Structured Products Allow Investors to Copy Buffett’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 (http://www.cboeoptionshub.com/2013/11/26/buffett-put-trade/) 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 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.

‘More and more investors are starting to see what Buffet saw many years ago’

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.