Be Like Warren Buffett: Sell Put Options.
How would you like to go into the insurance business, collecting premiums for insuring people against catastrophes? The product in question is crash insurance, which pays out if stocks take a dive. Your potential buyers are worried bulls–people who want to be in the market but don’t want all the risk that goes with it.
You don’t need a license for this underwriting work, just some loose cash and a steady nerve. One product you could sell: a put option on the SPDR S&P 500 fund, exercisable until December 2014 at a strike price of $125. The buyer of the option obtains the right to sell you a share for $125.
This option is out of the money–meaning it can’t be cashed in immediately for profit. The SPDR is trading at $134. The SPDR would have to fall by nine points for the buyer of the option to want to use it.
In return for promising to buy under adverse circumstances, you collect a premium. In this case it’s around $18.
Why be a seller of puts? Because there’s a lot of demand for them. European banks are falling apart, our own economy remains sickly, and memories of the crash of 2008–09 are still fresh. So products that protect against market crashes are richly priced, says Gregory Peterson, a mathematician at Ballentine Partners who helps wealthy families manage risks.
As a seller of crash insurance, you’d have distinguished company: Through Berkshire Hathaway , Warren Buffett has sold several billion dollars’ worth of this stuff.
The Berkshire puts are custom-designed contracts originally maturing over 15 to 20 years. You’d be doing options traded on the Chicago Board Options Exchange, where maturities stretch out only to the end of 2014. But in essence your bet would be the same as the ones Berkshire made.
Before playing this high-risk game, ask whether you have the right personality for it. Your willingness to own stocks should go up as their prices fall. Value investors like ­Buffett are of this sort.
A lot of investors are emotionally wired in the opposite way. While they may behave in a predictably rational fashion when buying gasoline or airline tickets–a lower price makes them more willing to buy–they get turned around when they go to Wall Street. There, a fall in prices makes them want to sell. They sell because other people are ­selling. As a vendor of puts, you will be insuring these lemmings.
Perhaps you think stocks are a bit overpriced with the SPDR at $134 but a good buy when it gets down to $125. If so, being forced to buy at $125 is not such a bad thing. You would be getting the same slice of corporate assets that other people (the lemmings) were buying at $134 a while before. You can shrug off the fact that, just when you are called on to fulfill your option promise, stocks are depressed. If your investing horizon is far away, you just stand pat.
Suppose you are willing to take on 1,000 shares of the SPDR. To be fully collateralized you’d have $107,000 of cash in your account. You’d write ten put option contracts, each for 100 shares. You thereby promise that if the fund drops by nine points or more over the next two and a half years you will buy 1,000 shares for $125,000. For this promise you get a bit less than $18,000 up front.
If the SPDR stays above $125, the put option will expire worthless and the option premium is yours to keep. Premiums pocketed from expired options are considered short-term capital gain (never mind how long you hold the position), and that gain could be taxed at high rates. So it’s a good idea to park this trade in a tax-deferred account. If you do that, putting up the whole $107,000 in cash is mandatory.
Options are often quoted with fat bid/ask spreads, and it makes sense to try to get in the middle with a limit order, says Randy Frederick, an options and derivatives expert at Schwab. This put was recently quoted at $17.70 bid, $18.06 ask. Following his advice, you’d express a willingness to sell at a price of $17.79 or better. There’s a good chance you will get some or all of the order executed, Frederick says. If you don’t, come back another day with another limit order. Don’t chase option trades.
The big question is whether that $18 price is a good one for the risk you are taking. Let’s start with the classic Black-Scholes option valuation formula. Plug in the 21% annualized volatility that stocks have exhibited since 1926 and an assumption that prices drift neither up nor down over time. The formula says those puts are worth only $13.
Frederick cautions that Black-Scholes underestimates the probability of big moves, like that freakish crash on Oct. 19, 1987. When you hear option traders talking about “tail risk” or “black swan” events, they are referring to this well-known deficiency of the formula.
Tail risk makes put options worth more than Black-Scholes predicts. But something else makes them worth less: The formula’s assumption that stock prices trend sideways is too bearish. A 5% annual upward trend, for example, would make $151 rather than $134 the most likely outcome in December 2014.
The sideways-market assumption doesn’t matter at all for short-term options, which make up the bulk of trading in Chicago. But it makes a big difference to the value of long-dated options.
Buffett seized on this failing of Black-Scholes in a letter to Berkshire shareholders three years ago. Retained earnings push stock prices up over long periods, he wrote, so put options due years from now are worth less than the formula says they are worth.
When that letter was written Berkshire’s options looked like a disaster. But the market largely recovered from the collapse, and there is a good chance that Berkshire will never pay out a penny on its insurance.
Fat tails and upward drift–experts can debate which of these has the bigger effect and whether the true value of those SPDR puts is closer to $13 or $18. But the circumstantial evidence is that $18 is a rich price because of supply and demand. There are a lot of nail-biters who want protection. People willing to sell insurance are scarce.
If the SPDR ends up below $107 you will have a paper loss. But you don’t have to cash out and go home. You could reason, much as Buffett would, that stocks worth $134,000 in July 2012 are not a bad buy at $125,000 in 2014.
Let the put be exercised, buy the SPDR shares and sit on them for 20 years.
Put = Covered Call. Why?
Put options, which give holders the right to sell stock at a prearranged price, are complicated enough. Taking a short position in puts, which means the investor agrees to have stock dumped on him at an inopportune time, makes some people downright queasy.
For these tremulous speculators there’s a work-around. You get the effect of a short put position without shorting anything. Instead, you do a “covered call”–you buy the stock in question and immediately sell a call option against it.
Suppose that the SPDR is trading at $134 and that a December 2014 call option with a $125 strike price is at $21. Buying the share and selling the call means your net investment is $113. This covered-call position is equivalent to a short put. How so? With the covered call, you’ll collect $6 or so in dividends by late 2014, so your net exposure is $107. As long as the market doesn’t sink too much, the call will be exercised and you’ll make $18.
If the SPDR lands between $107 and $125, you’ll make a smaller profit. If it ends below $107, you’ll lose. This range of payoffs is the same as the one for someone who deposits $107 with the broker and then shorts a put. Under the circumstances the put would trade at $18. (The arithmetic here ignores interest and transaction costs.)
The general rule, when interest rates are close to 0%: Today’s stock price equals the option strike price plus the dividends plus the value of the call minus the value of the put. In numbers: $134 = $125 + $6 + $21 – $18.