Buy low, sell high

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#14

Thanks Jim. You mentioned that when the P/B gets to 1.55, you sell the options. The assumption being,
it has now become a bit pricey…however, I noticed that you do not just sell and wait on the
sidelines for a better/ opportune buy, and just convert the options into shares.
So, if and when the share prices fall, would that not “artificially/ temporarily” reduce the portfolio value?

Remember that these numbers are valuation multiple levels, not price levels.
The price can rise steadily without the valuation ever getting very high or very low.
As a result, you can’t reliably sell at a given rich price and know you’ll ever get back in again at a lower price.
I don’t know of any way to create a trading system that would make that work.
The problem is this:
Maybe the stock gets expensive, then stays flat while the value grows into it: you sell at a rich valuation, waiting for a lower re-entry price, and wait forever.
Sitting in cash forever won’t get you much of a return.

We can’t predict prices; all we can predict is that if it’s unusually cheap, then it makes sense to pile on some more till the next time it isn’t unusually cheap.
The absolute price may be unpredictable, but it’s pretty predictable that the valuation multiple won’t stay unusually cheap forever.

So, the general idea of the scheme is this:
First, hold the stock all the time as a general rule.
It rises in value over time, it’s a good long term investment, and we don’t know what will happen to the share price in the short term so a long term hold makes the most sense.
Your baseline long run return is the long run return of the stock. Not so bad.

But also, if it occasionally gets unusually cheap, add some extra as a temporary situation.
If you keep that “extra” position until the next time the valuation level is good, you’ll have made a good bonus return with low risk.
It might be a little while later, it might be 3-5 years, but eventually the valuation level will be reasonable again.
End the “extra” position then. During that stretch, the extra position will get the value growth of the shares plus the expansion in multiples.
Those two combine to be a pretty compelling opportunity as a rate of return, so it’s worth the extra allocation…even with (say it softly) leverage from call options.

Jim

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#15

Any chance of adding a metric for capital gains tax showing how that would change the bottom line for us mere mortals?

Sorry, no, though I think that table has pretty much everything you’d need to work it out by pencil.
There are only 9 transactions.
As a crude rule of thumb, assume you can buy call options offering 2:1 leverage with two years to run for a premium of 6%/year on the leverage.
(= 3%/year on the number of shares controlled)
If you sell half your stock to buy 2:1 options, the cost on your portfolio would be around 1.5%/year of your starting portfolio value.

The US situation is always complicated. Most countries don’t distinguish between long and short term capital gains taxes, for example.

Jim

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#16

I don’t understand your calculation. How can cost basis of your shares be negative? It seems impossible.

It may be a terminology issue.
I don’t pay tax, so cost basis has nothing to do with what I paid for a given specific share or how long I’ve owned it or the order of my purchases and sales.
I just own a single amorphous block of shares that I put money into. And sometimes took money out of.
For me, my cost basis per share is average NET cost per share of my current position:
The total amount of money I’ve put into purchases of that stock, minus the cash raised by any sales, divided by the number of shares I own today.
(This is, incidentally, also the method used for taxable cost basis in some countries)

If I trade small amounts, buying low and selling high repeatedly, I’ll make a profit from that process over time.
If I withdraw those profits and spend the money rather than letting the number of shares rise,
then my cost basis per share still owned (only as defined above) will fall over time without limit.

Looked at another way:
If Berkshire went bust and the stock went to zero tomorrow, my all-time start-to-finish profit on Berkshire would still be substantially positive.
That can be true only for people with a negative net cost basis per share: they own shares, but they have taken more out of the position than they’ve put in.
I have no remaining skin in the game.

It’s not that rare or difficult–it depends on position sizing.
For example, say you buy 1000 shares of XYZ at $10 for a total cost of $10000, then sell 990 at $11 for total proceeds of $10890.
Your total net cost to date of your remaining 10 share position is -$890 or -$89.00 per share.
Is that meaningful? Sure. That’s your final start-to-finish profit if the company went bust tomorrow.
For any positive cost basis, that’s how much you lose if the stock is a zero.
If something going to zero leaves you with a profit, your net cost basis that day had to have been negative : )

Jim

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#17

Jim,

Thank you for these outstanding posts and sharing your wisdom. I have been dipping my toes into some DITM LEAPS options (better than dice and Blackjack!). What % of the time do you sell the option itself for profit vs. actually fulfilling the purchase of 100 shares/ contract?

Appreciate any insight into your thinking when this decision time occurs. Thanks Jim!

