This Little-Known Buffett Story Teaches An Important Lesson For Investors
The story I’m about to share with you has nothing to do with today’s market. But it has everything to do with becoming a successful investor (or perhaps how to not lose all your money).
It’s a story about Warren Buffett’s sister, Doris. And how she got wiped out financially and went bankrupt.
It was 1987, and Doris was living in Fredericksburg, Virginia. A small brokerage firm out of Falls Church, Virginia, was big on talking their clients into “selling” insurance on stocks to generate income.
This is better known as selling naked puts. Here’s a quick rundown on the premise of this options strategy…
Naked Put Options 101
A naked option, or uncovered option, obligates you to buy a stock at a certain price, called the strike price. When selling puts, you have no intention of buying the stock. Instead, you want the put you sell to expire worthless.
Let’s run through a quick example…
Say a stock is trading at $50 per share, and you think that in one month, it will be worth more than $50. You’re very bullish and confident that this stock is going up.
So, you decide to sell a put option to collect a little upfront income. Entering this contract means you must buy the stock if it falls to the strike price. In this example, let’s say you give yourself a little leeway and set the strike price at $47 per share.
In exchange for taking on this risk, you collect a premium, often touted as “income.” Let’s say your premium is $2 per contract.
Now, one options contract controls 100 shares of the underlying stock. So, if you sell one put option, you would collect $200 in this case ($2 x 100 shares).
Here you can see where this strategy is enticing for many people. After all, if you sell 10 put option contracts, you would collect $2,000 in premiums, or “income.” But that also means you are on the hook for 1,000 shares of the stock at $47 per share. That’s $47,000. Of course, the goal is not to have to buy these shares… just keep the income.
If the option expires in one month and the stock is trading for more than $47, this worked out great. You keep $200 or $2,000 and can do it again.
However, let’s say the stock tumbles and is trading for only $40 per share. Now, you have to buy the shares at $47, and you are immediately in the hole. Not to mention, you must fork over $4,700 or $47,000 to buy these shares (depending on how many contracts you sold).
This is where things can turn sour quick.
How Black Monday Wiped Out Buffett’s Sister
In short, naked puts are essentially a promise to cover somebody else’s losses if a stock falls.
Well, the broker may have failed to mention some of the risks involved in this options strategy. Instead, they emphasized that it would provide Doris a steady stream of income, which she needed.
Doris liked this idea and wanted to do something on her own. So, she never mentioned the investment strategy to her brother Warren. Plus, Warren was famous for recommending “boring” investments. This other strategy seemed way more exciting.
Now, if you recall, the year was 1987, which is now famous for “Black Monday.” As a quick refresher, Black Monday happened on October 19, 1987. That day, the Dow Jones Industrial Average crashed 22.6% — the largest one-day drop in history. Between August and November, the Dow Jones crumbled roughly 31%.
As you can imagine, a tanking stock market is a terrible time to be selling put options. Not only that, but the leverage the options provide, coupled with margin, means you only have to put up a fraction of what you might need if you get assigned the stocks.
When the market collapsed, Doris was margin called… but she didn’t have the money. She defaulted on $2.6 million in obligations owed to the firm.
Because Doris and other clients in a similar situation couldn’t pay the brokerage firm, the firm went under.
Buffett didn’t bail his sister out. He said that if he gave her the money to pay her creditors, it would only help the businesses to whom she owed money- the counterparties she had insured. His logic was that they were speculators, and we wouldn’t bail them out.
[Related: 10 Timeless Investment Principles From Warren Buffett’s Right-Hand Man]
The stock market attracts a lot of dreamers. Many people think it’s an easy way to make money. All they need is that “holy grail” investment scheme to nail every trade.
Of course, if you’ve been investing for any sort of time, you know it’s far from easy and not a get-rich-quick scheme.
To make matters even more confusing, the investment world is littered with hundreds of different strategies. And all these strategies get dangled in front of us, luring us to believe that it’s the one strategy or system that will get every stock trade correct (and make you an instant success).
But the moral of the story is that chasing that next shiny object (strategy) won’t make you rich. There is risk involved in all aspects of investing. And if there’s one thing I harp on more than anything, it is risk. Understanding it. Coming to grips with it.
Remember, rule number one is to cut our losses short. Don’t let small losses swell into large losses. Because if you lose your money, it’s game over.
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