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PROPOSED STRATEGY:

Buy very DITM LEAPS calls, say 50% DITM, on BRK or some other well-traded and well-chosen underlying (this has been discussed a lot on this board).
The DITM call's value will rise/fall nearly dollar for dollar with the stock price, so there's nearly 2x leverage for a 50% DITM call.
But leverage is not the point of the strategy below -- put protection is the point. We outline how to use some of the 'savings' from controlling shares with the call, as opposed to buying shares outright, to buy puts as a hedge.

"Leave the gun, take the cannoli."



STRATEGY DETAILS (real world numbers for BRK are shown in next post):

- Buy long dated very DITM calls, say 50% DITM, instead of BRK or some other stock. I'm not saying that *today* is a good time to buy BRK (or any other stock), am just outlining the strategy.
- You've "saved" nearly 50% of the stock price by buying the call
- What can you do with this near 50% savings?
- Many things: you can stash it in t-bills to be ready to snatch up stocks during a downturn, you can buy other investments to diversify,
OR:
- You can use some of the savings to buy ATM puts on the underlying to hedge. A worked example using real world numbers from this morning for BRK is in the following post.
- Buy long dated ATM puts, but roll them frequently for three reasons:
(1) To minimize time decay: if roll ATM puts about 1/3 way into the put's lifetime then it might lose about 20% value due to time decay (exact numbers depends on details, but generally you don't lose too much to time decay at 1/3 of the way into an option's lifetime)
(2) The investing thesis is that the stock will rise. If it rises, then the stock price can 'run away' from the put strike. But rolling the puts early addresses this. Rolling early also addresses time decay. so roll the long dated puts early.
(3) Typically, buying longer dated puts costs less *per day* than buying shorter dates puts. This is folklore and not a law (I've seen periods when it isn't true), so check both long dated and short dated puts at the time you plan to buy.
- The strategy doesn't have to use ATM puts, I picked ATM as the extreme case for a hedge (see real world numbers in next post). There's plenty of 'savings' left over even after buying ATM puts to hedge.
- "You need to buy 2x as many puts as the number of notional shares in order to hedge, because you have nearly 2x leverage in the 50% DITM call."
Not so: if you buy an ATM put and the price falls, then the intrinsic value of the put will rise dollar for dollar with the stock price fall. This offsets the dollar for dollar change in the value of the DITM call. Also, vol typically rises in a price fall, which further increases the put's value.

Pros:
- "You control the underlying with excellent put protection", ted thedog said hopefully.
Btw, you've still got leverage i.e significant 'savings' too, see next post for worked numbers.
So you're both hedged and have significant leverage or extra cash.


Cons:
- You give up any dividends (there aren't any on BRK, but other stocks or funds can have dividends. But it's not like dividends are 'free money' that you're missing out on, they deplete the coffers of the company.)
- If the stock price drops at the time you're ready to roll the puts and vol spikes, then the new puts will be expensive due to the vol increase.
But by the same token, the puts that you're holding/selling will also get more expensive (to the buyer) because you're rolling them considerably before time decay really hits, and they'll also be ITM, and vol will typically have risen, therefore, there'll be some offset of costs.
- Transaction costs enter due to somehwat frequent rolling of puts. But this shouldn't be much on a relative basis.
- It's not very tax efficient as outlined. Which may or may not be an issue, but a lot of U.S. people can do it in an IRA where it's a zero issue.
- It's more work. But you get canolli.

What's the catch?

What's the catch?

Comments on the assumption that you use the freed-up cash to buy T-bills: this is not a great idea, other than optionality (which isn't nothing).. You'll be paying more on the implied interest rate of the calls than you'll be making on the T-bills.

Comments on the assumption that you use all your funds for this, rather than just some: a problem if it is very expensive when it comes time to roll, which happens sometimes. You need to be prepared for the notion t hat a roll might consume quite a lot of cash, giving your thesis time to work out.

On the general long approach:

The leverage giveth, and the leverage taketh away.

