To The Moon

"If there comes a day when even the stock god Buffett faces a massive loss, the market might truly be in a tough spot!“

Unfortunately, that day has arrived. Just recently, in the third-quarter financial report disclosed by Berkshire Hathaway, Warren Buffett's conglomerate, it was revealed that the company incurred a net loss of $12.77 billion (approximately ¥932 billion) in the third quarter of 2023. This marks the first quarterly loss for the company this year, following a net profit of $35.91 billion in the second quarter. Additionally, investment losses in the third quarter amounted to $24.1 billion (approximately ¥175.9 billion).

It is reported that a major factor contributing to Buffett's portfolio losses is the substantial holding in Apple Inc., whose stock price experienced a decline of 11.61% overall in the third quarter.

However, when Buffett famously bottom-fished Coca-Cola using a 'Sell Put' strategy, he achieved legendary success. Considering this, if he had employed an options strategy to hedge risk during this period of Apple stock decline, what would have been the outcome for the third quarter?

To simulate the results of an options strategy, let's first examine what kind of options strategy Buffett should have employed in this scenario."

"What strategy should Buffett use when the stock price falls?

For Buffett's long positions, there are generally two applicable options strategies: Protective Put and Covered Call.

Let's start with the Protective Put. Essentially, it involves buying a put option on top of holding the stock. Since the greatest risk for long stock positions is a decline in stock price, the most suitable strategy for hedging this risk using options is the Protective Put. We discussed this strategy in detail in a previous article on options strategies - "Option Strategies Every Stock Investor Must Know." In the event of a stock price drop, the profits from the purchased put option can help offset the losses from the declining stock price.

Of course, some may be concerned about potential losses if the stock price rises instead of falling. The answer is no—the loss from buying a put option is limited to the premium paid. If the stock price rises, the future gains will be the difference between the profit from the rising stock price and the premium paid for the put option, resulting in a net profit in practical terms.

Next is the Covered Call strategy. In this strategy, one sells a call option on stocks already owned to receive the premium, thereby increasing the overall portfolio income. When the stock price falls, the full amount of the premium from the call option can be obtained. While it may not completely offset the losses from the falling stock price, selecting an appropriate strike price for the call option can enhance overall portfolio income regardless of market direction.

Now, let's backtest the impact of these two strategies on Buffett's portfolio returns.

If Buffett had employed options, what would have been the outcome?

Taking the Protective Put strategy as an example, which involves buying a put option on top of holding the stock.

Let's assume that the overall loss from Apple in the third quarter for Buffett's portfolio was 11%. Based on the current stock price, this would mean a drop from around $187 to approximately $164 after three months. The quoted price for an at-the-money put option expiring on February 16, three months later, is $7.75, with a delta coefficient of -0.505. This implies that approximately two put option contracts per Apple share would be needed for hedging purposes (1/0.505≈2)."

"We consider one share of Apple stock and two put option contracts as one unit of combination. The profit and loss scenario for this combination is as follows:

If, after three months, Apple's stock price drops to $164, the profit from the two put options would be (190 - 164 - 7.75) * 2 = $36.5. This profit offsets the $23 loss from the stock price drop, resulting in a net profit of $13.5 for the unit combination.

It's important to note that the only risk for this combination is if the stock price rises after three months. In such a case, the unit combination could incur a loss. The worst-case scenario is if the stock price rises to $190. At this point, the loss from the premium of the two put option contracts would be $7.75 * 2 = $15.5, offsetting the $3 profit from the stock price increase. The net loss for the combination would be $12.5. However, the maximum profit is theoretically unlimited. When the stock price rises to $202.5, the combination breaks even, and above $202.5, the combination realizes a net profit. Therefore, $12.5 can be considered as the insurance cost for Buffett's stock holding.

If the covered call strategy is employed, meaning selling a call option on top of holding the stock, what would be the effect?

Firstly, there is the issue of the strike price for the sold call option. If we choose a call option with a strike price of $205 expiring on February 16, as before, each contract generates a premium income of $2, with a delta coefficient of 0.216. Each unit combination is composed of one share of stock and five call option contracts."

"If, after three months, Apple's stock price drops to $164, the five call option contracts generate a premium income of $10, offsetting the $23 loss from the stock. The final net loss for the combination is $13. In this scenario, Buffett would only need to endure a loss of around 5%.

If, after three months, the stock price rises, as long as the final stock price is below the strike price of $205, the call option contracts can add $10 in profit to the entire combination. However, if the price rises above $205, the losses from the call option contracts might exceed the gains from the stock, so the strategy requires dynamic adjustments, such as reducing the number of contracts or closing positions midway.

In summary, implementing option strategies can effectively hedge portfolio risks and increase returns. It's essential to thoroughly study the secrets of options. If you find this article helpful, feel free to share and comment. There are rewards in the comments section!"