytraders can sell put spreads instead of just naked puts, they can sellboth put spreads and call spreads in order to establish moremarket-neutral positions, and they can sell spreads on a quarterly oreven monthly basis in order to profit from smaller time increments andsmaller market moves.
In fact, given the variety of strategies and tools that are availableto individual options traders, perhaps we shouldnít fret at all aboutbeing unable to duplicate Berkshireís positions. Instead, we might say(with tongue in cheek) that while Warren Buffett may have come aroundon the question of using derivatives to generate income, he canít hopeto duplicate the positions of any informed individual options trader.
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