Warren Buffett grounded the airlines this weekend. Berkshire Hathaway (BRK.B) held their annual meeting this weekend, one of the few, if not only, annual meeting that actually has an impact on individual stocks outside of the company hosting the meeting. In fact, it has an impact on the entire market. When Buffett disclosed that Berkshire sold its entire stake in the airline sector, investors took notice. Monday, we find most domestic carriers down 7% to 10% on the news. Buffett called into question the longer-term viability at these valuations as I see it. The news didn't translate well for Boeing (BA) or Airbus (EADSF) either.
One question I found particularly interesting revolved around the equity puts Berkshire Hathaway sold years ago during the financial crisis. The interesting part isn't whether the trades wound up winners or not (they have so far), but in their structure.
Berkshire sold European style equity puts rather than American style. For many traders, they aren't familiar with European style expiration. Some may have traded them via VIX options and not even realized it before. Unlike American options, European style options cannot be exercised prior to the expiration date. That doesn't mean they can't be sold, however, the ability to exercise an option early has an impact on the price movement of the option.
When I look back, this approach made a ton of sense for Berkshire during such a volatile and risky period in equities. Why? Because of stability. If the puts were sold "early", before the market bottomed, there was a good chance the puts would weather the storm without causing a big drawdown on paper. The reason is the lack of early exercise.
Think of it like weather. I live in Austin, Texas. The average weather for us on the Fourth of July sits in the low to mid 90s. Would you be willing to bet five years from now the weather will be under 85 degrees because we have a 78 degree Fourth of July this year? And if next year comes in at 82 degrees, will you change your view of the future? Probably not. And you probably wouldn't pay a whole lot more to make that bet in the second year since seasonality is still against you.
Or consider VIX options. There's a reason December VIX calls didn't skyrocket in price when the VIX skyrocketed in March. Without the ability to exercise early and capture the intrinsic value of an option, the value/premium isn't the same. The VIX fights a constant reversion to the mean, so when we spike to 50 or 60 in March, history tells us repeatedly that we're going lower in the next few months. We're going to revert to the mean or recent moving averages that are longer than 10 or 20 days.
Equity indexes have a long-term bias to the upside. It's difficult to find 10-year and 15-year periods that are negative in terms of returns. Sure, there are periods which are flat and there are periods of drawdowns during those 10 and 15 year periods, but history sides with the bulls over a long enough time period on indexes.
Additionally, indexes are built with survivorship bias. A company gets weak, price falls, it gets booted from the index and replaced with something stronger. We know this. The bias is higher.
That's why when an index falls, even drastically, during the first or second year of a 15-year time period, the European style short put isn't likely to rise much in value. There's no early exercise provision. There's still a ton of time. And bias is working in favor of the short-put holder.
For Buffett and Berkshire, it was a great way to psychologically show support for the market while also not having to worry about a big drawdown on paper in the following 12 to 24 months after the puts were sold. If the market had fallen, Berkshire would have been able to show they managed risk well. If markets rose, Berkshire has enough exposure through businesses to do well. The short puts might show a small gain, but that wouldn't matter because operating businesses would have taken the lead.
Unfortunately, most folks don't have a 15-year time frame to sell puts. Heck, most folks don't have the patience for a 15-month investment these days. But when I look back on the strategy used, I realize how underappreciated the approach was given the events of the market at that time. If we had continued to cascade lower, Berkshire likely could have taken a loss quickly and one rather well contained since it utilized European style put options rather than American style options.