Almost every investor wants to be like Warren Buffett in some way. While there is unlikely to ever be another Buffett, we can certainly learn from studying his investments. Many analysts point to his ideas about value investing and being patient as keys to his success. What they could be missing is how, at times, Buffett has combined value investing, patience and a desire to generate cash into a successful investment strategy. The strategy associated with this lesson is one any individual investor can apply.
One of Warren Buffett’s biggest winner is Coca-Cola (NYSE: KO) according to Berkshire Hathaway’s latest annual report. Buffett owns 400 million shares of KO. When the price of the stock is adjusted for splits, the report indicates he paid an average price of less than $3.25 a share. His $1.3 billion investment is now worth more than $17 billion, a return on investment of more than 1,200%. The dividend from KO provides more than $560 million a year in cash for Buffett to invest. KO is a classic Buffett investment story where he buys low, holds his position for decades, enjoys significant income from his investment and enjoys a large return.
Some believe Buffett is a “one-decision” investor. He decides to buy a stock and then holds forever. In hindsight his decision to buy KO was a great one. But, there were actually a number of decisions he had to make. Like all investors, Buffett needs to decide how much of the stock to buy and what he should pay. In the case of KO, we know when Buffett decided he wanted to own the stock, the price was too high. We know this because he used a strategy to get paid to wait for a pullback in the stock.
When he looked at the market price of KO in 1993, Buffett seemed to believe the price was about 10% too high. He decided to buy on a pullback. But as we all know sometimes a pullback never comes or it can take months to get the price we want. For Buffett, with millions of dollars to invest, waiting can be expensive. Cash on his balance sheet earns little interest, even in 1993, and carries an opportunity cost. The opportunity cost is the amount of money that could be made by putting the cash to work in an investment. To limit the costs of holding so much cash, Buffett sold put options.
This allowed Buffett to generate income rather paying the market price which he felt was too high. By selling put options, he earned an estimated $7.5 million in profits while he waited for a price correction.
You don’t have to be Buffett to sell puts. A put option gives the buyer the right, but not the obligation, to sell a stock at a certain price for a specified amount of time. Put sellers have an obligation to buy the stock at the price in the contract, known as the exercise price or strike price, prior to the contract’s expiration date. Buyers will only exercise this right when the market price is below the exercise price.
If you know you want to buy a stock anyway, selling a put allows you to earn income while waiting for the stock to pull back to the price you want to pay. If the price of the stock falls, you get to buy at a price you considered to be the correct value of the stock. If the stock doesn’t reach your price, you keep the income and can continue selling puts to generate more income.
To understand the strategy, we can look at what Buffett did in a little more detail.
Using pre-split prices, KO was selling for about $39 a share in early 1993. Buffett liked KO as a long-term investment and wanted to add about 5 million shares to his portfolio. He completed an analysis of the stock and determined he was willing to pay $35. Buffett is a disciplined investor and prides himself on never paying one cent more than he considers to be fair when buying. With KO above his buy price, he could wait or move on to find another use for his cash.
He decided to wait and sold put options that created an obligation to buy 5 million shares of KO at $35, being paid $1.50 per share for his promise to buy KO later at $35 a share.
In effect, because Buffett received $1.50, the shares would only cost him $33.50 since he could apply the premium he received when selling the option towards the purchase of the shares.
Eventually, the price of KO fell and the put buyer exercised the option. Buffett had his KO and would make billions on the investment. If the price had not fallen the option would not be exercised and he could continue selling new put options. This could go on indefinitely and an investor can earn a great deal of income from this strategy.
Any investor can use this strategy as long as they are approved for options selling by their broker. You will generally need to have some experience in the market to obtain approval. For each put you sell, the broker will require a deposit, known as a margin deposit, which guarantees you have the cash available to meet your obligation. Margin deposits are calculated with a formula but are generally equal to about 20% of the strike price. For a $35 strike price, since the contract covers 100 shares, you would need a $700 margin deposit (20% * $35 * 100 shares). This can be in the form of cash or securities.
Put prices tend to be around 1% to 10% or more of the exercise price, depending on a variety of factors. For a $35 stock, the price of a put option could be $1. Selling one contract would generate income of $100, a potential return of 14% on the margin deposit required. Options generally expire in just a few months. You could use this strategy to get paid to wait for pullbacks on stocks you want to own or to generate income.
To generate income, you find a stock you believe will go up or will fall just a little. You then find a put option expiring within the next few weeks. For this strategy, it is best to avoid selling puts that will be open when the company reports earnings. This means contracts should expire in less than three months and you could be able to sell options at least our times a year with a limited amount of capital. If you generate income equal to 5% of your margin, your annualized rate of return could exceed 20% even after accounting for commissions.
For example, assume you sold a put option on a stock trading at $100 a share. The option expires in one month and has an exercise price of $90. As long as the stock is above $90, you keep the income from the sale of the put.
You could use technical analysis to find support levels and sell options with exercise prices above a support level. Or you could use fundamental analysis to find undervalued stocks and sell puts at prices at least 10% below their current market price. Value stocks tend to lose little since they are already undervalued.
Put selling can be used to buy stocks you want during pullbacks or to generate income in any market environment. Options are a versatile tool and can help many individual investors meet their goals.