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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214654  
Subject: Re: BRK Leaps: Date: 11/10/2012 8:16 AM
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Buying calls has a risk I am not sure is clear thus far in this thread:
Berkshire's stock price could be cut in half, along with the rest of
the market, and stay there past your expiration date, only to recover
fully and a whole lot more at some point down the line. Your call options: Worthless.


Nice post. But I wouldn't consider this specific point a big risk.
My $45 BRK call options will expire worthless? It could happen, but it seems unlikely in the extreme.
Even an ending price under $75 seems rather unlikely, though it's in the realm of possibility.

I buy call options with the intent of having the money (if need be) to exercise
them at expiry or another viable strategy to stay in the position till the price is acceptable.

Berkshire's price is below strike when the calls expire?
Then it's cheaper to buy the stock then it would have been to exercise, so do that.
You're better off having done this than buying the stock to begin with.

The price is so low that you still want the position, but not so
low that your calls are worthless? Exercise them, or roll them out
to approximately the same options expiring much later.
I'd generally roll out, but you can't know 100% for sure that appropriate
low-strike long dated options will still be listed when the time comes.
It's also possible that interest rates will be 20% and it will be unfeasible.
It's only because of these two rather rare risks that one has to have a
plan for coming up with the money to exercise them, just in case.
My central planning expectation for any call I buy is a four year hold:
LEAPS with two years to run, rolled forward once.

e.g., you might look at IBM Jan 2015 $140 calls at $61. Just before
expiration, you'll probably be able to roll them to Jan 2017 for a
premium of under $15 extra, so total cost probably under $76.
Breakeven is with IBM trading at $216 or better, not far from its price last month.
Barring another global financial crisis I think a central estimate of
the share price in 2017 would be $275 or more, a doubling of the cash
committed and at risk during the option-holding period.

The situation you mention is a serious concern for "gambling" out of the money or
at the money options, but not so much for "investment grade" deep in the money options
where the bulk of the cost is in-the-money value and the time value erosion is negligible.
They don't offer much leverage, but you don't want or need much—a tiny bit goes a long way.
I normally lean towards the deepest in the money, longest-dated call options I can find.

Leverage in investing is a good thing if and only if you meet five criteria:
- the underlying asset is sufficiently safe and sufficiently reliably not falling in value
- the price/value ratio is attractive enough at the time of entering the position to offer a good margin of safety
- the cost of the leverage is very low and will remain so
- the loan can't be called
- the loan is long term or guaranteed to be renewable in some way.

IMO buying deep in the money long dated call options on Berkshire now meets four and a
half of those five points, so it's almost a good enough idea to count as prudent investing.
The "renewability" is probable but not guaranteed, so either you have to
class it as speculation, or have a contingency plan for coming up with the money to exercise,
or be willing to sell at a low market price if that should happen.
Since the latter was the beginning assumption at the start of the thread,
it's quite likely an improvement over a willy-nilly regular liquidation plan
which is guaranteed to be selling during any period of very low market prices.

Jim
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