Do you have the English version of this? Or if you could point me to a good introduction to
options for dummies I might have a chance of understanding anything you just wrote.
I can try!
Option primers are very good, but with few exceptions they generally don’t talk about how or why to use them.
It’s like taking a woodworking course and they tell you in great and accurate detail how to use a screwdriver, then a hammer, then a drill.
But nothing about how or why to use one or the other to build a book shelf.
The particular effect I made use of yesterday is a bit obscure, but not unreasonably so.
Grab a coffee.
An in-the-money call option is a rain cheque.
The holder of a call option has the right, but not the obligation, to buy something any time they like, up to a certain date, at a pre-agreed price.
In this case we’re talking about things that are more expensive than the price on the rain cheque…“in the money” options.
So, if bags of flour are selling for $5.00, you might have a rain cheque giving you the right to buy
it any time this year for $3.50, or a different one giving you the right to buy it any time this year for $4.90.
The price on the rain cheque, in option terms, is the strike price.
Now, what is the value of the right to buy a $5.00 bag of flour for $4.90 any time this year?
Obviously it’s worth at least ten cents at the moment, the difference between the current price of flour and the strike price on the option.
(in option circles that’s known as the intrinsic value: the immediate profit if you exercised the option and immediately sold the goods)
But less obviously, it’s worth a bit more than ten cents, because you don’t have to put up the money till the end of the year.
Plus, you don’t even have to decide whether to do so or not till then: you can wait to learn more about the wheat harvest, for example.
That extra time to make a decision–optionality–is also worth a bit.
Put together, that’s the time value in the option: the “extra” price of an option in addition to its obvious intrinsic value.
The time value is of course higher if there is a longer time to expiration.
For reasons that can be explained but I won’t bother, the key point is this:
The lower the strike price on an “in the money” option, the lower the time value premium.
The $4.90 rain cheque might be worth 75 cents, meaning a time value of 65 cents.
The $3.50 rain cheque might be worth $1.55, meaning a time value of only 5 cents.
So, the rule: the time value of an option is at its highest when its strike price matches the current stock price.
When it’s “at the money”, in options lingo.
The upshot of this is that there “expensive” and “cheap” ways to hold the upside on the same security.
That’s no surprise.
But, less obviously, which ways are expensive and which ones are cheap will change from day to day, as the price of the stock (sorry, flour) changes.
A few months back I wrote a call option. In return for cash up front from somebody else, I gave them
the power to buy some of my Berkshire stock any time they like in the several months, at an agreed price.
I was thinking of selling that quarter anyway, but didn’t HAVE to, I got paid quite nicely for being willing to let someone else decide.
At the time the stock price was $310 and I gave them the right to buy it for $310 for a while.
Since the two prices were the same that day, the time value in that option was very high. I got paid quite a bit.
And, if I ended up selling to that person, because of the price I got for the option, in effect I
end up selling at a net price quite a bit higher than the market price that day.
But…you’ve been paying attention, right?
The stock price moved. Now it’s much higher, about $325.
Since the options that I sold no longer have a strike price equal to the stock price, the time value in the options fell quite a bit.
Plus, time was passing, which also makes the time value fall somewhat.
(separately, which we’ll ignore for the moment, the intrinsic value went up and I was losing money on that—
but that was exactly offset by the gain in the shares that I already owned that were “backing up” the option.
It’s no more important than the price movement in something you’ve already sold.
It might make you feel good or bad, but it doesn’t change your financial situation)
Since I sold these options instead of buying them, evaporating time value for the buyer is income for me.
Now, the stock price is higher, so the options with the highest time value are the ones with strike prices around $325, not strike price $310.
So, I closed the position of $310 calls that I had written (= sold = shorted) for a loss.
And simultaneously wrote (= sold) new ones with a higher strike price and much more time value in them.
Why?
The high time value in the new ones means that, even though the calls I wrote were a losing proposition
(somewhat like being short the stock while it’s rising),
by switching from one option to another the amount of my loss has been very much less than the amount the stock price has gone up.
The gap in the strike prices from 310 to 325 was far greater than the gap in the price of the options I bought and sold.
I was a buyer of options that had low time value because they were not “at the money”, and a seller of ones with higher time value because they WERE at the money.
I also extended the date by a quarter, which increases the time value of what you’re selling.
Though the number of shares I was long and short did not change, my breakeven changed a whole lot.
In effect, I now have a small wager (which I was paid well to take) that the stock price will be
lower a year from now than what I think it will probably be.
And if I’m wrong, I end up selling a little stock which I was intending to sell anyway, at a net
overall price higher than what I would have realized had I simply sold it the day I started the process.
It’s a bit messy because I had two different contracts before and two different contracts
afterwards, but here is one pair, rolling “up and out” from June $310 to Jan $330.
The wager, started when the stock price was about $310, was this:
I’d be better off having done the deal if the stock price remained below $323.56 till June.
The outcomes were either I’d sell at that net exit price, or pocket $13.56 and still have the stock.
With the price then at $310 and an equivocal desire to sell, a net exit price of $323.56 didn’t look so bad.
By my trades yesterday, with the stock at about $325, my wager changed, and is now this:
I’ll be better off if the stock price remains below $355.83 until January.
The outcomes are now that either I sell at that net exit price, or pocket an additional time premium of $1.98 on top of what I garnered the first time.
i.e., doing this trade raised that much cash per B share for me yesterday, while simultaneously improving my breakeven.
With the price now at about $325, I figured it’s now better to be wagering that the price will be
below $355 till the end of the year than to be wagering that it will be below $323 till June.
And, as with the starting motivation for all this: I want to sell some stock at some point anyway.
So, a net exit price of $355.83 some time this year doesn’t look so bad.
That’s 1.687 times currently known book per share, and the value of a share rises only so quickly.
As mentioned, this was a pretty obscure bit of reasoning and trading.
99% of my option trades in Berkshire are super boring:
When the stock is cheap, buying deep in the money call options makes a lot of sense. Or at least a lot of money.
The time premium is low, so it’s exactly like taking out a low-rate fixed-rate uncallable loan for a couple of years to buy somewhat more stock than you could otherwise afford.
No more to understand than that.
Round numbers, I find myself bumping leverage this way to (say) 1.5:1 when the P/B gets below 1.35,
and holding that till the next time it’s over 1.5 at which time it makes sense to drop back to no leverage.
Though I am loth to admit it in public, sometimes I bump the leverage a bit more than that when the omens are particularly good : )
Jim
