The Buffett Option Strategy

I’ve never been one to really contemplate an option strategy, though I’ve been intrigued at the prospect of options to generate income. I read a piece on an option strategy that Warren Buffet has put in place that has started to change my mind. 

In general, I’m not one for short term plays. I generally buy with intent to hold for the long term and not look to exit with 3-4 months. To me, options have always been more of a short term play, consistent with more of a short term mindset. Options give the option holder the right, not obligation, to purchase and sell stocks at a particular price.

So for example, you are concerned that Coca Cola stock may tank in the next few months. You want the ability to sell your Coca Cola stock at a certain, fixed price to somebody should that occur. So if the talked about correction does occur, and Coca Cola dives to $30, some folks may want to hit the exits, and have the ability to lock in a sell at say $35, a slight discount to todays trading price.

If you are a long term holder and you don’t believe Coca Cola’s business will disappear anytime soon, such a decline in stock price shouldn’t really worry you. If anything it should make you want to buy more.  So having the ability to buy or sell stocks based on minor short term fluctuations didn’t really do much for me.

However I recently came across a very interesting article about an options strategy that Warren Buffet put in place a number of years ago. I admire Buffett, he’s a very savvy investor. Buffett essentially provided insurance against the total collapse of the US stock market (and other international markets) by selling puts to a number of large institutions. The nature of these puts was that Buffett would offer to buy back a certain number of shares in major indexes at fixed prices if they were trading at lower levels in 2017 than they were in 2008.

Essentially, Buffett is providing stock market insurance against major falls in the marketplace that pull the DJIA or S&P significantly below where they were in 2008. I think that’s actually a pretty smart bet. Here’s why. Over time, companies in a major index  (or any index for that matter) tend to generate greater and greater earnings per share. Thus, over time, they are more and more valuable, and the index that they are part of should be worth more and more.

This makes it highly unlikely that an index will actually be worth less over time. And give index components get weighted by value, one or two failures will not even cause a blip, they’ll just get replaced in the index. And what does Buffett get for providing this insurance? A nice fat insurance premium (I believe he collected almost $5B in options premiums for the options he wrote).

Buffett’s strategy got me thinking about whether it could be possible to replicate something like that. I’m always looking to buy stocks cheaply. I don’t necessarily want to own everything now. Given I have a pretty wide basket of individual stocks, having more exposure to an index may also not be a bad thing.

I recently discovered that while I may not be able to copy Buffets strategy entirely, there were a few things that I could try that could achieve a similar outcome. There is an S&P 500 etf, which trades at close to 1900 currently. I could write an out of the money put option for 1 S&P 500 put, whereby if the S&P 500 ETF dropped to a level of 1700 of lower within the next year I would agree to buy $17,000 worth of S&P 500 ETF. I’d receive close to $1,000 upfront for doing this.

Overall, this doesn’t strike me as a bad trade. I’d be getting a diversified basket of S&P 500 securities at a substantially lower price. Dow 17,000 doesn’t interest me much, put Dow 15,000 is a very different story. I’d also be getting a little upfront cash. Of course, it’s entirely possible that the Dow may not drop to 17,000. That’s not necessarily a problem for me, I’d happily just keep the $1,000 (in fact, close to 67% of all option contracts expire unexercised).

One could implement this same strategy on individual stocks also. In general, I’m not as keen on this, as while an index doesn’t carry stock specific risk, stocks do, Such a strategy may work on stocks like Coca Cola and McDonalds, though I probably wouldn’t extend it to any stocks much beyond this. Of course the premiums are lower on these stocks given their perceived safety, but I wouldn’t want to deploy this strategy for companies that I wouldn’t be happy to own more of.

I think I’ll wait for resolution of my potential new job situation before making a commitment on this. Alternatively, I may get my feet wet with a smaller option commitment to provide insurance on a fall in the Coca Cola stock first. Morningstar has this at 4 stars already, a further 10% dip would have Coca Cola stock at 5 stars and would get me a 3.3% dividend. Collecting a few hundred dollars here doesn’t sound like a bad trade!

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