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#18

Jim, you ruined it. Mid-June I bought Jan’24 Calls. Since then I am waiting for Mid’24 Calls coming out to buy those - - - but now I will have to buy them at “Jim’s Newsletter said …” prices :frowning:

Kidding off.

Thanks for your newsletter and thanks for it not coming out only on a monthly basis, and for keeping the subscription price low.

Anybody any idea when those Mid’24 Calls will be available for BRK? I am waiting since quite a while now, getting frustrated while the stock price is rising.

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#19

Thanks for all the Berkshire thoughts and information you have provided over the years Jim. I’m also too dumb/scared to trade options, use leverage, etc, but I do like reading about your strategies.

His information about using long-dated DITM call options on BRK are great. As synthetic leverage. Once you understand the math. The implied interest rate is still too high right now, IMHO. It’s usually around 3% but now it’s 6%-7%.
Gives you plenty of time to work out and understand the math.

The price/book is quite low right now, reported as 1.25 to 1.31. From that aspect it seems like a good time to do it.

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#20

As a crude rule of thumb, assume you can buy call options offering 2:1 leverage with two years to run for a premium of 6%/year on the leverage.
(= 3%/year on the number of shares controlled)
If you sell half your stock to buy 2:1 options, the cost on your portfolio would be around 1.5%/year of your starting portfolio value.
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
RVT: The implied interest rate is still too high right now, IMHO. It’s usually around 3% but now it’s 6%-7%.

I’d like to better understand the role of fluctuating interest rates on the timing of option buys. I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.

Tom

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#21

Anybody any idea when those Mid’24 Calls will be available for BRK?

In 2021 I had already purchased JUN23 calls by mid June. I don’t know why they are not available yet. At this rate the Jan25 calls might be available first.

Jeff

#22

For example, say you buy 1000 shares of XYZ at $10 for a total cost of $10000, then sell 990 at $11 for total proceeds of $10890.
Your total net cost to date of your remaining 10 share position is -$890 or -$89.00 per share.
Is that meaningful? Sure. That’s your final start-to-finish profit if the company went bust tomorrow.
For any positive cost basis, that’s how much you lose if the stock is a zero.

This is certainly a different terminology. In the US terminology, you booked a capital gain of $990 when you sold 990 shares for $10,890 and the cost basis for the remaining 10 shares comes to $100. If the share price then subsequently goes to 0, you then have a capital loss of $100 and the total net gain comes to $890 (=$990-$100). My guess is that most western democracies use the US terminology and it is independent of capital gains tax rates.

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#23

This is certainly a different terminology. In the US terminology, you booked a capital gain of $990
when you sold 990 shares for $10,890 and the cost basis for the remaining 10 shares comes to $100.

Once again, I’m not talking about tax, I’m talking about economics.
What’s your skin in the game?

For some purposes the weighted average value of all purchases is useful, ignoring any sales.
For other purposes–most–it’s the net of the in-and-out to date: the net amount of money contributed to the position from elsewhere.

For example, say you write a call against some of your stock, turning some of your position into a covered call for a while.
Let’s say that call expires worthless and you pocket the premium as a profit.
For most practical purposes as an investor that’s best viewed as a reduction in your net cost basis.
If there are many transactions over time, I find the net of all of them to be the most meaningful view in terms of tracking an investment.
As mentioned, it’s what you could lose (the net across all purchases and sales through history) if the stock went to zero.
The call in this example wasn’t a different investment, just one variation in the chosen way of holding the single long term exposure.
A very close analogy is the shareholders’ equity figure of a company doing buybacks over time at prices averaging above book value.
Eventually the book per share will turn negative, and for the same reason: that is the net value of share capital contributed to the firm by the set of all shareholders.

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.
A more normal change would be this:
You buy a stock at $70 and write a $100 call for $1 while the stock stays at $90, making your skin in the game drop to $69.

Jim

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#24

Option price fluctuates a lot more than stock price and quite often offers excellent but limited opportunities. For example, I sold BRK-B Jan 2023 $380 call for $19 a few months ago and bought it back for $0.5 a few weeks ago. It’s limited because one would need a lot of cash or stocks to back it up.

#25

I’d like to better understand the role of fluctuating interest rates on the timing of option buys. I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.

You need to read up on the strategy and understand the bit about implied interest rate, which I call pseudo-rate. It’s got nothing to do with normal interest rates.

FWIW, here’s the info for a typical set of these trades I’ve done. As you see, most of them have been around 3%.

