In Berkshire Hathaway’s 2002 annual report, Warren Buffet summarized his views on derivatives in a now-famous remark:
In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
The instinctive response of a retail options trader might be to scoff at this kind of condemnation, but we’ll make two points in Buffett’s defense (as if he needs our help): first, he’s writing here about credit default swaps, interest rate swaps, and other complex institutional products, not the handful of index puts that you might use to hedge your portfolio. Second, he has been proven completely right: all of the concerns in the 2002 letter - counterparty risk, the dangers of mark-to-model bookkeeping (what happens if the model is wrong?), the overuse of leverage - now feature regularly in mainstream headline explanations of the financial climate. His worry, that
the derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear
has been confirmed beyond any doubt in the stories of ill-fated DAPs (Derivative Acronym Products, if you’ll forgive another coinage): MBSs, ABSs, SIVs, CDOs, etc. Just as Buffett famously avoided the tech bubble, he seems also to have avoided the housing bubble and related financial afflictions.
The Thesis: Long the Global Economy
Although traders who are comfortable flipping stock and spreading options typically don’t look to Berkshire Hathaway for advice or for trading cues, an interesting idea showed up in Berkshire’s recently released 2007 annual report. On page 16, the chairman explains the two categories of derivative contracts that the company does hold. The first category involves collecting premium against high-yield bond default. The second category is explained thus:
The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Briefly stated, they’ve sold some extremely long-dated European style index puts. It’s notable that three of the four stock indexes used as underlyings are foreign indexes; the global view is consistent with the position Buffett took in currencies in 2007 (swapping US dollars for Brazilian reals). Essentially, this means Buffett has a bullish view on the global economy over the long term. The current recession shouldn’t impact this position, especially since the put options can’t be exercised until their expiration dates - though a serious depression might mean trouble if it takes an extra 5-10 years for equity indexes to recover.
This appears to be a naked put sale (which, recall, is the same thing as a covered call): the report doesn’t mention anything about owning the underlying indexes or any related products, and even if we factor in Berkshire’s significant equity holdings ($75B, p. 15), most of their exposure there is to large cap US equities.
Constructing the Position
Just as value investors perennially look for ways to mimic Buffett’s equity moves - and frequently end up frustrated - so any attempt to copy this bullish (if comparatively straightforward) options play will take a little effort.
First we need to get clear about which underlying indexes we’ll use. We know that the only U.S.-based index is the S&P 500, so that’s easy enough, but since we don’t know which three foreign indexes Berkshire is following, we’ll have to do a little guesswork. We’ll look at Europe for stability or “value,” and the BRIC countries (Brazil, Russia, India, China) for growth. Since we’ll be using ETFs for these foreign holdings, we don’t have to tie ourselves to individual national or regional indexes, and that added diversification means we should be able to get by with just two foreign holdings. We’ll use iShares MSCI EAFE ETF (NYSEARCA:EFA) as a proxy for Europe/Japan, and iShares MSCI Emerging Market ETF (NYSEARCA:EEM) since its holdings represent the BRIC countries quite well.
Perhaps the first concern is early exercise. Buffett & Munger don’t have to worry about where equity indexes are in 2015, because the options they’ve sold can’t be exercised until expiration in 2022 or 2027. To duplicate that feature, we need to trade European-style options. That’s not a problem as far as the U.S. underlying goes, since SPX 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 early exercise.
As far the time horizons themselves, we simply can’t duplicate Buffett’s derivative contracts. LEAPs only go out so far in time, and they don’t even get close to the 15-20 year horizon that Buffett is working with. The longest dated options on SPX/SPY expire in December 2010. That’s less than three years away, and the volume in that listing is still relatively light. EFA and EEM are listed through January 2010. This means we’ll simply have to roll these positions forward every year or two, which obviously increases transaction costs and forces us to book profits/losses more frequently.
Another important issue is liquidity. Since we’ll have to roll our sold puts every few years or so, we want our options to be liquid enough to make those trades simple. This won’t be a problem with SPX (or SPDR Trust, Series 1 ETF (NYSEARCA:SPY), if you want the dollar-denominated ETF), since these are some of those most liquid options in existence. As for EFA and EEM, current volume in the LEAPs isn’t huge, but it should be workable. (Note that for stock investors, neither of these funds is ideal under normal circumstances, since they have higher expenses than their competitors: Vanguard’s Emerging Market ETF (NYSEARCA:VWO), for instance, is nearly identical to EEM, and at half the cost. But the alternatives to EFA and EEM just don’t have listed options that are sufficiently liquid.)
The Trade: Naked Put Sales
With all of those parameters in place, this is how we would attempt to duplicate Buffett’s 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, you’ll clearly need to sell about twice as many EFA contracts as you do in the other underlying issues. We’ve selected strike prices that are currently a couple strikes out of the money, because we will have to roll these positions forward so we want to price in a little bit of downside into the trades. As for the adjustments themselves, when and how to roll these contracts forward will depend somewhat on how severe the U.S. recession gets.
There are some important disadvantages to actually entering these positions. For one, you’re tying up quite a lot of capital for quite a long time, and because so much of the value of these contracts is time value (not intrinsic value), any major moves in your favor in the underlying indexes won’t translate into quick gains. Additionally, although there’s technically a limit on any potential losses (a stock can’t drop any lower than zero), for practical purposes these are unhedged positions, which will not only expose you to more risk, but will tie up more margin than would a hedged trade.
One purpose of this little exercise is to show how difficult it is to duplicate the moves of institutional investors on a retail level. But that disconnect need not be seen as a negative thing: retail traders actually have far more flexibility and can use that advantage to avoid many of the risks that large institutions must face, such as counterparty risk. In fact, several of the features of Berkshire’s position may simply be ramifications of the size and relative inflexibility of their situation: it is much harder to deploy four billion dollars than it is to deploy four hundred thousand.
To take advantage of their flexibility and reduce risk, ordinary traders can sell put spreads instead of just naked puts, they can sell both put spreads and call spreads in order to establish more market-neutral positions, and they can sell spreads on a quarterly or even monthly basis in order to profit from smaller time increments and smaller market moves.
In fact, given the variety of strategies and tools that are available to individual options traders, perhaps we shouldn’t fret at all about being unable to duplicate Berkshire’s positions. Instead, we might say (with tongue in cheek) that while Warren Buffett may have come around on the question of using derivatives to generate income, he can’t hope to duplicate the positions of any informed individual options trader.
Disclosure: Author holds the above-mentioned positions