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.

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.