DIY Investor Magazine
/
March 2016
39
STRUCTURED PRODUCTS ALLOW
INVESTORS TO COPY BUFFET’S SECRET TRADE
Warren Buffett has a secret, well not a secret, but a
not-well publicised investment strategy. Behind his
somewhat derisory comments about derivatives he
makes significant amounts of money from his own
derivative trades. He is a consistent, large scale seller
of put options.
For the rest of us, one of the best ways to do the same
thing is to buy structured products with capital at risk.
When investors buy these products they are selling
puts, and earning the premium from doing so. This is
the fundamental driver of many structured products
An article on CBOE Options Hub
shows that not only is Buffett selling puts, but that he
was selling options on multiple indices. Other reports
have suggested that these were worst-of European
puts.
As ever with the sage of Omaha he has identified a
market anomaly and capitalized on it. He has taken a
common sense approach to identify a situation where
the financial models that dominate markets create
curious pricing. The pricing makes sense for derivative
trades, but also means that for longer term investors
there is an easy and reliable source of additional
returns.
Here is how I think that this plays out:
•
Institutional investors that want to own more equities
than their balance sheet can support have to buy
short dated puts. They are buying puts because
they are bullish and want more equity, or because
they hold equity but are worried about the risk to
their balance sheet.
•
The only meaningful supply of volatility is retail
buyers of autocalls and other structured products.
These are investors selling medium dated puts
when they buy structured products with capital at
David Stuff
Chief Executive, Cube Investing
risk. Regulations, such as Solvency II, that cause
institutions to buy puts mean that they can’t sell
them.
This is where the Buffett trade comes in. He has
identified that the premium option market makers are
prepared to pay for long dated puts is a function of
volatility and the forward price (the Black Scholes price)
Right now because rates are so low the forward is low.
The recent volatility has caused short term volatility to
increase. So the absolute premium paid for medium
dated puts is very high.
Option traders hedge their exposure to markets and the
other variables in the books that they run. They know
that Black Scholes option pricing works for them. They
are mainly interested in the implied volatility, and know
that they can make money by actively managing the
exposure that they have. Option market makers have no
regard to economic fundamentals. The consequence
is that the premium paid for these options looks eye-
wateringly high to “investors”, but most of the big-boys
of the investment market are simply prevented from
taking advantage of this.
Globally it has been investors in structured products
that have benefited from the pricing of these puts.
Investors in medium dated structured products capture
the high premium when buying products with capital
at risk. It is this premium that fuels the annual return in
Autocalls, synthetic zero’s, reverse convertibles and
other products.
Our analysis shows that structured products have
delivered great results in the past. Our stress test
suggests that they will offer good results looking
forward particularly if markets drift sideways. More and
more investors are starting to see what Buffet saw many
years ago.
