Buffett’s Secret Income Technique… that Anyone Can Use
Last week, I explained “How to Turn a Losing Stock into a Winner” by selling options on Bed Bath and Beyond (NSDQ: BBBY). In that case, it took eight months to close out that position at an 8% net profit. That’s because the stock moved against me shortly after I opened my position in it.
Today, I will discuss what happens when just the opposite situation occurs. That is, when I sell a put against a stock that immediately jumps up in price, which is what I want to happen.
Below, I’ll also explain how Warren Buffett, the “Oracle of Omaha,” got rich using these tactics.
During the first week of January, I sold a short put option on Xerox (NYSE: XRX) while the stock was trading around $20 at a $19 strike price that expires in July. At the time, XRX had lost 30% of its value in less than two months.
Sure, the overall stock market’s 10% decline at the same time had something to do with that. But for Xerox to drop three times as much as the S&P 500 Index struck me as extreme.
Consequently, I sold a put option against Xerox that generated an immediate credit of $2 per share ($200 per contract representing 100 shares). Of course, I was obligated for the next six months to buy XRX for $19 no matter how far it fell. That’s the risk when you sell a “naked” put option.
In this case, my timing turned out to perfect. The day before I sold that option was the last day XRX traded below $20 this year. By the end of the month, XRX was back above $28.
That’s great, but the option I sold did not expire until July 19. Anything could happen between now and then. A disappointing earnings report or unexpected bad news could push XRX right back down to where it was three months ago.
So on January 30, I closed out my position in Xerox by buying back that same put option for 25 cents. That means I booked in a net gain of 10.3% on my capital at risk in less than a month!
Capital at Risk
Some of my readers that made this trade reported that they earned a return of 700% since they sold this put for $2 and bought it back later for 25 cents. However, that calculation fails to recognize the amount of money that they would have had to cough up if the trade went against us.
Had we first bought the option for 25 cents and later sold it for $2, the 700% figure would be correct. That’s because the only money at risk throughout the entire trade would have been in the initial outlay.
In this case, we first sold the put option and were at risk of having the stock assigned to us at $19 per share. We must divide our profit of $1.75 into the net strike price of $17 ($19 minus the $2 premium received from the initial sale).
The reason we must do that is your broker will require that you have enough money in your account in the event the stock is put to you. That’s what happened in the case of Bed Bath & Beyond when its share price fell below our strike price prior to the option’s expiration date.
Be Like Buffett
If you think using options in this manner is too risky, consider this: even Warren Buffett, the paragon of value investing, has sold billions of dollars of put options to generate income for his Berkshire Hathaway (NYSE: BRK.A, BRK.B) portfolio.
Buffett loves investments that pay him cash now for the small probability that he may have to return that cash later. That’s why he has so much money tied up in the insurance business. The way Buffett sees it, selling put options is akin to selling insurance against a stock market crash.
Of course, the stock market does crash occasionally. The last time was 10 years ago when it lost 50% of its value. If you owned puts on the S&P 500 at that time, you made a lot of money.
Since then, the stock market has gained 250%. Investors have spent billions of dollars buying put options to guard against a similar drop that has yet to occur. The people that sold all those put options, including Buffett, haven’t had to pay out on many of them.
One day, Buffett will probably have to pay out on some of the options he has sold. But by then, he will have already received enough option premium to more than pay for it.
The good news is you don’t have to be as rich as Warren Buffett to do the same thing in your portfolio. You only have to follow the advice of my savvy colleague, Amber Hestla.
Amber is chief investment strategist of the premium trading service, Income Trader. She routinely uses some of the techniques I’ve just described, for phenomenal gains.
Amber isn’t just an investment expert. She’s also a former Military Intelligence Analyst with the U.S. Army and an Iraq war veteran.
Amber’s job was to sift through a mountain of military intelligence to pinpoint roadside bombs, to protect our troops. She uses similar analytical skills to sift through the white noise of the investment world, to pinpoint hidden investments that are about to surge on the upside.
Amber’s followers are racking up market-crushing gains. Want to learn her investment secrets? Click here now.