Warren Buffett Is Right: Long Term Puts Are Dramatically Overpriced

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When Warren Buffett speaks the average investor should listen.  The Oracle of Omaha weighed in several years ago on the pricing of long-dated put options, saying that they are considerably overpriced.  While an average investor cannot engage in selling some of the longer-dated options that Berkshire Hathaway has, they can sell puts on individual stocks or ETF index funds. 

Below is a chart published by the CBOE of the Put-Write Index, which is calculated assuming that since June 30, 1986 a theoretical investor sold on-the-money puts for the S&P500 index with quarterly rebalancing.  The remarkable result is a return far in excess of simply holding the S&P500 index with less volatility.  The drawdown during the 2008 bear market was approximately 30%, compared to an approximately 50% drawdown for the index itself.  This makes intuitive sense when one considers that selling an on-the-money put gives you the premium as downside protection and lowers your entry price should the put be exercised. 

In total, this strategy yielded an 1,126% gain, which is superior to the 807% return one would have received with more volatility by buying the index and reinvesting the dividends.  Furthermore, the outperformance in the past 12 years has been even better, the Put-Write index increased from about 700 at the top of the 2000 bull market to 1126 at the end of 2011, a period in which the S&P 500 fell from over 1500 to about 1250 at the beginning of the 2012 calendar year.

<img src="/media/images/user_14730/put_index_large.jpg" />


Now I am not a mathematician and this article is not meant to be a theoretical critique of the Black-Scholes formula for pricing options; however, what I see when I look at the graph above is a steady transfer of wealth from the buyers of put options to the sellers of put options.  What it highlights is how a put option is a depreciating asset.  Since a seller of such options is inherently short the option, he or she is continuously transferring wealth away from their counterparty. 

Intuitively there are two primary reasons this is true.  First, over longer periods of time the stock market has an upward bias, while the Black-Scholes formula assumes a random walk without an upward bias.  Thus the formula overprices long-dated options because it underprices the likely value of the stock or index at a date further in the future.  Second, buyers of insurance are likely to overpay for insurance when they buy out of fear that the stock price will fall.  When focusing on falling stock prices nervous investors often overestimate the odds of a future loss and pay too much for insurance to protect themselves.  I can tell you after looking at prices of long-dated options on individual stocks that the amount investors are willing to pay is often usurious.  You can sell on-the-money options on stocks you want to own that have already fallen 20% and collect a 13% annual premium. 

Sometimes looking at these premiums makes me wonder if I should ever buy a stock directly.  Intuitively it seems preferable to sell the option, collect the premium and wait to see if the shares are assigned.  If they are wonderful, I get to own the stock at a price that is significantly below where it was at the time I executed the order.  If the shares are not assigned that is also wonderful, I get paid a 13% annual fee to make someone feel better about the volatility of their portfolio.

So How Can You Use Put Options in Your Portfolio?

I don’t know about you, dear reader, but personally I am unsatisfied with a traditional portfolio that is a 60:40 mix of stocks and bonds.  Vanguard’s Total Bond Market Index ETF (NYSEMKT: BND) presently yields a paltry 2.37%, a yield which doesn’t even keep pace with inflation.  Furthermore, a buyer of bonds during a period of zero-interest rates has to beware of the immediate loss of market value that would accompany a period of rising interest rates.  However, allocating all of one's money into stocks can certainly keep you up at night due to the unprecedented volatility the market has delievered over the past five years. Other alternatives, such as cash or real estate, either yield nothing or appear to be very generously priced.  What is a poor investor to do?

Another option (pun intended) is to allocate a portion of your portfolio to stocks (depending on your risk preference) and set aside the bond portion of your portfolio to sell put options. A mix I like is 60:30:10 stocks: put options: cash. If you do your homework you can sell options on a particular stock: just be careful to do your due diligence and not sell options to protect stocks with the potential for large losses.  Companies that would be more appropriate to sell insurance for are well-priced “sure-thing” companies, such as Conoco-Phillips (NYSE: COP) for which an on-the-money option currently yields about 10%.  A Jan-2014 put with a $57.5 strike price trades for a last price of $5.80, while Conoco-Phillips closed at $58.61 on Dec. 21. 

For the lazy option trader, you can sell put options against an S&P 500 index fund, such as the SPDR S&P 500 ETF Trust (NYSEMKT: SPY). I find it very desirable that you can specify a price at which you would be willing to commit to holding stocks.  Let’s say you are only willing to be invested if the market falls 20%, to accomplish this you sell an SPY out-of-the-money put option dated one year later with a strike price of 20% below the present value of the index.  You are paid a premium for the contract, which is comparable to the coupon payment on a bond.  Personally, any money I hold in bonds is just waiting to invest in stocks if the price were right.  By selling puts, I don’t need to wait for the market to fall 20%; instead I get paid to wait.

For example: SPY closed on Dec. 21 at $142, thus I would be a buyer if the index falls into a bear market or a decline of 20%.  Multiply $142 by 80% to give a strike price of $115.  A $115 strike SPY put traded last Friday with a price of $3.90.  In other words, for writing the put you receive a 3.4% return, which is considerably more than the return on a broad bond-market index fund.  Are you not satisfied with a 3.4% return?  Then set a limit order that will fill for the amount you would be satisfied with.  Note that the chart above is the return generated by selling the put on-the-money not 20% below.  While the former strategy is more aggressive, the seller of the more aggressive option has historically been compensated with a superior return.  Selling the option on-the-money today would net a premium of $12.25 or an 8.6% annualized return.  Because of the premium even if the market goes down you have entered with a cost basis below where the market is presently trading.  Because the market mostly goes up and because the time value of the option is slowly eroding as the expiration date draws closer, it is easy to see why this strategy has been hugely effective over the past 25 years. 

With all that said I would be remiss if I did not warn you about the drawbacks of this strategy.  First, I am not advocating selling naked puts; you must have cash in your account to cover the value of the insurance you are selling.  Second, remember that there is someone on the other side of the trade and the decision of when to exercise the option is not yours to make.  It may be expensive to unwind the trade during a market crash since the volatility spike will cause your puts to increase in value and buying them back to unwind the position could cost you.  Therefore, you must be content that the index or stock could fall below your strike price before it is executed. 

This isn’t quite the same as a limit order: know the difference and do not sell puts if you cannot handle this risk.  Furthermore, a frequent trader will lose money to the bid/ask spread each time he or she trades.  The bid/ask spread on options is significantly greater than for individual stocks or ETF index funds.  Thus, I am not advocating a trading strategy, instead when you sell the put you should intend to hold the position until the expiration date.  By that time one of two things will have happened: either you will own the stock or index at a lower cost basis, or you will have netted a premium minus your broker’s commission.  You can calculate your cost basis should the option be executed or your premium if the option should go unexecuted. 

Personally, I want the premium to be in excess of a normal equity return (so at least 10% annualized) and I want the cost basis to set the stock at an attractive purchase price (based on a thorough analysis that I have conducted on the company).  Then sell your put and forget about it until next year, there won’t be much excitement during that time and your portfolio will have correspondingly less volatility because of it.

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