Playing With Fire: Trading Put Options With Warren Buffett - Conclusion

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The Trade: Naked Put Sales

With all of those parameters in place, this is how we would attempt to duplicate Buffettís options positions:

    * Sell the SPY December 2010 105 puts for $9.30 per contract
    * Sell the EFA January 2010 60 puts for $5.00 per contract
    * Sell the EEM January 2010 100 puts for $11.50 per contract

Position sizing matters here: if you want to even out your exposure,youíll clearly need to sell about twice as many EFA contracts as you doin the other underlying issues. Weíve selected strike prices that arecurrently a couple strikes out of the money, because we will have toroll these positions forward so we want to price in a little bit ofdownside into the trades. As for the adjustments themselves, when andhow to roll these contracts forward will depend somewhat on how severethe U.S. recession gets.

There are some important disadvantages to actually entering thesepositions. For one, youíre tying up quite a lot of capital for quite along time, and because so much of the value of these contracts is timevalue (not intrinsic value), any major moves in your favor in theunderlying indexes wonít translate into quick gains. Additionally,although thereís technically a limit on any potential losses (a stockcanít drop any lower than zero), for practical purposes these areunhedged positions, which will not only expose you to more risk, butwill tie up more margin than would a hedged trade.

Conclusion

One purpose of this little exercise is to show how difficult it is toduplicate the moves of institutional investors on a retail level. Butthat disconnect need not be seen as a negative thing: retail tradersactually have far more flexibility and can use that advantage to avoidmany of the risks that large institutions must face, such ascounterparty risk. In fact, several of the features of Berkshireísposition may simply be ramifications of the size and relativeinflexibility of their situation: it is much harder to deploy fourbillion dollars than it is to deploy four hundred thousand.

To take advantage of their flexibility and reduce risk, ordinarytraders can sell put spreads instead of just naked puts, they can sellboth put spreads and call spreads in order to establish moremarket-neutral positions, and they can sell spreads on a quarterly oreven monthly basis in order to profit from smaller time increments andsmaller market moves.

In fact, given the variety of strategies and tools that are availableto individual options traders, perhaps we shouldnít fret at all aboutbeing unable to duplicate Berkshireís positions. Instead, we might say(with tongue in cheek) that while Warren Buffett may have come aroundon the question of using derivatives to generate income, he canít hopeto duplicate the positions of any informed individual options trader.

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