The Difference Between Warren Buffett and You
You don't have to be a billionaire guru to benefit from this strategy -- you just have to act like one.
You say you wouldn't touch them with a ten-foot pole? You're not alone.
In a 2011 survey, securities broker TD Ameritrade (NYSE: AMTD) found that more than three-quarters of "buy and hold" investors have never bought or sold stock options.
The reasons? "Too risky," according to a third of the respondents. Twenty-five percent said they "don't need them," and another 23% admitted they "don't know how they work."
Yes, stock options can be risky, but so is investing in Apple (Nasdaq: AAPL). And, no, stock options are not necessarily "needed" by everyone -- only those investors who want to reduce exposure to market volatility, preserve capital and, yes, generate income.
Take Warren Buffett, for example.
The King of Buy and Hold first bought stock in Coca-Cola (NYSE: KO) in 1988. At the time, Buffett said he expected to hang on to the shares of this "outstanding business" for "a long time." Today, Coca- Cola is Buffett's largest holding. As of September 30, the Oracle owned 400 million shares of Coca-Cola, valued at $15.2 billion -- a fifth of his equity portfolio.
But Buffett is not the type of investor who'll buy shares of a favored company at just any price -- not even Coca-Cola.
The world's greatest investor is a bargain hunter. If Buffett likes the company, but believes its share price is too high, then he'll wait until the market "cooperates" by correcting lower before he'll buy shares.
And that's where options come into play.
In April 1993, Buffett's beloved Coca-Cola was trading at about $39 a share (before two splits) -- a price he regarded as too expensive at the time. But did the self-made billionaire let his cash sit idle while waiting for a downturn? Not a chance.
Buffett employed an options strategy that in this case earned him income of $7.5 million -- all without buying or selling a single share. Here's how he did it...
After determining that $35 would be a reasonable entry point for Coca-Cola, Buffett wrote 5 million put options with a $35 strike price. A put is an option contract that gives the owner the right, but not the obligation, to sell 100 shares of the underlying stock at a specified price (which is known as the "strike price" -- in this case $35). In exchange for writing the puts, Buffett in this instance received a premium of $1.50 a share from the buyers of the puts. (In options, the premium, or cost, is determined by such factors as the stock price, strike price and time remaining until expiration.)
If Coca-Cola were to fall below $35 the buyers of the options that Buffett wrote would exercise those options and sell their shares to him. In other words, Buffett would be obligated to buy Coca-Cola at $35, which is precisely what he wanted to do in the first place.
If Coca-Cola instead were to rise during the life of the contract, the owners of the options wouldn't exercise them. They'd let them expire and Buffett would simply pocket the $7.5 million premium ($1.50 X 5 million shares). And that's just what happened -- Buffett received $7.5 million in instant income for the opportunity to buy shares of Coca-Cola at $35 each.
The best part: You don't have to actually be a billionaire guru to benefit from this strategy -- you just have to act like one.
Action to Take --> My friend Amber Hestla-Barnhart, an options strategist at ProfitableTrading.com, a StreetAuthority sister site, has just put the finishing touches on a report that details who should (and shouldn't) try these strategies and answers 10 commonly asked questions about boosting income with options. If you'd like learn more about generating income using options, then simply click here.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.