During stretches that the stock does badly, your market-value portfolio balance will sink like a rock. This bothers some people.
During stretches that the stock is flat, you lose money. Slowly, but you lose.

When it comes time to roll your calls, there may not be suitable new options available to replace the ones you own. The implied interest rate might be prohibitive, or long-dated alternatives may not be available, or they might be banned. This is OK if the stock price is good at the time, but not good if the stock price is poor.

Your choice of underlying security might be poor. Sometimes the thing that looks safest can turn around and bite you. As a random example, GE was the sure thing in the late 20th century. Pennsylvania Railroad in the early 20th--there is a very famous huge trust that went bust that way.

Jim

The investing thesis is that the stock will rise.

Mhmm, as I made and still make money from buying and selling Berkshire puts, and expect at the current level to continue to do so, I rather think the anti-thesis is valid currently and until the price is clearly lower => think this is the worst of times for this thesis.

Just Btw, on another note: I know nobody here believes me, but the easily observable facts clearly did and still do support what I so often said this year: Berkshire since quite a while (most of the year actually) moves opposite to the general market. Using the "market momentum" trend upwards to forecast the trend of Berkshire in my book hold as little water as it did in 1999.

Sorry for the delayed response

Comments on the assumption that you use the freed-up cash to buy T-bills: this is not a great idea, other than optionality (which isn't nothing).
As mentioned, you could do many things, including diversify etc. T-bill was one possibility.
Am curious - what do you do?

the assumption that you use all your funds for this, rather than just some
That assumption wasn't made.

As for possibly being expensive at time of roll:
The strategy mitigates this by buying long dated puts and rolling way before time decay sets in. If vol is up at time of roll then new puts will certainly be more expensive, but your existing puts will also be more valuable. You can't eliminate time decay, but you can mitigate it such that the existing puts have considerable value at roll time if the new puts happen to be expensive at roll time.

During stretches that the stock does badly, your market-value portfolio balance will sink like a rock.
Not sure I see a rock sinking, the proposal is to buy put protection with part of the 'savings' from using a DITM call (as opposed to being being strictly long stock.) You could do many things with that 'savings', the proposal is to buy good put protection with some of it.
I gave some real numbers in the following post using data as of yesterday. I can't say for sure what would happen in future, but the strategy is set up (i think) to mitigate future nastiness.


When it comes time to roll your calls, there may not be suitable new options available to replace the ones you own ...snip
Agreed, but that's always an assumed risk when doing something like this. It's good to state it however.

As for possibly being expensive at time of roll:
The strategy mitigates this by buying long dated puts and rolling way before time decay sets in. ...


FWIW, that's not the risk that I was contemplating.

There are options available now. They might not be in future. For reasons unknown, the implied interest rate might be 40%/year two years from now, due to some strange capital charge on those who are short them or some other thing we don't foresee. Who knows? Or equivalent options may not be available for any price. Derivatives come and go. (speaking of someone who used to use single stock futures).

The risk is this: you can't safely enter a position whose safety may rely on the future existence of a security that may or may not exist being available at a reasonable price. I have done it, but I'm consciously aware of the risk that I'm taking. It is very much like taking out a loan for two years when you really need one for five or six, assuming that you can always get another two year loan when the time comes. But maybe you can't. You may choose to borrow for only two years, which is fine, but one should be aware that there is a risk being taken.

Leverage is safe only when it is uncallable (check), decently priced (adequate at the moment), and lasts as long as you need it. It's that last one that you have to watch out for.

Jim

Ah, all good points of course.
I guess I've inculcated these points from your previous posts (and btw, I've made significant money from your strategy, so thank you!), but it's good to make all the risks very explicit.

What intrigued me about this strategy is the perverse notion of essentially using leverage (the 50% DITM call) to buy protection.

If things don't go wonky (your points above), then you're effectively long, have ATM-ish put protection, and have money left over to boot (at least using numbers from the other day).

Again, I'm not suggesting that anyone do this now, the point of the post is simply to sketch out the general strategy.

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