Buffett's Secret Map to Option Profits

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This article is part of ourseries on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.

In his 2008 Berkshire Hathaway (NYS: BRK.B) shareholder letter, Warren Buffett suggested that long-dated options (i.e., options with a faraway expiration date) are mispriced using the standard option pricing model. One man's broken model is another man's source of profits. Let me explain.

If you're not familiar with options terminology, here are the basics you need to know to follow Buffett's argument: A put option gives you the right to sell an asset at a predetermined price (the "strike" price) on the expiration date. If the price of the asset is lower than the strike price at expiration, you pocket the difference between the two. In other words, the put option buyer is making a bearish bet on the underlying asset -- the lower it goes, the more valuable the put becomes.

The 100-year option
To prove his point that long-dated options are mispriced, Buffett uses the extreme example of a 100-year put option on the S&P 500 index with a strike price of 903 (the value of the index at the end of 2008). Using the prevailing assumption for volatility at the time and assuming a large enough position to require a $1 billion payout if the index went to zero, Buffett estimates the value of the 100-year put option value at $2.5 million, using the Black-Scholes formula -- the popular formula for deriving option prices.

Assume you sell the put at that price, receiving the $2.5 million upfront, Buffett says. Now assume the S&P 500 loses half its value over the 100-year period until expiration -- a catastrophe scenario for a put writer, because you'll have to pay a much higher price than the prevailing index price in the market. Yes, you're underwater on the option you sold, but what about the cash you received up front? Assuming you invested that cash, in fact, assuming you did anything other than sticking it under your mattress, any return in excess of 0.7% will mean you are profitable. In other words, even under a catastrophe scenario, selling the option is equivalent to borrowing money for 100 years at an annual rate of 0.7%.

If you're interested in a detailed analysis of Buffett's argument on option (mis)pricing, I highly recommend a fascinating paper (pdf file) by Bradford Cornell, a professor at Caltech. He concludes that Buffett believes that the volatility input overstates the risk of an extreme decline in the S&P 500.

Past performance and future returns
The volatility input investors use in the Black-Scholes formula is usually based on the asset's historical volatility -- how much the price has zigged and zagged. In other words, the formula assumes that the future will be similar to the recent past in terms of how the stock price moves around. In that context, it's worth remembering the disclaimer that mutual funds put (in small print) at the bottom of their marketing documents, according to which past performance is not indicative of future returns. And I would add, "Past volatility isn't indicative of future volatility."

That holds for both long-dated and short-dated options. Take the case of BP (NYS: BP) , for example. In the period that immediately followed the Deepwater Horizon disaster, the oil company's share price fell dramatically. In responding to a headline event of this magnitude, investors overreacted by selling the shares down to bargain levels. Naturally, the news also affected BP options -- option investors share the same fundamental behavioral traits as stock investors. On June 9, 2010, a Bloomberg article reported that "Trading of bearish BP plc options surged to a record on the U.S. as investors bet on further declines and bought protection from losses."

Leveraging your knowledge
Whether betting on declines or seeking to hedge against them, option traders were bidding up put options with a strike price below BP's stock price. I'd venture there was a lot less interest for the upside call options -- a bet on the future price gains in the shares. The recovery in BP's share price over a relatively short period (the shares bottomed in June 2010) is an indication of share investors' overreaction to the initial bad news concerning the oil spill, but it was a boon for investors who bought longer-dated call options.

There is more to estimating a stock's future price than a mechanical calculation that sums up what happened over the recent past. If you understand a stock's fundamentals and are willing to a take a longer-term, contrarian view, options are a powerful tool to leverage that knowledge into profits.

Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments.Click back to the series introfor links to the entire series.

At the time this article was published Fool contributorAlex Dumortierholds no position in any company mentioned.Click hereto see his holdings and a short bio. The Motley Fool owns shares of Berkshire Hathaway.Motley Fool newsletter serviceshave recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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