Stock      Date      ITM %      rate
BRK.B   06/24/16        -11%    5.20%
BRK.B   11/07/17        -44%    2.40%
XSP     11/09/17        -24%    2.89%
XSP     02/05/18        -20%    3.25%
UNP     10/12/18        -25%    3.45%
BRK.B   02/15/19        -46%    3.79%
BRK.B   08/15/19        -50%    3.52%
SPY     11/01/19        -48%    0.34%
SPY     12/13/19        -31%    0.84%
AAPL    02/05/20        -41%    1.89%
BRK.B   03/02/20        -37%    3.67%
RSP     10/13/20        -21%    2.34%
UNP     10/16/20        -45%    0.85%
AAPL    04/06/21        -56%    0.91%
BRK.B   04/19/21        -39%    2.67%
BRK.B   08/19/21        -30%    3.71%
DLTR    09/03/21        -40%    3.02%
BRK.B   10/18/21        -38%    3.24%
BRK.B   11/18/21        -29%    3.70%
RSP     12/31/21        -30%    1.65%
BRK.B   03/23/22        -26%    5.79%
#26

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

Tom

#27

I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.
…
It’s got nothing to do with normal interest rates…As you see, most of them have been around 3%.

I mentioned 6% just because it’s a conservative estimate to figure out whether an “occasional leverage” strategy would have been a good idea in the past.
You would have done much better than that rate on almost any random date in recent years…so if it works assuming 6%, it definitely would have worked in real life.

Interestingly, the implied interest rates in options are much higher at the moment, but arguably not high enough.
For example, Jan 2024 $165 calls offer 2:1 leverage and cost 6.07%/year in implied interest.
Headline US inflation in the last 12 months has been over 9%.
So, if inflation is 7%/year or more in the next 1.5 years (a big if), the market is paying you to borrow the money to buy Berkshire shares.
On the surface of things, the real interest rate has fallen in the last year or two, not risen.
Unfortunately the definitive answer to that requires knowing the inflation rate in the next year or two, but it’s probably not going to be zero.

Jim

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#28

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

As a general rule when I am holding BRK call options I am also holding shares. If I were to get to expiration and need to inject additional cash to roll the options out into the future my plan would be to sell shares to enable the roll. I can’t think of any time in the last 8-9 years of using options when I have had to sell any shares to cover a roll though.

I did have an instance earlier this year where I was holding a fair number of Jan22 leaps purchased in the spring of 2020 in a taxable account that were deep in the money and facing a large capital gain. Because I’m still a working stiff, I still have cash coming in that I need to allocate occasionally and near expiration I chose to exercise some of the options to hold as shares to avoid capital gains. I tend to think of those shares in my taxable account as going into cold storage and would not plan to sell them to switch to options or cover rolls. I usually have a reasonable cash balance in that account to take advantage of opportunities with BRK options being one of those.

In my tax free accounts I switch between shares and options more frequently but always maintain shares that can be sold to cover any potential rolls needed. It all comes down to what level of overall leverage I’m comfortable with that allows me to sleep at night. Everyone’s risk tolerance will be different.

Jeff

#29

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

The ideal is to have a cash stash sufficient to exercise the calls if that becomes necessary.
But if you do keep that cash, then you’re earning nothing on that, so there is no benefit to the occasional leverage, right?

So, let’s say you do not really have the cash that would be required. How risky is that?
It depends on various things.

First, do you think LEAPS might be banned?
I don’t think it’s likely, but it might be up to a 1% chance. Maybe January 2026 LEAPS will never exist. It could happen.
So imagine it is December 2023, your Jan 2024 calls are about to expire, and the Berkshire price is very low, and there are no newer option contracts available.
You might have to close our position at a big loss if you can’t roll them out.
You have to be able to live with this: either have another source of funds to exercise the calls (as you mention),
or live with the risk of losing money–possibly up to the entire value of your calls.

There are ways to reduce the risk further, though not reducing it to zero without the cash needed to exercise:

Don’t have everything expiring at the same time.
The price might be arbitrarily low on any given date, but the chances of it being arbitrarily low continuously for a year or more are considerably lower.

Pick very low strikes. You might lose the same dollar value per share that the price of the share falls, but it’s very much less likely you will go to zero.

Even if you don’t have a way to come up with the cash to exercise your calls, make sure you have at
least a smallish cash stash: if you can roll, it will cost you a little extra money.

Don’t roll at the last minute…roll as soon as you can, preferably when the stock price is reasonably high.
If you can roll on any date that the price is not unreasonably low, do so: if that opportunity arises,
this preempts the possibility of having to roll when it is too low to roll, later on.
You don’t want to be in t he situation of having no choice of dates because the expiry date is looming.

