Lesson Overview

Warren Buffett The Options Trader?

Though he is mostly known for his stock picking ability and long-term hold investments, Warren Buffett is actually a very smart options trader as well. In today's video, I'll show you how he is investing billions of dollars in short index put contracts on multiple indexes. We'll even dig deep into his 10K filings at Berkshire Hathaway so you can see exactly what his reasoning and assumptions are for these options trades.

Show Video Transcript +

In this video, I want to show you guys that Warren Buffet is a pretty big time options trader. I'm going to show you proof in this video as we go through some of his quarterly and annually filings for Berkshire Hathaway.

Now just to be 100% clear, I'm not saying the he just trades options, so before a bunch of you start commenting on this and saying but he trades stocks, yes I get that and he's got a lot of money to invest, so he can't just trade options, he's too big for the market himself.

But he recognizes the huge opportunity that options present and uses them for leverage in his portfolio, to the tune of billions of dollars of potential investments in options. It's safe to assume that if he's doing it, we should probably try to mimic that type of strategy that he has as well.

Let's look inside BRK, which is Berkshire Hathaway's ticker symbol, their annual and quarterly reports. Again, this is where we see how and when he's trading options in a pretty big way.

Here we are inside of Berkshire Hathaway's website. Again you guys can go to it to double check, all of this stuff that we talk to you about here in this video by going to Berkshirehathaway.com, and we're just going to look at the annual and interim reports that the file.

We're going to start with the 2008 annual or 10-K report that they filed, and again as I scroll down here, you can see that this is all the way back from 2008.

The reason I'm looking at 2008 is that I want to show you guys just when he started to make these investments in options, and I'm going to go down to a particular page, I've already kind of dug through this and combed through it.

In here he described how he continued to add a short premium to his overall positions in Berkshire Hathaway. He said down here; he said, "We added modestly to the equity put portfolio as described in last year's report.

Some of our contracts come due in 15 years, other in 20." That means that he's trading options about 15 to 20 years out. Now that's obviously way too long for what we can do as retail and individual traders, but the whole concept still is hinged on this idea of selling option premium when volatility is high.

To illustrate this, he said, "We might sell $1 billion in 15 year put contracts on the S&P 500 and if it is at say 1,300 at the time. If the index is at 1,170, down 10% on the day of maturity, we will pay $100 million. If it's above 1,300, then we owe nothing."

Again, it's that same concept as selling a put option, he's right inside of his annual report describing that strategy to us, and again most people really miss this because they don't go in here and start digging through these reports, that's why we've done it for you on this video.

Again, for us to lose $1 billion, he said, "The index would have to go to zero. In the meantime, with the sale, the put, we have delivered us a premium, perhaps $100 million to $150 million that would be free to invest as we wish over the next 15 to 20 years."

You can see he's investing a considerable amount of money in this and believes in it or else he wouldn't invest millions of dollars doing it. He also said, "Our put contracts totaled $37 billion and are spread among four different indexes: the S&P 500, the FTSE in the UK, the stock in Europe and the Nikkei in Japan."

Now you can also see not only is he doing this in the US markets where he's been pretty profitable doing this for years and years and years, but he's also diversifying his risk among many other major indexes.

Again, because option premium at the time in 2008, when things were kind of falling, he was smart and got in there and sold a lot of contracts and now you can obviously assume how much those contracts are worth because the markets are much, much higher.

Let's fast forward just a little bit, and we're going to go actually to a current 10-K from last year. This is the form 10-K, this is their annual report for the end of 2014 for again, Berkshire Hathaway.

If we go down to some particular pages here, I just want to scroll down here so you guys can see some of the things that he talked about as it relates to what's happening now with his portfolio.

Let's go down here to page 60 of this report. A couple of things that he described in here I think is really important. One he talks about the fair value of these put contracts is using the Black-Scholes option pricing model, which is the standard option pricing model that everyone uses for valuing option contracts.

Even though he's trading these contracts over the counter because they're much larger, much more long-term, he's still using the same basic option valuation that we all use. Again he says, "Inputs in this model include a current index value, strike price, interest rate, dividend rate, contract expiration date, etc."

Then he also said below that, "The Black-Scholes model also incorporates volatility estimates that measure potential price change over time."

As we've said numerous times here on Option Alpha, this is our edge in the market, and this is why he was so aggressive in selling options back in 2008, 2009 because he realized at that time that volatility was very high.

That means that option pricing, even for these large contracts that he's trading, was overpriced because volatility was high. You can see that the volatility input for each of these put contracts is a major portion of how they invested back in 2008 and 2009.

As we skip down to page 87, again of the 2014 10-K, they release a little summary of the value of these contracts and then how much he's putting up in what they call notional value or what's referred to as just margin exposure on the retail or individual side.

You can see here as of 2014, 2013, the equity index put options that he sold had a value or contract liability basically of $4,500 and these are in millions, this is about $4.5 billion.

The notional value, see there's a little one next to that, and that's because down here it says that this represents the aggregated, undiscounted amount payable at expiration dates, assuming that the value of each index is at zero at each contract's expiration date.

Again remember, if he sold options on the S&P on indexes in Europe and Japan, so this is assuming that all of these indexes that he still has contracts on are at zero by expiration.

What's the likelihood that these indexes are going to be at zero by that time? Probably not likely, probably no possibility that they're actually at zero. This is the value that he puts up as far as notional value in his books or marginal value; it's about $29 billion.

Again, people who tell me that he's not a big options trader, he's got almost $29 billion of potential risk on his books right now. He's a huge options trader. Of course, he trades stocks, and that's mainly what he's known for, but he's a very smart savvy investor and knows how to play options.

When we dig down just a little bit deeper, one last time, we're down on page 96 of the recent 10-K. You can see that his measurable input that he is basing this whole technique on is the option pricing model for again.

This equity index put options and the unobservable input, or really the unknown is volatility that he's looking to take advantage of. You can see that the average weighted volatility when he sold these options was about 21% for these different index options, which is relatively high given when he sold most of these options.

Again, he describes in a lot of detail, you just have to look through a lot of these reports, and they're hundreds of pages long, but he describes in a lot of detail why he's doing these, how he's doing them and exactly the position sizes that he's using.

You can see 100% proof that Warren Buffet is a really big time options trader. Now you get to decide. You can continue to rely on random, shot in the dark stock picks and trades hoping to make money in the long run, or you can recognize the huge opportunity that options trading presents and start making smarter decisions with your money.

Now one of our members posted this on Facebook, and it was cool that he did it. He said, "Great education today. You can make these trading techniques and adjustments seem so basic, and as commented, for some reason this type of education is not easy to find.

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