Warren Buffett’s Option Trade

I just read Warren Buffett’s 2008 letter to shareholders.   It is always refreshing to read him.  His writing is very clear because his thinking is so clear.  A huge part of Berkshire Hathaway (ticker BRK-A) is the four large  insurance companies that they own.  Insurance is like writing options.  The company collects premium payments and promises to pay the buyer of the policy if something happens to his car (GEICO) or damages his house.   BRK-A has 58 billion dollars of this premium money to invest while it waits to see what it might have to pay out.

Buffett Wrote Puts

So it is no wonder that Buffett is also willing to write puts on the stock market as a whole.  Actually, he has written $37.1 billion worth of puts on four stock markets, he has sold SP500 puts (US market), FTSE 100 (UK market), Nikkei 225 (Japanese market), and the Euro Stoxx 50.  Some of the contracts come due in 15 years and others in 20 years.  They are all European style, they cannot be exercised before expiration.  The reckoning is when they expire.

As an example, BRK-A may have written $1 billion on the SP500 when it was at 1300 and received $100 million – $150 million in premium to use for the next 15 years.  If in 15 years the index is at 1170, down 10%, BRK-A would have to pay $100 million.  If it is above 1300, they pay nothing.

Because the index is now at 713, BRK-A has a large loss to record.  Accounting rules insist that the puts be marked to market and so they show a large loss now.   But what is the probability that the index will be below 1300 in 15 years?  That is how Buffett really thinks of his risk.

To get to 1300 from 713 in 15 years, the index would have to increase by 82%.   In order to increase that much in 15 years, the index would have to grow by 4.1% per year.  Inflation runs more than 2% per year, so the real increase per year would have to be 2.1% per year.  This seems like a very good bet, the US economy grows at 3% per year on average.

Cost of Funds

What if the index stays at 713 for 15 years?  Berkshire Hathaway would have to pay $452 million to their counterparty.  (If the index went to zero, they would have to pay $1 billion, 713 is 45% of the way to zero).   In this case, they had the use of $1 billion for 15 years, at the end of that period they have to pay $452 million.  What do they have to earn every year in order to have that money to pay back?  If they can earn 2.5% per year for 15 years, BK will have $1.452 billion at the end of 15 years.  Their cost of funds will have been 2.5%

That is a very good deal.

We cannot do the same thing because brokerages insist that we put up margin for the trade.  Buffett will not enter into a contract where he has to put up collateral.  He wants to be able to use the float to invest.  That is his model.

But there are good trades for us too, get my free CD, “7 Secrets to Make $1,000 Per Week Trading Options”.