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!

Comments

  1. It sounds like a solid idea Integrator, provided the premium justifies the risk. I have no experience calculating such a premium, but I agree the risk should be low. Plus, unless we have a Japanese style stagnation……it’s unlikely prices would stay depressed very long…….therefore, being forced to buy wouldn’t be all that risky in it’s own right.
    -Bryan

    • Integrator says:

      I agree Bryan, I too don’t have a lot of experience with Black Scholes for option pricing. Buffett did suggest that options didn’t correctly impute the effect of sucessively higher earnings on long dated index options, which suggests that longer dated index options could favorably misprice the risk for a put seller for the reasons I outline above.
      I think this could be an interesting play, some nice way to get some option income, and potentially be forced to buy cheap stock (if it comes to that)

  2. Hmmm very interesting option strategy approach. I have venture out with options as right now I am only doing covered calls.

    • Integrator says:

      I’m not so keen on the covered calls because I don’t want to risk my stock being called away. Do you generally buy the options back before your stock gets called away?

  3. Martin says:

    It is a standard put selling strategy.Buffett does this all the time. He only does it against stocks he doesn’t mind owning if his option ends up in the money, so he buys the stock cheaper than he would if he opened a trade directly by buying a stock in the open market. Options then provide him with a bigger protection than the stock itself. So for him, it is a win win situation. The option either expires worthless and he keeps the premium, or he ends up buyin a stock he wanted anyway and for cheaper (strike price – premium).
    You can add naked calls (short calls) to your trading and double your gain potential. Not sure if Buffett does short calls as these can be risky if done wrong. The whole structure is then called a short straddle or iron condor but without wings. I do this trading all the time and generated 45% three years ago, 69% two years ago, 89% last year, and I might make 80% this year again.

    In order to trade these strategies, you would want to start your trading as a business and not a person – investor (at least in the USA), since as an investor, it is tax unfavorable trading these trades. You will be hit by a short term capital gains tax. As a registered trader, the taxation is a lot favorable under the 60/40 rule plus other deductions nornally unavailable to an investor. That’s also why Buffett can afford doing such trades without a tax hit. He does it as a business – Berkshire Hathaway, not as Warren Buffett.

    Study this strategy and learn using it. You will be surprised how profitable and safe put selling really is. Good luck.

    • Integrator says:

      Thanks for the detailed feedback Martin. I never really considered the tax related aspects, but you are right, having a bunch of short term capital gains could suck out a lot of the potential return. Funnily enough, I have a bunch of short term losses from my 2008-2009 days that I was thinking to offset against these short term capital gains, just to soak them up. I think I may at least start that route, and when these are used up I’ll consider how to more tax effectively structure this. It will be a good way to get my feet wet with option trading.

  4. I like to sell puts against companies that I want to build my position in. It’s a great strategy in general and I like to add it with my margin account to reduce the cash required. I only do this on solid companies so usually you have to strike fast with selling the puts whenever the company’s share price is getting unduly punished. In volatile markets the option premiums increase which makes the risk/reward ratio much better. I usually look for 10% annualized returns if it expires worthless or a good entry price if it is executed. Unfortunately that decreases the opportunities but it’s worked well for me so far. I’ve been thinking of doing a bit more put selling to close out the year.

    • Integrator says:

      That’s exactly how I’m thinking about this as well JC. Only options on stocks I want to own. I need to pick up some possibilities from you on which current puts look like they offer a decent annualized return.

  5. Evan says:

    Every so often I get very excited about this strategy but I have yet to pull the trigger on it. I don’t think I have the bankroll for it just yet. Using your coke example a purchase would be $30K if it closed…way too much coke for me lol

    • Integrator says:

      Evan, I think the Coke case would only be $4k actually. An option lot is generally 100 shares, so if you were forced to pick up Coke in these circumstances, you would be out 40*100, or $4,000 I think (at least I hope so!)

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