Buffet's Annual Letter

It's must-read for every investor, and something to look forward to every February.  Buffet once again addressed the put options that he sold on a major US index that expire within 3.5 to 9.5 years.  From the sale of these puts Berkshire has acquired $6.3 billion worth of "derivatives float" as Buffet calls it.  I would call it $6.3 billion worth of options premium.  Many have criticized Buffet for getting involved in these derivatives contracts, but I think depending on the strikes these European options Buffet sold will likely expire worthless.

The way Buffet looks at his short long-dated puts are similar to the way that I look at mine.  Although mine are expiring within a year, I see them as a great way to sell stock insurance on the price of companies I wouldn't mind owning at the strike price minus option premium received.  For my short AAPL puts I would own AAPL at prices of between 160 and 173.  Meanwhile, while I wait for these strike dates I can use my cash balance to take other equity positions I like.  On this topic Buffet says: 

• Only a handful of our contracts require us to post collateral under any circumstances. At last year’s low point in the stock and credit markets, our posting requirement was $1.7 billion, a small fraction of the derivatives-related float we held. When we do post collateral, let me add, the securities we put up continue to earn money for our account.

Good Weekend Reading

I enjoyed reading Keith McCullough's Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.  He takes you on an insider's story along his short career starting as an analyst during the tech bubble and bust, followed by his quick ascension up the hedge fund managing ranks (aka $ managed).  Most of all I enjoyed Keith's conclusion about where the industry is headed - more transparency.

I know old money likes the idea of having all their money taken care of in a far away place and they don't have to think about it, a quarterly letter from their fund saying the money's still there is enough.  However, I think that when my friends grow up to have money that won't be enough.  When you get updates from 500 people you barely know every time you log into Facebook, an update on what your money's doing seems a lot more relevant and hardly too much to ask.

Keith also takes pride in the fact that he never uses leverage, which I think is great considering he's using other people's money.  Of course, you do need a margin account to short stocks - but I assume he means he's never buying on margin or trading options.  I feel fine using leverage with my own money, but it is a choice I'll have to face if I ever managed other people's money.

I'd say the most interesting part of the short novel is after he's fired from his position at Carlyle Blue Wave Partners for being a couple months early in shorting the market in 2008.  After that he's done with the secretive hedge fund world and decides to open up his own independent research firm, open to all institutions and individual investors with a subscription.  I checked out the site, hedgeye.com and enjoyed listening to yesterday's morning call that they have up on their site for free.  The intensity with which this guy follows the markets really comes through on the call.

-- The book was a quick read and I read the entire thing on my iPod Touch in an afternoon after buying it through the Kindle app.  The experience of reading it off the iPod wasn't as bad as one might think.  Nice to get a book instantly rather than waiting three days, and makes me believe in the whole e-reader movement.

The other read was Warren Buffet's annual letter (pdf) that came out today.  I'll try and put up my take on that tomorrow.

Sold Out of Berkshire Hathaway

So, my limit sell order that I put on Friday went through today at $79.88.  That along with the chart above makes me feel like I actually know what I'm doing.  I'm still just picking up pennies in front of the steamroller though.  Looks like I saw the steamroller coming today as lots of sell orders came in after it hit $80 - see the big spike in volume around 1:30pm when it briefly tested above $80.  I don't normally analyze intraday charts this closely, but I do like the feeling of selling right at the high.

We'll see if this becomes a 1 or 2-month high, as I'm more of a monthly holding period trader.  Looks there is still some index buying going on, but after that subsides I think a lot of people will sell-out.  Interestingly enough, with all the action going on in Berkshire with money following the index move, option premium prices seem low to me.  If I were more adventurous I would try an option straddle a couple months out.

I will wait and see how high Berkshire ends up going before a major pullback.  Then I will look at selling a put to get back in - but the premiums are pretty low.  I think people are expecting more of Berkshire's traditional (pre-split) volatility and beta, and are viewing the volatility we have seen as a symptom of the index rebalancing.  However, I think what we are seeing is more of what to expect as Berkshire is becoming a popular trading vehicle.

Getting Back, Going to View this Less as a Blog and more as a Trading Journal

The more I think about it the more important I think it is to keep a trading journal. I'm going to be posting my trades here for my sake once again. I think making it public helps keep me honest, and forces me to have a fully rationalized trade plan. It'll make sure I don't cut corners on the journal entries.

Just to recap, my 2009 performance came in at 100%, well 99.8%, but I'll round that up. Handily beating my after-tax goal of 25% a year.

The only big plays I've done since posting was selling an M&T Bank (MTB) short January 2011 put at a strike of 65 for $15. At the time MTB was trading at around 66 - can't remember exactly because I didn't write it down. I closed out of that position on 2/4/2010, buying back the put for $8.50 to reduce risk exposure when the market pulled back a couple weeks ago.

I also sold a Chipotle (CMG) February 2010 put short at a strike of 90 for $4.50. This was done with Chipotle trading around 88, as a potential way to buy into Chipotle. However, on a big analyst upgrade CMG shot up a few days later above 95. After a good earnings report Chipotle has reached $105, and my short put has expired worthless. I don't mind missing this move, as I already captured about 1/3 of it with my option play. I am looking to sell another short-dated put on CMG at either a 90 or 95 strike on any significant pullback - looking for a pullback around $100.

Although much of my gains from 2009 came from option plays with Apple. So far, in 2010 I have yet to learn from my failed option moves of AAPL in 2009. I got really bullish about AAPL around the January 25th conference call, where I correctly expected them to finally change their GAAP iPhone accounting. Apparently, this was already priced in - wish someone had told me because I got long two 220 February calls for $5.50 each when AAPL was trading around $210. I ended up closing them out for $1.50 each - a total loss of $800. My biggest lose from a single trade yet. I have decided that I am not an option buyer, I am an option seller.

I think it's easier to make mistakes on the buy side of options as theta hurts you, and harder to make mistakes on the sell side as theta helps you.

I have sold a $220 January 2011 AAPL put for $50, now trading at $36.8. I am also staying short a $220 July 2010 AAPL put I sold for $27.67 and its sitting right where I sold it. I added the $220 July short put when I was really bullish in January. I am proud to say I stomached the pullback to $188, when my stomach wanted to take a loss on the July put. 'Just wait til July, just wait til July' got me through it though - a mantra that doesn't work for me on the long side of options.

Finally, back in December I bought a share of BRK.B for $3,365. I thought Berkshire was undervalued as it was, underperforming during the rally from July onward. Once, I heard about the stock-split for the BNI deal, I couldn't resist owning a share of such a great company for its historic first stock split. I also thought the S&P 500 addition rumors had some validity to them, and it turns out I was right. After the split I owned 50 BRK.B's at a cost basis of $67.30. BRK.B closed Friday at $78.73 - when I first bought in I thought a sell price target of $4,000 was good. And I think I'll stick to this, I have a limit sell order on at $79.88 - gotta front run all the sellers at $80 a little bit.

I think Berkshire is such a great company I wouldn't mind keeping it as a buy and hold component of my portfolio long-term, but given such great gains on such a short time-span I must take them. I will look to re-enter at a lower price through short-dated put sales (awesome that you can trade options on BRK.B now, kinda hard to afford 100 shares at 3.5K).

Overall, up 2.9% YTD - not bad considering the blunder with AAPL calls.

Alright, that's quite the post - lots to write down when you don't do it for months. Feel like I've been reading Philip Davis too much and I'm picking up his writing style, haha.