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Why You Shouldn't Make Berkshire’S Put Sales: Buffett Always Has An Edge

|About:Berkshire Hathaway inc. (BRK.B) Includes:Berkshire Hathaway Inc (BRK.A)

I was recently considering Berkshire's (NYSE:BRK.A) (NYSE:BRK.B) investment in financial weapons of mass destruction. According to the most recent shareholder's letter, Berkshire received $4billion in premiums for selling long dated puts on various market indexes. In 2012 Berkshire recognized $1.2b of that based on reduced likelihood of impairment. I've even found some sites suggesting how you too can use this strategy for safe profits. Here's the spoiler - no you can't.

The basis of Buffett's thesis is that long dated put options are over-priced. Roughly speaking, long dated options are priced on the chance of realizing the potential volatility over that time. But, most companies make money. That means that broad market indexes have long term drift. In addition, the accumulated assets (via retained earnings) create a floor under the company value. While Mr. Market may occasionally look under the floor boards during a major panic, in time he gets his head out of the basement. In essence, options models price based on chance of a panic sometime, and hedgers buy based on desire for protection. But clearly the market doesn't panic all the time and if protection desire is high, it will drive prices up. So far, the thesis applies to any long dated put sale, including LEAPS and SuperLEAPS the retail investor has access to. Of course there's a catch - in fact, a few of them.

First is exercise type. American style options, the style used for most US traded equities, allows the buyer to exercise at any time. This would make irrelevant the observation that markets don't panic all the time - as long as the market panics once, the buy can take profit. Of course Buffett knows this and sold European style options, which can only be exercised at expiration. As long as the market doesn't panic at the expiration time, Berkshire should be fine. This removes some of the risk of the market panicking 'sometime'. Now the rest of us can still find European options. CBOE has European style option products on indexes - the S&P 100 (XEO) and Nasdaq-100 (NDX) are both available if you have enough margin. And that leads us to the next catch.

For most of us, proceeds from an option sale don't become available immediately. The other side - usually represented by CBOE - wants collateral to ensure the option can be covered if exercised. So even if the option cannot be exercised at the worst possible time, the collateral is going to tie up useful funds just when it would be best to invest them. Berkshire on the other hand, is not required to post any collateral on its option sales. This has two important outcomes: 1) Berkshire is path ambivalent - no matter how bad things look in the interim, only the final outcomes matters and 2) Berkshire has immediate access to the funds, which allows them to be invested now, for the long haul.

The third important part is that long haul. CBOE posts most options out up to three years. The SPXpm can be had out to 5 years - though I can't find that option. In the run of a few years, the market can be exceedingly volatile - 1999 to 2002, 2006 to 2009, etc.. Berkshire however sold puts out 15 and 20 years. Think 1987 to 2009, from the worst day to buy in 1987 to the worst day to sell in 2009, the market doubled (not counting dividends). Buffett's logic is quite simple - over twenty years, the effect of just 1% retained profit yearly is over 20% increase in value. The market can be quite crazy in the short term, but over decades it has a strong bias, even under extremely conservative assumptions.

The combined effect of these special features is huge. The market is strongly biased over very long time periods. Insuring that will be highly profitable, but requires that no chance of being forced to pay out in the interim. For retail investors, options always come with a string attached which can be used to hang the option seller by forcing an exercise or collateral costs. The only way I've found to make a no strings attached put sale is buying Berkshire. Plus you get Buffett's other unique advantages thrown in too.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BRK.B over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Stocks: BRK.A, BRK.B