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This (Naked) Investment Strategy Helped Warren Buffett Make Millions

Updated July 1, 2016
by Steve Gillman
Image: Stock Exchange

With a net worth of $65 billion, Warren Buffett is perhaps the best investor of all time. What makes him so successful?

Reporting on Buffett suggests that that he just buys quality stocks at good prices and then holds them for years, and this is a big part of his investing success. But it isn’t the only thing he does. He also profits by selling “naked put options,” a type of derivative.

That’s right, Buffett’s company, Berkshire Hathaway, deals in derivatives. In fact, in one annual report, Buffett acknowledged that Berkshire collected $7.6 billion in premiums from 94 derivatives contracts. Put options are just one of the types of derivatives that Buffett deals with, and one that you might want to consider adding to your own investment arsenal.

How a Put Option Works

Suppose you want to buy “XYZ” stock, which is selling for $20 per share. Now suppose a trader pays you $150 to let him sell you 200 shares for $18 per share any time in the next two months. When the time is up, you might have to buy the stock you already wanted, but for $18 instead of $20 — so you’ll earn $150 on top of the $400 you save by buying at the lower price. If the trader decides not to sell those 200 shares, you keep the $150.

Does that sound like a good deal? You’re not the only one who thinks so.

When you sell, or “write,” a “put,” the buyer of the option has the right to sell you 100 shares of a stock at the “strike price” any time before your contract expires. In our example above, the trader paid you $0.75 per share for the two XYZ $18 puts for a total of $150 (prices are always quoted per share, but one option represents 100 shares). Now, let’s say the price of the stock drops to $15. Naturally, he’ll “put” it to you, forcing you to buy 200 shares at $18. You’ll pay him $3,600 for stock currently worth $3,000 ($15 times 200 shares). Even after the $150 premium you collected for your option sale, you’re out $450. So why take the risk?

Think of it this way: if the price drops enough, you’ll have to invest $3,450 ($18 per share minus the $150 you earned for the put option) instead of the $4,000 you were willing to paywhen the price was $20 per share. Whatever the price is at that point, you like this stock because you expect it to be priced much higher someday, so you wait — just like you would have if you’d bought it at the higher price. Otherwise, if you aren’t forced to buy it, you just keep that $150.

Years ago, with Coca Cola stock around $39, Warren Buffett sold 50,000 put options (which represent 5 million shares) with a strike price of $35 for $1.50 per share, making $7.5 million immediately. If the stock price went up before the contracts expired, he would simply keep all of that money. If the price dropped sufficiently, he would be forced to buy Coke stock for $35 per share, a price he liked. Granted, he could just wait and buy if the price dropped to $35, but this way he got $7.5 million no matter what happened.

Buffett has used this strategy on other occasions too, but nobody knows exactly how many times because Berkshire Hathaway does not publicly share details of its derivatives deals. Also, Buffett does custom deals that are not available to the average investor. But imagine what happens if you keep selling puts that are “out-of-the-money” (meaning the strike price is below the current price) on good companies whose stock prices don’t drop much? You might just keep collecting money without ever buying any stocks at all. Or you might have to buy some good companies once in a while for a discount from the price that you determined is fair.

The Catch

Of course, there’s a catch. Some brokers might not allow you to sell these kinds of “naked” options because they consider them to be too risky. However, the two types of naked options are very different in terms of risk. The term “naked” means you don’t own the stock in the case of a call option, or haven’t sold it short in the case of a put option.

It’s easier to understand a call option, which is like promising to sell a house for a set price in the future — if the buyer chooses to buy. If you own the house, you’re “covered.” Imagine doing this when you don’t own the house. In that case, you’re “naked” because you don’t have the underlying security to cover your promise. If the option holder decides he wants to exercise his option and buy the house from you, you’ll have to pay any price necessary to buy it from its current owner just to sell it to the buyer at the price you promised. Naked call options are risky.

Put options are not so easy to understand. Essentially your put options are “covered” if you’ve sold short the underlying stock — sold a stock that you don’t own, planning to repurchase it later — and “naked” if you haven’t. Fortunately you don’t need to understand covered puts to sell naked puts, but if you want to know more, the explanation of covered puts is pretty good.

A “naked” put option is simply a promise to buy 100 shares of a stock at a specified price before a certain date — if the seller wants you to do so. You’re essentially saying, “I agree to buy that stock at that price before this date if you want me to.”

To understand the difference in terms of risk, consider our XYZ example. If you sell two $18 puts, your risk is limited to $3,450 — the amount you’ll lose in the unlikely event that the stock goes to zero and you have to buy 200 shares at $18 each, and you keep the $150 option fee. But suppose you sell two naked call options on XYZ at a strike price of $22 (meaning the buyer has the right to buy at that price), for $0.50 per share ($100 total). The stock could climb to $150 per share, in which case you’d have to pay $30,000 for 200 shares — just to hand them over to the option holder for a measly $4,400 ($22 times 200 shares), resulting in a loss of $25,500 ($25,600 minus the $100 you got for your call options).

Clearly, gambling on a stock price not rising is riskier than agreeing to possibly buy a stock you like for less than the current price, but most brokers lump both types of naked options together. Each brokerage has rules about account approval and which types of trades are allowed. You’ll have to fill out some extra forms stating that you understand the risks of this kind of trading, and you might need to have a few years of investing experience. Brokerages specializing in options might be more understanding of your interest in exploring these methods — and some of them will even pay you to open an account.

If your account is approved for naked option writing, the process of placing the trades is relatively easy using your brokerage’s online platform. To sell put options on Coke stock, for example, you would find the stock symbol (KO), enter it in the options field and see what the current prices are for various strike prices and expiration dates. With a few clicks, you can place and execute your order in seconds.

What Other Options Can You Try?

What if you can’t get your account approved for naked option writing? Usually you can get approval for covered options, in which case you might try a covered call strategy. You are “covered” when you own the stock on which you sell call options or have a short position in a stock for which you are selling puts (and yes, the latter is harder to understand).

In our example above, suppose you first buy 200 shares of XYZ for $20 per share, and then sell those two $22 call options for $0.50 per share. You collect $100 (minus commission) right now, and if the stock is still below $22 when the options expire, you can repeat the process to collect more money. If the price is above $22 you’ll be forced to sell for a profit of $2 per share (even if it soared to $150 per share), plus you keep the option premium. It’s easier to get approval to sell covered calls because it’s less risky.

Whether you want to get naked like Warren Buffett or be covered, you’ll want to do further research before planning your investment strategy. Here’s a good primer on stock options. Meanwhile, keep in mind two simple concepts:

1. When you sell naked puts, you collect money now but might be forced to buy the stock, so be sure you want to own it at the agreed price.

2. When you sell covered calls, you collect money now for a stock that you own, but you might have to sell it, so be sure you are willing to sell it at the specified price.

And yes, you can lose money — even a lot of money — with almost any trading or investing strategy. Be sure you’re comfortable with the risks involved, and of course, don’t bet your entire portfolio on this investment strategy — you’ll want to balance it with more conservative options.

Note: Neither The Penny Hoarder nor the writer are investment professionals. We encourage readers to seek detailed advice from professional advisors before acting on this information.

Your Turn: Have you ever traded stock options? Have you done covered calls or naked puts? Please tell us about your experiences.

by Steve Gillman
Contributor for The Penny Hoarder

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