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The Mother of All Easy Trades


twacowfca
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Note the price action on BRK after hours.  BRK closed today a hair below the new repurchase level. Then, immediately after close, 500K shares traded, and the B shares popped up above the repurchase level. 

 

We've been levering up with cheap in the money leaps.  There is no skew in the near the money BRK options. Mr Market doesn't have a clue about the asymmetry of the trade.  This is only one of many ways to take advantage of the opportunity.  The easy way is simply to buy BRK at the repurchase price.  As Yogi Berra says: "If it don't go down, it'll go up.  :)

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Note the price action on BRK after hours.  BRK closed today a hair below the new repurchase level. Then, immediately after close, 500K shares traded, and the B shares popped up above the repurchase level. 

 

We've been levering up with cheap in the money leaps.  There is no skew in the near the money BRK options. Mr Market doesn't have a clue about the asymmetry of the trade.  This is only one of many ways to take advantage of the opportunity.  The easy way is simply to buy BRK at the repurchase price.  As Yogi Berra says: "If it don't go down, it'll go up.  :)

 

Most of my options experience is with buying calls, although I have written puts once or twice before. I have never executed anything more complex than that. One of things I have been looking at for situations like this is the following:

 

sell the 2015 77.50 BRK puts and buy the 2015 75.00 puts. This would allow for levering up the amount of premium you collect while reducing your margin requirements for the trade. Obviously the down side is that you would have to potentially pay the difference of 77.50-75.00 out of pocket if the trade goes bad. I guess my question is between now and January 2015 if the price goes below $77 for a period of time how likely is it that the counter party will attempt to put the stock to you before expiration? From a little bit of reading it sounds like it is possible but not likely. Is that true? What are the gotchas?

 

I had looked at doing this type of trade with LUK when it was trading at 16 after the JEF deal was announced. I held off and at the moment it looks like it would of worked out quite nicely.

 

 

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You wouldn't have a problem if someone puts the stock to you before expiration: you still have your own puts with a lower strike price to protect you in case the stock drops below 75. The odds of early exercise for put options is by the way low: it only makes sense when the option is deep in the money, and the lower the interest rate the lower the possible advantage of exercising early.

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Thanks for the observations as the (in-the-money) near term call options look a little funky.  Not quite, but reminds me a little of the FFH calls back in the day when out-of-the money leaps were selling at on 12-13% time value as the market thought FFH was going bankrupt.

 

Cheers

JEast

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But you may be overthinking this trade, buying calls makes more sense than a put spread since it's asymmetrical.

 

LUK/JEF is totally different, stock merger, no particular reason why that would use a put spread either.

 

 

That's right.  By far the least likely scenario is that BRK will trade below $89.27 for any appreciable length of time.  The current probability of a significant rise in price is many, many times the current probability of a significant decrease in the price.  This is why it makes sense to consider using non recourse leverage if you ever do that.

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Note the price action on BRK after hours.  BRK closed today a hair below the new repurchase level. Then, immediately after close, 500K shares traded, and the B shares popped up above the repurchase level. 

 

We've been levering up with cheap in the money leaps.  There is no skew in the near the money BRK options. Mr Market doesn't have a clue about the asymmetry of the trade.  This is only one of many ways to take advantage of the opportunity.  The easy way is simply to buy BRK at the repurchase price.  As Yogi Berra says: "If it don't go down, it'll go up.  :)

 

Simple & robust.  Little downside and several catalysts on the upside, love it!  Thanks Twacowcfa!

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Note the price action on BRK after hours.  BRK closed today a hair below the new repurchase level. Then, immediately after close, 500K shares traded, and the B shares popped up above the repurchase level. 

 

We've been levering up with cheap in the money leaps.  There is no skew in the near the money BRK options. Mr Market doesn't have a clue about the asymmetry of the trade.  This is only one of many ways to take advantage of the opportunity.  The easy way is simply to buy BRK at the repurchase price.  As Yogi Berra says: "If it don't go down, it'll go up.  :)

 

Being relatively new to options, I wondered if you wouldn't mind detailing exactly which LEAPs you're buying (i.e. strike and premium).

 

Thanks!

 

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Note the price action on BRK after hours.  BRK closed today a hair below the new repurchase level. Then, immediately after close, 500K shares traded, and the B shares popped up above the repurchase level. 

 

We've been levering up with cheap in the money leaps.  There is no skew in the near the money BRK options. Mr Market doesn't have a clue about the asymmetry of the trade.  This is only one of many ways to take advantage of the opportunity.  The easy way is simply to buy BRK at the repurchase price.  As Yogi Berra says: "If it don't go down, it'll go up.  :)

 

Being relatively new to options, I wondered if you wouldn't mind detailing exactly which LEAPs you're buying (i.e. strike and premium).

 

Thanks!

 

BRK isn't likely to become a rocket ship , despite the upside downside asymmetry.  I have often been right about direction on very selective option trades and still lost money or wound up with small gains because the trade took longer to work out satisfactorily than anticipated. 

