We have discussed Warren Buffett's option trading at length in the past, but a flurry of recent news stories has prompted us to take another look at the Oracle of Omaha's practices.
The articles are primarily focused on whether the some of the index puts that Buffett sold were "worst of basket" put options. If you are really interested in what those are, check out the stories here , here , and here . But what stood out to me was the mark-to-market losses that Berkshire Hathaway took in these trades.
Buffett sold very long-term puts on the S&P 500 and equity indexes in the United Kingdom, Europe, and Japan. He sold at least a large portion of them at the market high in 2007 when volatility was very low and they were struck at the money . He took in roughly $5 billion in premium with a maximum risk of about $37 billion, with a time frame of 15 to 20 years.
One very important point is that Buffett didn't have any collateral requirements, so he was free to use that cash however he wanted. By contrast, any retail trader selling puts must have a margin requirement to hold the positions in case there are losses.
If we look only at the SPX trade, he sold puts with the index around 1500 and the VIX at 13. The crisis of 2008 hit Berkshire Hathaway hard, much of that from those short-put positions . In the first article linked above, the Financial Times reported that the liabilities during the crisis on the puts were about $10 billion--twice the premium taken in.
I pulled up an option calculator and plugged in the data. A 15-year put on the SPX at 1500 struck at the money with volatility of 13 percent would give a credit of $230.
If we take the days from 5,475 (15 years) down by 175 and drop the price of the index from 1500 to 700, the put value goes up to $700--a 200 percent increase. We know that volatility increased, and while it didn't move as much on long-term options, let's assume that it increased to 26 percent (as opposed to the 90 for the VIX). That would take the put value to $815. Options also have interest-rate and currency risks, which also would have gone against Buffett.
A number of firms have gone out of business because of such short-put strategies. It was these type of positions that put Long Term Capital Management out of business, not to mention Bear Stearns , Amaranth Capital , and some big traders such as Victor Niederhoffer .
So it is interesting that Buffett was able to weather the storm with so little consequence. Short-volatility strategies such as put selling are very seductive and can be very profitable. But the Buffett example is a good reminder that having plenty of cash and capacity can be necessary to overcome the risks carried in these trades.
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