Warren Buffett Looks At Mispricing Long Term Options

Warren Buffett and Berkshire Hathaway released their annual letter to shareholders last Friday. There were plenty of useful comments on a wide variety of topics revolving around investing, and this document will be a major part of the conversation of investors over the following weeks ahead.

Warren Buffett touched upon one area in his letter to shareholders revolving around the type of investment that very few investors have in their portfolio: stock options. Buffett has used options to boost the profits of Berkshire Hathaway, and in his shareholder letter, he talks about his belief that options can produce profits of a greater magnitude later on in the future. By making this claim, Warren Buffett calls into question if the entire open market for this type of investment is potentially mispriced – and it creates other opportunities for intelligent long-term investors.

Let’s now take a look into Buffett’s argument a little bit further, and overturn some stones by discussing ways to take advantage of this untapped opportunity.

The Big Bull Market Bet

During the years 2004 until 2008, Warren Buffett and Berkshire Hathaway took massive exposure upon themselves within the options market. They were selling put options on the major stock market benchmarks covering Europe, Japan, the UK and the US. By doing so, Berkshire Hathaway was extending its traditional insurance business to provide protection that is stock market related for its counterparties. Berkshire Hathaway brought in $4.2 billion by selling these put options, and just like the other premiums Berkshire receives from its insurance businesses, they turned around and invested these billions of dollars in sales into its stock holdings and operating companies.

When the market melted down in 2008 and throughout the early part of 2009, the put options looked like a really bad move. At the time, Berkshire Hathaway was sitting on what appeared to be a potential $10 billion loss, with the possibility that the losses would be even greater if the market stayed low past the options expiration dates, which range from the years 2018 through 2026. But at the time of this writing, the current intrinsic value of the options are now below the premiums Berkshire Hathaway received, thanks to the large bull market that’s happened over the last four years. Overall, Buffett expects the final amount due under the options to be a lot less than the current figure of $3.9 billion.

Is There a Flaw in Long-Term Option Pricing?

Brendan Conway of Barron’s posted a fantastic blog post last Friday afternoon, which reminded investors of Berkshire Hathaway of the history behind these Buffett puts. As commonly noted, Buffett has gone to tremendous lengths in one of his previous shareholder letters to describe the inefficiencies and pricing of the options market and how Buffett planned to exploit it.

The root of the options problem lies specifically in the volatility assumptions made in the very commonly used Black-Scholes formula. From year to year or day-to-day, stocks can move rather abruptly, and the assumptions of volatility often are baked into the price of options. But when you look at them over longer periods of time, stock market returns are much smoother, and Black-Scholes will value options more highly than it is actually appropriate – which makes them much better to sell instead of buy, and this is especially true when you have puts expecting the market to continue to trend upward.

Warren Buffett’s behavior points to a much different view toward trading options for the long term on the buy side. When Buffett has previously provided financing to large corporations like General Electric and Goldman Sachs, he used warrants that are options like, and they provide a long-term equity kicker to Berkshire Hathaway with this investment. By being willing to hold onto these warrants strongly points to Buffett’s belief that volatility on the downside is overestimated, then the upside volatility is also underestimated, which will make long-term call options the better buy for investors.

Can Anyone Take Advantage of This?

The short answer is no. The deals put together by Warren Buffett are not typically available to your average investor. The long-term options available to the public will normally only run just a few years into the future, but that is not a long enough time for an entire bull – bear cycle to run its course for reversion to the mean to take place.

The one place where long-term options are available at this time is in financial stocks. This is thanks to the TARP bailouts, so five to six year warrants are currently available from several major banks and other financial institutions. For Capital One and Hartford Financial, these warrants are already in the money – which means that the current price of the shares already exceeds the exercise price of the warrant. This will limit the impact of volatility estimate errors on the warrant price.

But on the other hand, Bank of America and Citigroup still have warrants where the strike prices are well above the share value at the current market price. With the bulk of the value coming from the time value and the estimates of volatility that are generated, the warrants for these shares are very susceptible to the type of mispricing that Warren Buffett is discussing.

Take a Look for Yourself

Remember that options and warrants are a very specialized type of investment and they present a substantial risk. But regardless, the questions revolved around proper pricing for the long term bring up the possibility that you can use this type of option to your advantage, which means you might want to take a closer look.

The long-term track record of Warren Buffett’s success has made him the best investor of our time, but currently Berkshire Hathaway shares are trading at their all-time high. Is it the right time to buy Berkshire right now? You decide.

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