Goldman Sachs is Bullish on Berkshire (BRK.B)

Tuesday morning, Goldman Sachs initiated coverage on Warren Buffett’s Berkshire Hathaway – the “B” or “Baby Berkshire” class – BRK with a buy rating. Becoming only the third brokerage firm to follow the shares (and the first to name it a buy), Goldman opined, “The disconnect between the market value of the stock and the intrinsic value of the business is close to a multi-decade high.” In other words, the market is undervaluing the shares. The brokerage has set a 12-month price target of $101 for Baby Berk, representing roughly 25% of additional upside over the next year. Berk shares have rallied 16% since their June 8 low and are currently approaching their annual high of $83.57 (reached in early March).

As The Wall Street Journal was quick to point out, Berkshire was a good friend to Goldman during the 2008 financial markets meltdown, as Buffett invested $5 billion into preferred shares of Goldman Sachs yielding 10%. The Oracle of Omaha received additional warrants giving Berkshire the right to buy $5 billion additional Goldman common shares at any time over the next five years at a set price of $115.

While the buy, hold, and sell ratings scale can be somewhat cut and dried, options traders have access to a robust selection of strategies they can use depending on their outlook and other factors. Two option strategies on Berkshire – one bullish, one bearish – are detailed below. Remember these are hypothetical examples, not recommendations. Consider your risk/reward parameters and trading goals before executing any new trades.

*Prices given as of Tuesday afternoon. BRK.B was trading at $80.35.

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Bullish Option Strategy: Bull Call Spread

Those who believe in Goldman’s optimistic thesis could consider a relatively short-term bull call spread. The September 65/80 call spread is currently priced for $12 (by buying the 65 call and selling the 80 call). The most the investor can lose is $12 (if Berkshire is trading below 65 when the options expire on September 17) while the maximum potential gain is $3 (the difference in strike prices minus the debit paid).

While a 25% reward on risk may seem unexciting, the probability of success should be higher as the call options are already in-the-money. With increase reward potential typically comes increased risk. Also remember that this 25% potential return would transpire in under three months. Breakeven for this spread is $77, so Berkshire has more than 4% in downside cushion before the spread enters losing territory.

Profit/Loss of Berkshire Hathaway (BRK) bull call spread

Bearish Option Strategy: Put Tree

Investors expecting moderate downside could buy a “put tree,” which is sort of a modified ratio put spread constructed by buying one in-the-money put and selling two different out-of-the-money puts. For this example, investors could buy the August 85 put, sell the August 75 put, and sell the August 70 put for a combined net debit of $3.10 (the 85 put is currently priced above $6 while each of the out-of-the-money puts are priced between $1 and $2 each). The maximum potential gain, collected if BRK is trading between 70 and 75 at expiration, is $6.90 (the difference between the long put and the higher-strike short put, minus the debit paid). Above the 85 strike, losses are capped at the premium paid, or $3.10. The upper breakeven point is $81.90, which is the long put minus the premium paid.

Below the lower breakeven price of $63.10 (the lowest-strike put minus the maximum potential gain), losses are theoretically unlimited down to the zero mark and are capped at $63.10. This risk exists because of the naked short 70-strike put that creates the obligation to purchase Goldman stock should the price fall below $70.00.

Profit/Loss of Berkshire Hathaway (BRK) put tree