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Investing

How Warren Buffett Use Put Options to Increase Berkshire’s Returns

Chris Lee Susanto, Founder at Re-ThinkWealth.com

3 September 2019

Warren Buffett Put Options

Image source: CNBC

Berkshire Hathway is an investment holding company controlled by Warren Buffett which currently as of 3 September 2019 has a market capitalization of about 500 Billion USD.

Warren Buffett himself is worth about 80 Billion USD.

Now many people would know Warren Buffett as one of the greatest investor alive who is very good at picking undervalued stocks – and holding them for the long term. He has made a lot of money from buying stocks like Coca Cola and American Express a long time ago.

But not many people know that Warren Buffett also have made a lot of money for Berkshire Hathaway by selling put options.

There is a very good article written in Guru Focus talking about Warren Buffett selling put options. It talks about the difference between buying and selling put options and why Buffett sells put options.

The article from Guru Focus described an example of Buffett back in April 1993 where he sold 30,000 contracts of Coca Cola stock that will expire on December 17, 1993, at the strike price of $35 for $1.50 of premiums per stock. After that, he added 20,000 more contracts. In total, he got paid $7.5 billion of premiums in cash upfront for selling those put options.

So what does it mean? It means that if the Coca Cola stock stays above $35 on December 17, he gets to keep the premiums of $7.5 billion, and if it drops below $35, he will purchase the Coca Cola stocks he promised to buy at $35.

Here’s an example that shed even more light on how and why Buffett sold put options (taken from one of Berkshire Hathaway’s annual report):

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019, and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black- Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9 billion in premiums we have received – means that we have so far reported a mark-to-market loss of $5.1 billion from these contracts.

One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.” – Warren Buffett

So what is the key learning point so far on how Warren Buffett makes money from selling put options based on the above examples?

1. Warren Buffett usually sells a long term dated options of 6 months or more and uses the cash proceeds to generate investment returns.

2. He also forecast in advance if the securities that he sold put options on fell below the strike price by the end of the period of contract, he would have enough cash coming from the premiums he got and the investment returns from those premiums have generated (plus I believe with cash on hand too).

3. As a gauge, based on the above example, he generated about 13.2% absolute gain on his put options ($4.9/$37.1 billion x 100%).

Warren Buffett method of selling put options to me is a classic example of where investment is most intelligent when it is most businesslike

Too often we will get affected by emotions when our stock rise and fall, but the key to any investment success is forming a conclusion from facts and act on it – even if others hesitate or differ – because as Benjamin Graham has said before, we are neither right nor wrong because the crowd disagrees with us. We are right because our data and reasoning are right.

By selling put options, Warren Buffett insures the buyer of the put options to promise to buy the stocks when it fall by the contract end period.

I think for Warren Buffett, he have definitely asked himself what is the estimate of how much cash the business can make over its lifetime — and what is the price that the business is selling at. That I believe is his way of looking at stocks like looking at it as a business.

Viewing stocks as a business would also mean that the underlying value of the company will increase when it makes profits and retain those earnings and reinvest them on behalf of the investor. Remember that in the early 1980s, Berkshire Hathaway was trading at around $500 a share and now, it is around $300,000 a share – that was achieved without paying a cent in dividend, ever.

Now, looking at stocks like a business complements with the beauty of selling put options. Warren Buffett for example, when he sold the put options on Coca Cola stock, somehow knew with high convictions that the value of Coca Cola will increase overtime because the business is doing very well and he can predict that in the future it will do the same. So he did not mind promising to buy the stock at a lower price to “insure” the buyer of the put options and in return, he get premiums or cash up front in which he used it to invest in other securities.

Disclaimer:

The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.

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