No. of Recommendations: 4
hromay
If it gets executed you are buying BRK/B @ 457.6 and if it not gets executed you are getting a 2.5% on less than 2 month.
Not a bad strategy ! Am I missing something ?
Its a good strategy, but it might be fun to be aware of its limitations.
The black-scholes model assumes that the "expected" future price of BRK rises by the risk-free rate of interest, about 5%, but that it fluctuates around in a log-normal distribution with a volatility that rises with the sqrt of time. If this were true, then the you would have about a 53% chance that your option expires worthless, but if it expires in the money, its expected value in the money would be about $26. So the expected value of the put option you sold is right around the $12.40 you got paid for it. So on average, you would make nothing shorting these puts at $12.40.
But history shows us the average rate at which BRK stock price rises is more like 10%/year than 5%/year. If we look at what happens to your option in 2 months with an expected 10%/year rise in BRKB stock, the probability that your option expires worthless rises to ~57%, and the expected value of the option at expiry is ~$10.60. So if THIS model of BRKB stock price is correct, that it has a drift upwards of 10%/year plus its log-normal noisy variations, and you could keep selling options at $12.40 that on average only cost you $10.60 to buy back at expiry, then you are making $1.80 every 2 months! Of course that is much less than the $12.40 you counted on to esimtate your "2.5% in 2 months" return. Yes, you will make that 2.5% on about 57 out of 100 times you sell those puts, but you will lose, on average, about $25 bucks on the 43 times out of 100 that your puts expired ITM.
So the thing you are missing is you don't estimate how much you will take home net by just looking at the most you can possibly take home if the outcome is as good as it can possibly be for you. Especially if that is predicted to happen not very much more than 1/2 the time.
Of course the other thing you are missing is that as BRKB becomes more overpriced, the "drift rate" drops below 10%/year and if BRKB is sufficiently overpriced it can easily drop low enough that instead of expecting $1.80 average earnings per turn, you have an expected loss of a buck or two per turn. This is why people like mungofitch studied, how do we tell when BRKB is likely to go up at its trend rate or faster, vs when it is likely to go up slower than its trend rate. He knew to make money on options, the counterparties to his deals had to be underestimating the rate at which the stock is going up.
So yup, you'll make money on your trade if BRKB price is neither too high nor too low, because when BRKB's price is in the middle, it is rising at 10%/year, not the 5%/year that the market makers figure in pricing options. But you'll be making more like .5% every 2 months (assuming you are using fully cash covered options as your benchmark) than 2.5% every 2 months like you said.
Enjoy!
PS, you don't have to know how to do math to get all these numbers. I got them all just asking google search which has an AI behind it know to estimate the prices of your options under the various assumptions, and also estimate the likelihood your options expire ITM etc. YMMV.
