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Jim repeatedly said options move strongly when their strike price is reached. Really? I am a bit sceptical because of my current experience: In March I bought lots of BRK out of the money puts (Sep+Jan ones, strike 395/400/405/410). Last week with BRK around $405-410 I sold the $400's for $13.50. With BRK/B now at exactly their strike of $400 I expected the price of those puts to be a lot higher. But no. While Bid/Ask is $13.5/15.5 the last actual transaction was done for a mere $12.15 = instead of higher a lot lower.

???

While Bid/Ask is $13.5/15.5 the last actual transaction was done for a mere $12.15 = instead of higher a lot lower.

It's a good rule of thumb always to ignore the last trade price of any option. It is usually anywhere from hours to days old and gives no current information. Look at the midpoint of the bid/ask instead. In this case, the "price" of the option was $14.50. You'd probably pay 50 cents more if buying and get 50 cents less if selling, but the midpoint of the current national best bid and best offer (NBBO) is the "official" price when brokers are doing statements at end of day, for example.


Jim repeatedly said options move strongly when their strike price is reached.

To break it down more...

The time value of the option price is at its highest when the stock price is at the strike price. The time value alone is a type of bell curve shape.
The total option price is the sum of the time value (that bell curve) plus the in-the-money or intrinsic value, which is a wedge which hits zero at the strike price.

The price of the option doesn't move most quickly when the stock price is at the strike. The amount (in dollar terms, not percent terms) that an option price moves with each $1 move in the underlying stock price is called its "delta". This is actually highest for a deep in the money option, when it approaches 1. The option price becomes asymptotic to its in-the-money value.

It sounds like you are looking at the variation in the percentage price change in the price of an option, not the usual way to think of it. Viewed that way, yes, an out-of-the-money call option will start to rise in price more quickly as the stock price rises up through the strike, because the price move suddenly starts to include intrinsic value (which moves $1 for each $1 rise in the stock price), not just the slowly changing time value which was its only value when it was out of the money. Honestly I'm not sure what the exact function is, but I think it's close to this: "for each unit rise in the price of the underlying, an out-of-the-money call option rises in percentage terms a relatively constant amount, but as it goes into and further into the money, for each unit price rise of the underlying the call option rises as smaller and smaller percentage amount, the percentage falling only slowly".

For puts, just reverse everything : )
Plus the little "extra" when you remember that puts are much more in demand on panicky market days, so their prices are often momentarily higher. Like a hard insurance market.

This all ignores the variation caused by the falling amount of time till the option expires.

Jim

Seems to be the question is, WHY would you do covered writes on illiquid brkb vs very liquid SPY , in size ? The correct comparison should be an spy covered write strategy vs a brkb covered write strategy.

Seems to be the question is, WHY would you do covered writes on illiquid brkb vs very liquid SPY , in size ? The correct comparison should be an spy covered write strategy vs a brkb covered write strategy.

I don't have the numbers in front of me at the moment, but...
When I calculate what Jim calls "the implied interest rate", it is generally lower for a BRK call than the similar SPY call.
That's why BRK over SPY.

Also, you can pick your spots better with BRK than SPY. Price/book low means the odds are in your favor, price/book high means the odds are against you. I don't think there is an equivalent easy to see thing for SPY.

Also, in these deep ITM long dated call options the liquidity doesn't really matter. The counterparty is not other investors. The counterparty is a computer running an algorithm.
You run the numbers to decide which stike & date you want, then look at the bid&ask numbers to decide what to offer. If that doesn't meet your acceptance criteria you don't even place the trade. If your offer is close enough to the ask, you will get an immediate fill.

(Jim has said that you can usually get a fill at 3/4 inside the spread.)

There is very little action on these calls. There have been many times when my trade of 1-4 calls has been the ONLY trade for many months. There have been many times when my trade was the very first time that particular option has ever traded. Liquidity doesn't come into play.

Of course, I could be all wet here.

Seems to be the question is, WHY would you do covered writes on illiquid brkb vs very liquid SPY , in size ? The correct comparison should be an spy covered write strategy vs a brkb covered write strategy.

So, so many reasons.

