(KMI) Mispriced long-term options – Glenn Chan's Random Notes on Investing

Founded in by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. Last Friday, Berkshire Hathaway NYSE: BRK-B CEO Warren Buffett released his annual letter to shareholders.

How to Trade Mispriced Options Contracts

Filled with his usual colorful comments on a wide variety of investing topicsthe missive will be the topic of conversation among millions of investors in the days and weeks ahead. One area that Buffett touched on in his letter involved a set of investments that relatively few investors use in their portfolios: Buffett has used them to boost Berkshire's profits, and in his letter, he discusses his belief that they will produce even greater profits in the future.

By doing so, Buffett calls into question whether the entire market for these investments may be mispriced -- creating opportunities for smart long-term investors. Let's take a closer look at Buffett's argument and then reveal some investing ideas to take advantage of it. The big bull-market bet From toBerkshire took on massive amounts of exposure in the options market, selling put options on major stock market benchmarks covering the U.

In essence, by selling put options, Berkshire was merely extending its traditional insurance business to provide stock-market-related protection for its counterparties.

During the market meltdown of and earlythose put options looked like a terrible move. But the current intrinsic value on those options has now dropped below the premiums Berkshire received, thanks to the big bull market over the past four years. Is long-term option pricing flawed? An excellent blog post from Brendan Conway of Barron's Friday afternoon reminded Berkshire investors of the history behind these "Buffett puts.

The root of the problem lies in volatility assumptions made under the commonly used Black-Scholes formula. From day to day or year to year, stocks can move abruptly, and those volatility assumptions tend to get baked into options prices. But over longer periods of time, stock market returns have been smoother, and so Black-Scholes values options more highly than is appropriate -- making them better to sell than to buy, especially with puts if you expect the upward trend of the market to continue.

Buffett's behavior indicates a different view toward long-term options on the buy side. In providing financing to major corporations like Goldman Sachs and General ElectricBuffett has usually used options-like warrants to give Berkshire a long-term equity kicker on his investment.

Warren Buffett Looks At Mispricing Long Term Options

American binary options mobilized as nadex launches ipad app willingness to hold on to those warrants strongly suggests his belief that if volatility on the downside is overestimated, upside volatility gets underestimated -- making long-term call options scarface money makes the world go round mp3 download better buy for investors.

Can you take advantage? Unfortunately, the deals that Buffett has made typically aren't available to investors. Publically available long-term options usually run only a couple of years into the future, which isn't long enough to allow for the market to run an entire mispricing in the options market cycle and for reversion to the mean to occur.

But one area where long-term options are available is in financial stocks. Thanks to the TARP bailoutssignal trading stock forex hari ini to six-year warrants are available on several popularly traded stocks banks and financial institutions.

For Hartford Financial NYSE: HIG and Capital Onethe warrants are already in the money, meaning that the current share price exceeds the exercise price of the warrant and limits the impact of volatility-estimate errors on the warrant price. On the other hand, Citigroup NYSE: C and Bank of America NYSE: BAC have warrants with strike prices well above current market values for the shares.

With all of their value coming from the time value that volatility estimates generate, warrants on these shares are most susceptible to the mispricing that Buffett discusses. Take a look Warrants and options are specialized investments and carry substantial risk. But even so, questions about proper long-term pricing raise the possibility that you can use options to your advantage, making them worth a closer look.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

You can follow him on Twitter DanCaplinger. The Motley Fool recommends Berkshire Hathaway and Goldman Sachs. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, Citigroup, and General Electric.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Dan Caplinger has been a contract writer for the Motley Fool since As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.

With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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