With Options, Less Can Be More

This weekend the Striking Price column in Barron’s referred to the Options Industry Council’s educational series of videos. I have to say I have mixed feelings on the topic. On the positive side of course educating investors is a good thing. The videos currently available are extremely basic, offering definitions on terms such as “strike price” or “in the money”, but presumably there will be additional offerings that will explain how options can be used in various strategies.

The negative element is that the vast majority of individual investors really ought not to be using options at all. At their most basic, options introduce leverage and leverage makes the timing of an investment return far more important than it ought to be. Buying call options on a stock you think will rise will never be as profitable as buying the stock, if the stock rises. Buying put options to protect against a market fall is not as good as limiting your overall exposure to that which you can sustain through a market fall.

Options turn investors into traders, and while this is good for the options industry and for firms that make markets in options, transactions costs, taxes and missed opportunities will render long term returns lower than they would be otherwise. In short, for the majority it’s fair to say that the less time you spend on options the richer you’ll be. FINRA’s Investor Alerts page offers a lot of sensible advice, but including advice to focus on the long term term is probably a step too far.

For many years I ran an interest rate options trading business. Broadly speaking, market makers are more often sellers than buyers of options. It’s too much of a simplification to justify this bias by saying most options settle worthless, but the demand is heavier from those seeking protection (i.e. paying the option premium) than the reverse.

Warren Buffett made an interesting options investment some years ago (it was in long dated options with ten or more years to expiry; exceptionally far out and therefore an exception to the notion that options are usually for traders). In effect he bet that the Black-Scholes (B-S) formula  so often used to price options is flawed. B-S takes today’s security price and extends it out into the future at the risk free rate to estimate its future value. The volatility of the stock reflects the model’s confidence that the stock in question will be at that projected level when the option expires.

By selling long dated options priced this way, Buffett was acting on his conviction that projecting out today’s value for the S&P500 at the yield on the ten year treasury note (i.e. the risk free rate) understates the likely level of the S&P500 in ten years time. The B-S assumption allows for an elegant algebraic solution to the price, but in Buffett’s view the solution was wrong. So Berkshire sold put options on the S&P500 to B-S reliant options market makers, based on his insight that their models were assuming the future price of the S&P500 to be too low and therefore overvaluing the put options they were buying.

Berkshire had to stop adding such trades because of the possibility they’d have to post margin if the trades moved against them, which in an extreme case (i.e. very weak equity market) might have tied up more liquidity than was prudent to support their insurance business. The settlement dates extend into the next decade, so it’ll be many years before the result of those decisions is known. Berkshire’s 2013 10-K noted $2.8 billion in gains from equity index put option contracts whose fair value (i.e. what Berkshire owes at current prices) has dropped to $4.8 billion (excluding premium taken in).

However, I doubt the Options Industry Council will publish videos on how to trade options like Warren Buffett. Like alcohol, best used in moderation.

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1 reply
  1. Scott Jordan
    Scott Jordan says:

    I have a brokerage account with a very prominent discount broker. This particular firm, while otherwise professional, effective and inexpensive, is constantly barraging me with requests to join their “trading academy” and take their option educational courses. They have trading screens available that I suppose are designed to make the customer feel like a “professional trader”, as opposed to the gullible tyro that you actually are. One can really visualize them salivating at the thought of pillaging my juicy account with endless trading fees. Clearly, this is a significant aspect of their business model. Unfortunately for them, they get no gratification from my account, which maybe turns 1% per year on average.


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