 

For example, last spring BRK was trading at my estimate of 110% of Q1 BV/SH.  We loaded up with out of the money leaps, the Jan 2014 $85 strike.  BRK is up about $10/SH since then, but that Leap is up only about 35% because of time decay and decline in the implied volatility of that option since then.  In retrospect, we would have made as much on that trade if we had bought a well in the money Leap that had far less risk of significant loss from time decay if BRK had not moved up as much as it did since then.  Normally, the deep in the money leap would be considered much more risky because one could lose much more on it if BRK's price went south.  However, with the asymmetry of the situation, I think the risk of significant principal loss on a deep in the money leap is very low.

 

If it takes longer than anticipated for BRK to appreciate, the deep in the money Jan, 2015 Leap should perform much better than an at the money or out of the money Leap.  If the market should head south, we can probably unwind the deep in the money leap at almost no loss at the repurchase price because we bought it at a very small premium to parity when BRK has traded at about the repurchase price.  :)

 

We also have a lot of $90 Jan 2013 calls.  These are purely speculative and  will lose money if BRK doesn't trade up 2% above the repurchase price by expiration.  We've had success with short dated, about at the money calls on BRK in the past, and on another stock that Warren backstopped a few years ago, when we bought them at about Warren's repurchase price, but this is no guarantee that we will make money this time.

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Guest rimm_never_sleeps

what about market risk? surely the notion that Buffett can buy shares at around current prices can't prevent a decline in brk price that would result if the overall market declined. or am I missing part of the trade?

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what about market risk? surely the notion that Buffett can buy shares at around current prices can't prevent a decline in brk price that would result if the overall market declined. or am I missing part of the trade?

 

BRK has a very stable shareholder base.  The turnover is much lower than for other stocks.  Warren has said that he will buy back shares aggressively when the price dips below the preset level except that his purchases may flag in a big selloff.  I expect that the repurchase level will hold unless we have people dumping shares to drive many stocks to bargain basement levels as we saw in 2008.  If that should occur, we should see the writing on the wall and exit the trade before the fullness of that event.

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I think it might be a decent idea to constantly sell puts at a strike price of 90 or thereabouts. Basically at the money or even a little higher.

You usually want to buy options when volatility is low and to sell options when volatility is high.  That would be the "value" approach to options... buy cheap and sell assets when they get more expensive.

 

2- Remember, you can generally turn call options into puts or vice versa due to put/call parity.

 

A call - a put + risk-free investments = common stock

 

(*There are certain scenarios where put/call parity for stocks can break down, but usually that doesn't happen.)

 

Due to put/call parity holding true most of the time, it doesn't matter too much whether you buy calls or you buy puts.  You can turn calls into puts and puts into call.

 

3- So really, you can break the pricing of options down into implied volatility according to the Black-Scholes model.  There is some value of implied volatility which is the "right"/appropriate value for an option.  When the options trade at less than that value, it is cheap.  When options trade at a higher implied volatility than the "right" value, it is expensive. 

 

The Black-Scholes model has well-known flaws.  Many experienced traders will fudge the implied volatility aspect of the BS model to take those flaws into account.  (So then it starts getting advanced... there is the volatility smile, skew, etc.)

 

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Due to put/call parity holding true most of the time, it doesn't matter too much whether you buy calls or you buy puts.  You can turn calls into puts and puts into call.

 

 

i'm no expert but i think the put/call parity you speak of exists not to ensure put & call trade at equal value- thus it does very much matter whether you buy calls or puts- but rather to arbitrage out the riskless profit opportunities that would otherwise exist because of things like skew & volatility smiles. and yes, you could turn your long put into a synthetic call of sorts by buying an equal weighting of the stock but it gets messy quick & expensive even quicker

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Trading on volatility is a decent idea, I havent thought much about it because I'm just trading my little Roth IRA, so it's not really feasible for me. I just like the idea of selling puts because I already own the stock, and I'm happy to scoop up near riskless profits driven by the fact I have a decent idea of the underlying's intrinsic value.

 

But broadly, what I think is - whenever you have a stock that is moderately undervalued, so not undervalued enough to buy, but just enough to follow, it would be a good idea to sell puts at a strike price such that your strike-option premium <= your target buy price. That way, if the option triggers, you can buy the stock at the price you want, and if it doesnt, then you still collect the premium. Doing this on regular 3 month basis could add up small, but steady profits.

 

In this case, I think the way to go would be to find a price such that the Strike-premium <= 89, where 89 is the 1.2*BV number. And If IV keeps going up as Buffett has done, the option value degrades very strongly, which is exactly what you want.

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i'm no expert but i think the put/call parity you speak of exists not to ensure put & call trade at equal value- thus it does very much matter whether you buy calls or puts- but rather to arbitrage out the riskless profit opportunities that would otherwise exist because of things like skew & volatility smiles. and yes, you could turn your long put into a synthetic call of sorts by buying an equal weighting of the stock but it gets messy quick & expensive even quicker

I think you're confused?

 

There is no riskfree arbitrage with put/call parity unless put/call parity holds true all the time (which is not true for stocks).  There are very few riskfree arbitrages in real life anyways (and the HFT algo shops are likely all over it).

