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Cash: A Call Option With No Expiration Date

Investopedia Staff

Cash is generally regarded as a drag on investment returns, but sometimes it may be preferable to hold a substantial cash amount instead of investing it in other assets. This is because having cash on hand gives an investor the flexibility to acquire an asset or assets at bargain prices when the opportunity arises. In this respect, cash can be viewed as a call option – on virtually any asset – with no expiration date.

Note that "cash" in this context refers to monies invested in Treasury bills, money market funds and other very liquid instruments. As well, recall that a call option or a “call” gives the buyer the option or right to purchase an asset at a pre-determined price (the “strike price”) on or before a specific date (the “expiration date”). The most appealing characteristic of call options is that they offer the call buyer theoretically unlimited upside, while restricting the maximum loss to the premium paid by the buyer.

Buffett’s View – Cash as a Call
Warren Buffett views cash as a perpetual call option, according to his biographer Alice Schroeder in her tome “The Snowball: Warren Buffett and the Business of Life.” Schroeder says that one of the most important things she learned from many years of studying Buffett and his holding company, Berkshire Hathaway, is that he perceives cash as a call option with no expiration date or strike price. “No expiration date” alludes to Buffett’s patience as a long-term investor, since he is quite content with waiting for the right opportunity to come along. “No strike price” implies that Buffett generally does not publicly specify a price level for a stock or index at which he would be willing to invest. Instead, he tends to invest at levels where he is confident of adding shareholder value.

Buffett’s perception of cash can also be summed up in one of his aphorisms - “Cash combined with courage in a crisis is priceless.” As Schroeder explains in her book, Buffett’s best opportunities have always arisen during periods of crisis and uncertainty, such as after the 2001 dot-com bust and corporate fraud epidemic (Enron, WorldCom, etc.). While others may lack the insight or resources to invest heavily during such times, Buffett went on a shopping spree in 2002 through Berkshire Hathaway, making investments and scooping up companies in a number of sectors. Buffett also famously urged investors to “Buy American” equities in an op-ed in the New York Times on October 16, 2008, a month after the bankruptcy of Lehman Brothers, when global stock markets were in free fall.

Can the Average Investor Benefit?
To benefit from this view of cash as a perpetual call option, an investor needs to have two prerequisites: access to a substantial amount of cash, and an innate sense of market timing. Savvy investors who possess both have generated a great deal of wealth by investing in stocks – or increasing their allocation to equities – at market lows.

But such investors are likely to be the exception rather than the norm, since not many people have the luxury of access to substantial amounts of cash on demand, and market timing is not easy to put into practice.

However, there are periods when the average investor may benefit from holding a relatively large cash balance, rather than being in a hurry to put this cash to work. The most common instance is when asset prices are trading at or near record highs, because at such times, the downside risk is likely to be greater than the upside potential.

Holding cash has an opportunity cost, which is equal to the difference in returns between other better-performing assets and the minimal return on cash. For example, if you decide to stay in cash and opt for a certificate of deposit paying 1% annually instead of investing in an equity index that subsequently returns 10%, your opportunity cost would be 9%. But if the equity index returns 2%, your opportunity cost is only 1%.

This opportunity cost should be viewed as the option premium paid for staying in cash, or the cost associated with having cash as a call option. The “cost” of such call options fluctuates over time. It is low when investment opportunities are few and upside is limited, at which time investors are better off holding cash as they await better entry levels. But at other times – typically during the uncertainty that reigns after a market crash – when downside is limited and investment opportunities are both abundant and compelling, the opportunity cost of staying in cash is too high. At such times, investors should consider aggressively deploying their cash holdings into assets that offer potentially higher returns.

Strategy Example No.1 – Equities
Consider an example to illustrate the concept of cash as a call option, using the SPDR units or “Spiders”. (The SPDR ETF is a portfolio representing all 500 stocks in the S&P 500 index, and trades under the ticker symbol SPY at about one-tenth the level of the index). Assume that you had $100,000 to invest in 2007, but because the S&P 500 was trading close to a record high, you decided to invest only half of your investment at the year-end price of $146.21. You retained the other half to invest if the S&P 500 declined, and parked the money in a money-market fund that offered a safe 2% return. This formed the call option part of your strategy, since it allowed you to add to your equity position if your view was correct and the S&P 500 declined significantly.

At the end-2007 price of $146.21, you would have purchased about 342 SPY units. A year later, with the S&P 500 down 38.5%, assume you used the $51,000 ($50,000 + 2%) in the money-market account to buy additional SPY units at the end-2008 price of $90.24, which would have given you an additional 565 units. You therefore have a total of 907 units at an average price of $111.36. As of mid-April 2013, the SPY units were trading at approximately $155, which means your potential profit at that point would be $39,600, or a return of approximately 40% on your initial $100,000 investment.

What if you had invested the full $100,000 in SPY units in 2007? In that case, you would only have acquired a total of 684 units ($100,000 / $146.21), which as of mid-April 2013 would have a potential profit of only $6,000 or 6%.

Using cash as a call option in this case generated an extra 34% of return. Note that dividends have been excluded in the above example for the sake of simplicity; if dividends had been included, total returns would have been boosted by about 2% annually.

Strategy Example No.2 – Real Estate
This thinking can also be extended to the realm of real estate, another important investment alternative for the average investor. Let’s say such an investor had $50,000 some years ago to use as a down payment on an investment property. While her desired price range was $200,000 (since she expected to obtain $150,000 in mortgage financing), the hot property market made it quite difficult for her to find anything suitable. Although she was tempted to extend her budget for a great property that was valued at $300,000, she resisted the temptation and decided to wait for better prices.

The housing crash subsequently unfolded, and two years later she was able to pick up the same property for $200,000. A couple of years later, with the housing market in recovery mode, she was able to sell the property for $250,000. To keep things simple, assume the outstanding mortgage balance on the property at the time of sale was unchanged at $150,000. Ignoring any closing costs or commissions, her gross gain would be $100,000, or 100% on her original $50,000 investment.

In this case, having cash as a call option on property had a number of benefits. First, it enabled the investor to wait for an opportune time, until prices had come down appreciably. Second, having 25% readily available as a down payment would have made it easier to obtain a mortgage, since fewer buyers were competing for desirable properties post-crash (a secondary benefit is that interest rates on mortgages also came down significantly). Finally, the leverage obtained through the mortgage boosted the investor’s return to 100%. Had the investor bought at the “market top” price of $300,000, her equity of $50,000 would have been essentially wiped out at a property value of $250,000. In this case, the flexibility of having cash as a call option resulted in doubling the initial investment instead of losing it all.

Cash is not the ideal long-term asset, especially at times like the present when interest rates are at record lows. But there are often periods of uncertainty when cash is king; and at such times, having access to ready cash enables investors to scoop up bargains at very low valuations. Under certain circumstances, therefore, investors should view cash as a perpetual call option on any asset instead of regarding it as an idle investment.

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