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Berkshire Hathaway
Writing Puts 101

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By mungofitch
December 17, 2009

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Selling puts, you are not participating in the upside, you are writing insurance on the downside. ... It depends very much on the expected price trajectory. With a suitably chosen strike, you can get probable income or probably improved entry point. I'm doing both.

I realized my response didn't describe what I meant very well. Here is a detailed description of an "improved entry" trade I'm doing.

Very specifically, a while ago I sold all my WFC stock at $26.74. I then wrote a cash-commitment-equivalent number of April $30 puts for $6.60 each. (take the proceeds from the stock and puts sale, and divide by the amount of cash you need to buy the stock if it's put back to you. This  results in a slightly higher number of puts than shares that you started with). Now, why would I do this? I think the stock is wonderful, and I want a large allocation to it, but I think the price is probably not  going to zoom all that much in the next year. Maybe, maybe not. So, the usual two basic put-writing outcomes are: - If it's put to me, I get the same stock back at a net price of $23.40. Actually it's a bit different from that, because I set it up to be cash  neutral if they are put to me. I used all the sales proceeds (at market price) as cash to back up the puts (at net re-entry cost = strike  minus premium). Thus, I end up with 14% more shares than I started with, no change to cash. That sounds good to me. - Or, the puts expire worthless. I make a return of 28.2% on the cash committed to the puts in 224 days. Annualized linearly, that's a 46%/yr run rate, not a wasteful capital allocation.

As usual, the downside is that you end up with whichever of those two outcomes appears to be worse based on the market price later on. As you mention, I've given away upside. If the stock soars, I make "only" my 28%.

However, I split that last case in two. If the stock is lowish (say $30.50) and the puts expire worthless, I buy back the stock and I'm still better off. If the stock starts zooming (let's say $35+), I don't wait for expiry.

How does that work? My breakeven is $34.26 at the expiry date. (the total revenue from stock sales and puts written, divided by the number of shares I sold). If the stock ends up below that, I can buy back all the stock I had originally and have cash left over. If the stock ends up above that, I'm worse off having written the puts.  This is where "giving up upside" comes into play. I don't intend to let that happen, so I'm watching the price. If it looks like it is rising above my current breakeven, then I'll buy back my puts (which will be cheap) and buy back the stock. My actual foregone upside therefore has only a statistically small distribution: how fast the stock zooms versus how fast I buy back in. If the stock zoomed right after I wrote the puts, it's a bit of a race. As time goes on, it becomes much more certain that I'll end up better off. Right now, on a mark-to-market basis the options have made me $1.82 per  original share. So, if the stock looks like it's zooming up above today's breakeven, I'll close the options and buy back the stock. Note that as the stock rises to that breakeven, the PL on the puts will  be a lot higher--they will drop in value as the stock price rises--so  the breakeven is a little hard to predict until it happens. As of today, maybe I won't have to switch over until it's over $31. A bit of a gamble, sure. But the odds of ending up meaningfully worse  off are pretty small, and I'm almost certainly making a nice income on it. At the end of the process I definitely end up with at least as much  stock as I started with, and very probably either extra cash or extra  shares, with a small probability of a little less cash if the stock  soars quickly and I have to spend some money to catch it. Despite being a short term loss, I'm still doing fine even in this last  case, as I consider the intrinsic value of WFC to be well over $40. Buying at $25 is better than buying at $28, but $28 is still OK if it's worth $40.

This process isn't free money, it's just a good wager, based on the fact that I think essentially all puts on WFC are hugely overpriced based on intrinsic value (not observed volatility, which I don't consider). I figure they're overpriced simply because I think the stock is  underpriced, plus there are [over]high premiums on offer because of widespread [over]worries. I'm sure most option practitioners would consider me insane, which is  understandable as few of them start with an intrinsic value estimate. We live on different planets and understandably come to vastly different conclusions. I don't imagine Mr. Buffett was considering volatility when he wrote $77 and $80 puts on BNI.

This convoluted approach is also a whole lot easier to contemplate if you're not particularly dogmatic about your position size being a particular number. I do this with quite a few different stocks. If the market crashes, a lot of them might bet put to me simultaneously. That's probably more stock than I need, so I have bought a few "disaster puts" on indices to comfort me in this situation.

Lest anyone get the wrong idea, I do not advocate ever writing puts which you don't have the cash to back up. Also, you should figure your returns based on that amount of cash needed to fulfill the put, NOT as a percentage of the margin requirement. Options allow the use of leverage, but there is nothing in the rules that says you have to avail yourself of it---so don't. If you abjure leverage, you never need to sell stock that is put to you at a panicky low price. The worst Mr. Market can do to you is shift the mix of short term and long term investments within your portfolio. And bear in mind that an all-stock portfolio is 100% long term.

Jim