The Buffett Put Trade – Year-End 2018 Russell Rhoads, TABB Group 27 February 2019 Berkshire Hathaway’s recently released 2018 financials provided some insight into what Warren Buffett calls his equity put trade. TABB Group head of derivatives research Russell Rhoads examines the performance of Buffett’s big derivatives bet. Last weekend, Twitter was abuzz with commentary and analysis of Berkshire Hathaway’s 2018 financials, which were shared on Saturday morning. While the majority of the focus is on what stocks Warren Buffett has purchased or sold as well as the performance impact of various Berkshire holdings, my attention is always on what Buffett refers to as his equity put trade. This trade has been around for some time, practically overlapping with the now famous statement in which Buffett referred to derivatives as weapons of mass destruction. The first mention of this trade shows up in the 2005 annual report. Berkshire noted that between 2004 and 2005 the firm had sold at-the-money equity index put options on four different indexes: the S&P 500, FTSE 100, EuroStoxx 50, and Nikkei 225. These options originally were set to expire over a 15- to 20-year timeframe. Berkshire also received foreign currency in exchange for the non-US options, which means there is a currency impact on the performance. The worst-case scenario is for all four indexes to go to 0, which would result in the puts being $14 billion in the money. This was just the beginning of the trade. In 2006 more puts were sold and the maximum exposure expanded, from $14 billion to $21 billion. Berkshire sold more puts in 2007, with the notional value increasing to $35 billion. Finally, a few more puts were sold in early 2008, and at the end of 2008 the notional value of the options was more than $37 billion. In summary, Berkshire sold about $37 billion notional value of at-the-money put options on the S&P 500, FTSE 100, EuroStoxx 50, and Nikkei 225 indexes between 2004 and February 2008. Net premium received for these options was $4.7 billion. These are European-style options, which means they cannot be exercised until expiration. Finally, the original contracts were set to expire between September 2019 and January 2028; those dates changed to June 2018 to April 2025 through some renegotiation of the terms that occurred a few years ago. In addition to the terms being renegotiated for a few of the options, others were exited in 2010. Early retirement resulted in the notional value of the options outstanding dropping by $4.3 billion and Berkshire booking a profit of $222 million. Finally, one option expired in 2018; no premium was paid out, as the option expired out of the money. The option that expired represented another $1.2 billion in notional value. [Related: “The Warren Buffett Put Trade Begins to Expire”] We learned a few things this weekend about these positions. Berkshire Hathaway lost $300 million on these positions in 2019, with a little more than $600 million coming in the fourth quarter alone. The notional value of the option positions dropped from $29.479 billion to $26.759 billion, which includes $1.2 billion from the expiring options and the rest attributed to currency fluctuations. The current intrinsic value of these options is about $1.653 billion, up from $789 billion at the end of 2017. The impact of the option that expired is difficult to determine, but since it expired out of the money, I assume it didn’t have much of an impact on the year-over-year change of the intrinsic value of these options. Using a Black Scholes model, the value of these options rose to $2.452 billion, from $2.172 billion. The rise in premiums can be attributed to the price drop for equities in 2018, but also from an increase in implied volatility that Berkshire used for its determination of the fair value of these options. Specifically, it changed its model volatility input to 18%, from 17% as of the end of 2017. Berkshire has shared its quarterly implied volatility assumptions since the first quarter of 2012. The chart below shows how this figure has fluctuated since then. The high is 22% from 2012, while the lowest level of this assumption is 16%, just this past year. The move lower in this assumption can be attributed to a combination of less time to expiration, but also to lower realized volatility across the four underlying indexes. Figure 1: Implied Volatility Assumptions Data Source: Berkshire Hathaway Filings Many readers may scratch their heads when seeing that some of these options that were sold more than a decade ago are in the money. The chart below will clear this up quickly. Remember, these options were sold on four indexes between 2004 and 2008; we don’t know what the breakdown is for the open positions, but we do know the specific indexes. Figure 2: Index Performance Data Source: Yahoo Finance All four indexes are calculated to 100 on the last day of 2003. It creates an easy-to-follow visual as to where each index is relative to the time period when the options were sold. Both the FTSE 100 and EuroStoxx 50 are below price levels where the indexes were in the 2004 to 2008 timeframe. If any options expire in the money this year, they likely will be associated with these two markets. An interesting twist is the timing of Brexit, which may be playing out in concert with the option expiration dates. The next options are set to expire in April, which means we won’t know anything material with respect to these positions until the second quarter report this summer. However, 2019 is going to give us a lot of insight with respect to these trades, as $12.1 billion notional of a total of $26.759 billion positions are expiring this year. Until then, we’ve learned a little bit more about the long-dated puts Berkshire Hathaway sold before the Great Financial Crisis. As of the end of 2018 the trade is running a profit, based on both a Black-Scholes valuation and the running intrinsic value of these options. The first quarter of 2019 won’t tell us too much, except for an update to the running profit or loss of the overall position. But beginning in April, these options will expire. With two of the four indexes trading below prices where they were during the window that options were sold, there is a good chance that some of these will expire in the money, resulting in a payout to the option holders.
Doesn't sound like Warren's option foray has been very profitable? At least not for a guy that averaged 20%/yr buying companies? Thems options is tricky, even for a bigshot guy like WB!
Some commentary of his letter. Decent read - https://www.cbinsights.com/research...ail&utm_term=0_9dc0513989-9281c4cdf2-89811433