 

Skew & volatility smiles exists because there is uncertainty as to the correct price of an opinion.  Nobody knows what the correct skew and volatility smile should be.

 

Trading on volatility is a decent idea, I havent thought much about it because I'm just trading my little Roth IRA, so it's not really feasible for me. I just like the idea of selling puts because I already own the stock, and I'm happy to scoop up near riskless profits driven by the fact I have a decent idea of the underlying's intrinsic value.

 

But broadly, what I think is - whenever you have a stock that is moderately undervalued, so not undervalued enough to buy, but just enough to follow, it would be a good idea to sell puts at a strike price such that your strike-option premium <= your target buy price. That way, if the option triggers, you can buy the stock at the price you want, and if it doesnt, then you still collect the premium. Doing this on regular 3 month basis could add up small, but steady profits.

I'm not talking about constantly trading options.  I'm saying that you should buy options when implied volatility is too low, and sell options when implied volatility is too high.  Of course, too low and too high are subjective.  Like stocks, the "correct" price of an option is generally considered to be uncertain (though there may be idiots out there who believe that the theoretical Black-Scholes model without any adjustments is correct).

Anyways... buy options when they are cheap and sell them when they are expensive.

 

2- A logical extension of the value investing philosophy is to buy/sell options when you have a large margin of safety.  If you don't have a margin of safety... then do nothing.  Doing nothing is sensible.

You could also avoid options if options aren't in your circle of competence.

 

3- I really don't think that you can make an argument for selling options on Berkshire.  Maybe you could make an argument for buying far-out-of-the-money puts... the opposite of what you propose.

 

There is a price where these far-out-of-the-money puts are so cheap that they would be worth buying.  And there is a price where these far-out-of-the-money puts are so expensive that they are worth selling.

 

Suppose that Berkshire's reinsurance did cover terrorism and that there was a major terrorist attack that devastated the reinsurance industry.  Intrinsic value of Berkshire Hathaway would likely drop a lot.  Suddenly the strike price of the put options may be far above the new intrinsic value.

 

4- There's another way of looking at things.  If you delta hedge, the direction of Berkshire Hathaway stock largely doesn't matter.

 

(*Nassim Taleb's book on derivatives is really good.  You don't really need to understand the math... I don't.)

 

5- If you think that selling puts is "near riskless"... you are crazy.

 

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The irony of using the Jan 2014 LEAPS for this trade (2015 is not really liquid enough for me atm) is that if WEB were to buy back a large amount of shares this year the BV of BRK goes down.  For example, if he were to spend $22bln to buy 10% of outstanding tomorrow at 120%, BV per share would immediately drop by a little more than 2%.  From WEBs standpoint, this is no problem because EPS will increase by 8-10% due to the smaller sharecount and he will recover his $3.7bln BV premium "investment" in about 3 years (earning over 20% IRR).  For an levered investor in 2014 LEAPs though, the 2% hit to BV is immediate and all else equal a negative since they won't be around long enough to receive the payback from EPS accretion.  Cruel world!  ::)

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The irony of using the Jan 2014 LEAPS for this trade (2015 is not really liquid enough for me atm) is that if WEB were to buy back a large amount of shares this year the BV of BRK goes down.  For example, if he were to spend $22bln to buy 10% of outstanding tomorrow at 120%, BV per share would immediately drop by a little more than 2%.  From WEBs standpoint, this is no problem because EPS will increase by 8-10% due to the smaller sharecount and he will recover his $2.5bln BV premium "investment" in about 3 years (earning over 20% IRR).  For an levered investor in 2014 LEAPs though, the 2% hit to BV is immediate and all else equal a negative since they won't be around long enough to receive the payback from EPS accretion.  Cruel world!  ::)

 

You bring up an interesting point.  the "Buffett put" becomes less valuable but such a large buyback would more than likely benefit the LEAP holder via share price appreciation.  I do find the trade attractive and think that some people are too focused on the verbage used.

 

1. We've got massive QE around the world through 2013, maybe longer

2. BRK is well positioned for the expected environment

3. WEB has made statements to set a weak price floor on the stock, barring massive corrections.

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The irony of using the Jan 2014 LEAPS for this trade (2015 is not really liquid enough for me atm) is that if WEB were to buy back a large amount of shares this year the BV of BRK goes down.  For example, if he were to spend $22bln to buy 10% of outstanding tomorrow at 120%, BV per share would immediately drop by a little more than 2%.  From WEBs standpoint, this is no problem because EPS will increase by 8-10% due to the smaller sharecount and he will recover his $3.7bln BV premium "investment" in about 3 years (earning over 20% IRR).  For an levered investor in 2014 LEAPs though, the 2% hit to BV is immediate and all else equal a negative since they won't be around long enough to receive the payback from EPS accretion.  Cruel world!  ::)

 

Good point.  Practically, large repurchases should be rare.  BRK's share turnover is very low.  The big recent buyback was about half a percent of all shares outstanding.  Typically other purchases have been more like rounding errors in calculation of BV/SH.  :)

 

 

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