In developing our options research methodology, we have taken many lessons from Warren Buffett, whose philosophies are also a touchstone of our equity research. One way the Oracle of Omaha shares his lessons is through Berkshire Hathaway's (BRK.B) annual letters to shareholders.
In his 2008 letter, Buffett discusses his derivatives positions and the mark-to-market losses on those positions last year. The background discussion of this topic is an excellent read for investors seeking a basic understanding of the involvement of derivatives in the current financial crisis.
Most interesting for us as option investors is that, despite his public criticism of derivatives as "financial instruments of mass destruction," Buffett has been writing long-dated put options on many publicly traded indexes. In Berkshire's 2008 letter, he discusses those positions and his thoughts about options and the Black-Scholes model (the most widely used mathematical model for valuing options). We thought it would be useful to summarize the insights from his letter for our option investors and those who are curious about options.
Right off the bat, we are quite pleased to see Buffett comment, "I believe each contract we own was mispriced at inception, sometimes dramatically so." To translate that into the terminology of the Morningstar Guide to Option Investing, Buffett is saying that each one of these positions was an investment because he had reason to expect a positive return. What he is saying is that, like us, he views options as a tool for investing, and mispriced options represent an investing opportunity. Let's just say that it's nice to have someone of his caliber approaching option investing as we do.
The Black-Scholes Model and Time Horizon
Buffett's discussion of the Black-Scholes model is also consistent with our opinion. Similar to what we discuss in the Option Investing Guide, Buffett points out that the implied volatility used in the Black-Scholes model is typically determined by how much the stock has moved around recently. He notes that the Black-Scholes model probably works well for short investment horizons, but the value of the model diminishes rapidly as the horizon lengthens because recent stock volatility isn't a good predictor of the long-run outcome for the underlying security. Additionally, the value of retained earnings of the underlying companies isn't accounted for in the model. He also points out that the model's creators, Fischer Black and Myron Scholes, probably understood these limitations of the model.
Buffett emphasizes his point--that using the model for extended time periods can skew results--by analyzing a 100-year option on the S&P 500 using the Black-Scholes model, and pointing out that even with a 100% drop in the S&P 500 Index, the premium paid would represent a 6.2% cost of funding. In this analysis, he uses a scenario and expected-return format, anticipating a 99% chance that the value of the S&P 500 would rise over 100 years, and a 1% chance that it would fall, and expecting a loss of 50% of the value of the index if it does fall. Therefore he uses fundamentally estimated values to check the pricing of options, just like our approach.
Berkshire Hathaway's Option Investments
Buffett says in his letter, "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."
As such, his strategy is twofold. First, he sells overvalued options by writing puts with very long horizons of more than 15 years, which are systematically overpriced. Second, he is making a classic Warren Buffett move, using the "float," or premium, from the options to invest. Because the options he has written are "European," which means they can only be exercised at expiration, he won't need to worry about having to pay out the notional value before expiration. All in all, this is just the type of elegant option-investing strategy to expect from a brilliant investor with a giant pool of capital.
Buffett's strategy has collected a $4.9 billion option premium so far on his $37.1 billion notional index options, but the Black-Scholes model currently estimates a $10 billion liability, so currently he has a $5.1 billion loss on a generally accepted accounting principles basis. However, on a fundamental basis, as he says, "It's only the price on the final day that counts."
Another requirement Buffett specifies for entering into a derivatives investment is that there be no counterparty risk, which can be a major risk of derivative investing. As investors using the listed options market, our trades are settled through the Options Clearing Corporation (OCC). This organization, which is closely regulated by the SEC and the Commodity Futures Trading Commission (CFTC), acts as a central counterparty to both sides of every listed option trade made in the U.S. Although theoretically the OCC could fail, it has maintained a AAA credit rating without concern through the entire financial crisis, so we think our counterparty risks are minimal as investors use listed options.
Now, unlike us, who are investing only in listed options, Buffett has a whole different set of issues. He has to put billions of dollars to work and therefore can't find enough liquidity in the listed option markets. Without the safety net of the OCC, Buffett manages his risks by only writing options; Berkshire Hathaway gets paid the cash up front for the options he writes, so he is never owed anything by a counterparty.
How Does This Apply to Joe Investor
Because we're not Warren Buffett, we can't write 15- to 20-year put options secured by our giant security portfolio and invest the premium. However, we can still invest in relatively long-dated options and have a few other advantages over Uncle Warren.
Because we're small, there is plenty of liquidity in the option markets for us to write put options on individual companies, and those options generate much higher premiums than index options. The higher premium is a result of company-specific risk, and unlike indexes, the share price of real companies can occasionally go to zero. However, we think the individual option market is more often mispriced relative to the long-run company fundamentals.
Also, because we're transacting in the listed option market, our counterparty is the OCC, so we think we can buy options and reasonably ignore counterparty risk.
Although we can't write 15-year options, we can stick to the longer-term options where the company's fundamentals become more important, and we can also capture some of the time-horizon premium by being willing to take possession of company shares if they're put to us. By stretching out the time horizon and holding the shares as they rise to fair value, we can make some money from the failures of the Black-Scholes model mixed in with our stock investing acumen.
If you are interested in exploring options as an investment vehicle, and Morningstar's unique approach to using fundamental research to invest in options, I encourage you to download the Morningstar Guide to Option Investing.
Visit Morningstar.com May 1-3 for on-the-spot coverage of the 2009 Berkshire Hathaway Shareholder's Meeting--including video reports, our Berkshire analyst's insights, and more dispatches directly from Omaha.
Philip Guziec does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.