I haven't seen any problem with liquidity on Berkshire B options, so there's no need to switch. The bid/ask of one of my calls is around 0.07% of the stock price, and the trading friction each way is about 1/4 of that. The SPY bid/ask is tighter on the equivalent OTM SPY call, but the execution friction cost is not a meaningful difference in the grand scheme of things: about 0.01% of strike.

I have a pretty good idea of what Berkshire is worth, and how the market will value it on average in the next couple of years. Not a perfect idea, but the "very probable" range is relatively small. The secret to writing calls is to do it only when the underlying is richly valued. That requires having good metrics of its value, and a good handle on its likely valuation multiples by the market now and in the near future. The returns from SPY will be relatively poor in the next 5-10 years, but beyond that there's little one can say with confidence about how it will get valued. The price might do anything, for a remarkably long time.

For me, writing a call is just an answer to the question: given that the underlying is getting richly valued at the moment, would you be willing to sell it at a price X% higher in the next couple/few months? Either you get that nice exit price or you get a nice little cash return. I'm fine with either. For example, I wrote some September $415 calls for a premium over $25, which if exercised give me a net exit price of just over $440 per B share. I don't foresee any poor outcomes from that, as I figure the most likely market price range at expiry is under $400. If the stock gets called away, I think it extremely likely I could repurchase it some time at a price materially lower than $440.

But most of all, I can't do a covered call strategy with SPY because I don't own SPY, and won't. I wouldn't own a broad cap-weight US market tracker if you paid me. The poor return outlook from the low earnings yield is just one of the reasons.

Jim

When I calculate what Jim calls "the implied interest rate", it is generally lower for a BRK call than the similar SPY call.
That's why BRK over SPY.

This is true, but it's actually a reason that the income from writing calls against Brk isn't very high, making SPY the better choice on that one test. To maximize rate of return from premiums, you'd want something with rich premiums, normally something with a volatile stock price.

But as both of us mentioned, that's not the overriding criterion. Most of all, you want an idea of which way the price is most likely to move. Berkshire's price is not that hard to predict: extrapolate the likely growth trajectory of observable value, slap on a typical multiple for the end date, and the error bars are usefully small.

Conversely, despite many years of analysis in the area, I don't have a clue what the S&P might be at a year from now. The mean reversion is just way too weak, and the observed extremes just too far apart. It's like an ant wandering around somewhere in the middle of Madagascar. You know his range is ultimately bounded, sure, but you have no idea at all whether his next move will be a mile north or a mile south.

Jim

As I just sold some more of the Berkshire puts I bought last month: I am curious. Are there others who bought puts?

All

I am thinking of buying some BRK.B, by selling puts. Today BRK is selling for 402.66. May be sell monthly put? There could be two events for BRK price, that could be higher or lower. Its earnings and Fed. Can someone suggest some strategy?

Thank You

Paul

I am thinking of buying some BRK.B, by selling puts. Today BRK is selling for 402.66. May be sell monthly put? There could be two events for BRK price, that could be higher or lower. Its earnings and Fed. Can someone suggest some strategy?

Using options to react to news opportunistically is an extremely difficult game to play. I devoted a whole chapter to news in Manlobbi's Descent. There is, as a rule of thumb, excessive attention upon news because we are attracted to novelty and seek causation (even when there is none), and invent catalysts - so trying to guess the market is best avoided. There are many other participants trying to guess both the news, and the effect of news, and the reaction to the effect of the news, and so on, all in the same way, and this tends to not only neutralise the effect of the news but owing to temporary trades being reversed upon the news braking, often the trading is the diametric opposite to what you expect.

One the other hand, amongst the many hundreds of investors at Shrewd'm there are many, some having shared with me personally, to have made insane improvements to their returns with the use of options, opportunistically when the price is particularly low relative to book value, and then undoing this leverage when the price is no longer particularly inexpensive, such as now. This is part of the reason why mungofitch's - and other's - estimations of the price / value ratio are very treasured here.

This approach of leveraging an investment opportunity with above-average expected gain still requires the usual required (and extremely high degree of) investing patience; when you are betting on valuations to return to normal, you tend to have to wait in the vicinity of 2-9 years, which is beyond the patience of most investors. But over the long-term, adding leverage (either using options, or a non-callable - ie. mortgage - loan) to a safe investment trading whilst nears historic lows is perfectly sensible as far as I'm concerned.

- Manlobbi

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