Use the longest dated, lowest strike calls you can. This gives time for value to work out, and gives you more choices of dates to roll.
When the odds are very good, even a tiny bit of leverage will turn a pleasant rate of return into a wonderful rate of return.

Enter leveraged call positions only when the valuation is very attractive, so that the odds of the price being lower at expiry become much more remote.
If you buy at book value today, realistically, what are the chances that the stock price will be lower in a couple of years?
It could still happen, but it becomes less and less likely depending on the valuation multiple the day you start.

Let’s say everything has gone against you: the expiry date is looming and the stock price is very low.
The market value of your existing calls is very low, and you don’t want to lock in that loss.
If you have both cash and calls, you can raise money by selling stock and buying a lot of VERY low strike calls.
The money raised can be used to replace both your stock and your about-to-expire calls, also at a very low strike.
This isn’t free, but it’s much better than letting calls expire when the stock price is temporarily low.
For someone willing to consider calls, plain stock can be thought of as a last-ditch source of funds.

But ultimately, this is not a risk free strategy if you do not have a way to raise the cash needed to exercise the calls.
Having some ace in the hole is always a nice idea. For example, I have an unused HELOC.

Personally, I tend to keep some calls even when I have a pile of cash.
(Flipped around, I tend to keep a pile of cash when I have calls)
This doesn’t maximize my returns…I’m wasting some of the cost of the leverage. I could simply have stock and less cash, more cheaply, right?
But cash has so many possible uses, I find it worthwhile for the optionality.
Sometimes in the distant past Mr Buffett would have Berkshire borrow money when it wasn’t needed, but cheap.
He said it makes sense to get the money when it’s easy, because when it’s useful it isn’t always available so easily.

Jim

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#30

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.

Each of us are free to choose anyway we want to account for the “cost” of our shares, but IMO this is not the the correct way to look at gains/losses irrespective of the underlying taxes levied on gains. And with taxes most of us have to pay outside your residential jurisdiction, it is definitely not the correct way to look at things. Let me provide another example where the distinction is not minor. Let us say I bought 2,000 shares of a stock for $20,000. The shares went up and now trade for 4X what I paid for and my 2,000 shares are worth $80,000 now. I then sell 1,000 shares for $40,000 and in your terminology/methodology the cost basis of the remaining 1,000 shares is -$20,000. Whereas using the “standard” terminology/method, the cost basis of remaining shares is $10,000 (with a realized gain of $30,000).

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#31

The ideal is to have a cash stash sufficient to exercise the calls if that becomes necessary.
But if you do keep that cash, then you’re earning nothing on that, so there is no benefit to the occasional leverage, right?

So, let’s say you do not really have the cash that would be required. How risky is that?
It depends on various things.

Many thanks for your elucidation of this, Jim. I’m in the camp of being highly intrigued with the prospect of enhancing my investment returns through the judicious use of options, but I’m still trying to sweep away the remaining cobwebs from my understanding of this (to me) very complex process. Your explications are most helpful in that endeavor.

Tom

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#32

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Each of us are free to choose anyway we want to account for the “cost” of our shares, but IMO this is not the the correct way to look at gains/losses irrespective of the underlying taxes levied on gains. And with taxes most of us have to pay outside your residential jurisdiction, it is definitely not the correct way to look at things.

I’ve been going back and forth on my own accounting for this situation.

Amidst the Covid panic I sold a lot, but not all of my BRK holding, my largest in a taxable US account, in accordance with first-in-first-out precedence. Three weeks later I bought back in, realizing that I’d allowed the fear induced by this extraordinary macro phenomenon to inappropriately drive my sale. So my sale and repurchase prices were roughly similar. However, in the process I incurred a substantial capital gains tax on the sale of my long-held BRK shares.

So I then faced a need to appropriately account for the cost of my present BRK holdings. Given the substantial gains I’d realized on the sale, this initially resulted in a negative cost basis for currently held shares, which I intuitively felt was inappropriate.

So I’ve been puzzling over this ever since. Any illuminations on this dilemma are most welcome.

Tom

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#33

I don’t wee why this is creating a bit of a stir.

If I trade around a position I add any gains or losses into my current cost of goods. This includes sold puts and calls that expire worthless.

I recently bought apple for $138. Then sold some naked puts instead of increasing the position at $105. When and if they expire worthless I will net the gain out of my $138 cost.

I sold some BRK in the $350 earlier in the year and bought them back in the $320’s. I adjust my carry to reflect the sell gain and the buyback.

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