How Warren Buffett Trades in Options
If you’re confused about options, I am not surprised. In the stock market the word “options” is used in two ways. There are the “employee stock options” that are used to compensate executives and other company employees, and there are “options contracts” that set fixed prices at which stocks will be exchanged at a future time. The option is the right buy or sell a commodity at a set price in the future. When you buy an option you’re not actually buying the stock. Instead, you’re paying the current owner of the stock to hold the stock for a certain amount of time and then to sell you the stock (if you still wish to buy it) at the agreed-upon price.
So how do you make money when trading options? There are several ways. You’ll want to study basic principles of options trading so that you understand all the terms and concepts, but here are several scenarios in which they work for buyers and sellers.
Buying an Option Guarantees a Price
If you know you’ll have money to spend on a stock at a future date but you don’t believe the price will be affordable at that time, you can buy an option to lock the price in until that date. Say you want to buy 1,000 shares of ABC Business in 2 years at $50 a share. Who knows what the stock will be trading for at that time? But you find someone who owns 1,000 shares of the stock and you offer to pay them $5,000 to NOT SELL THE STOCK until 2 years from now. And in 2 years you have the right to buy that stock at $50 a share.
You don’t have to buy the stock when the options contract matures. If the price on the stock falls below $50 a share you can walk away from the purchase and you’re only out $5,000. But if the price of the stock has soared to $70 a share you still get to buy your 1,000 shares at $50 and then you can turn around and sell them for a $20 profit per share ($20,000). In reality you only made $15,000 on your deal but it’s still a profit.
Selling an Option Produces Immediate Income
Maybe your shares in ABC Business are not producing much revenue, either when you trade in and out of the stock (buy low, sell high) or through dividends and corporate stock buybacks. So instead you decide to offer options on the stock.
You know the trading range is running to about $40-60 a share today but people expect that move up in a few years to maybe $70-80$. Of course, expectations don’t guarantee prices, so you offer an option to buy your shares in 5 years at $65 a share. If everyone’s projection is on target then that will be a deal for someone. They just have to pay you a little bit of money now for the right to buy those shares at $65 in five years.
Selling Shares at a Fixed Price When the Market is Down
Again, if you sold an option on 1,000 shares of stock a few years ago and the buyer decides to exercise the option, you may just be able to reap a profit. Suppose you bought the shares at a really steep discount back when the stock was young. The trading range has moved up several times over the years but now the stock is in decline simply because the market is.
Whomever bought the options contract from you may still see the price as a good investment because the stock will climb above that purchase price. An the guaranteed price may still be lower than the stock’s current price. So even though a stock is declining in value, if there is no killer underlying reason for that decline a good investor knows the price will increase again. And if he can buy the shares at what is a discount for him even though you still stand to make a profit, the deal works for both of you.
How Warren Buffet Makes Money on Options Contracts
Warren Buffet’s company, Berkshire Hathaway, makes a lot of money from selling “derivatives”, which are special options contracts written against their insurance business. As an insurance provider the Berkshire Hathaway empire collects premiums from millions of customers every year. A large portion of these premiums are redistributed to customers to settle insurance claims (that is the whole point of insurance — to replace predictable losses from a pool of shared assets).
Some of the premium money goes into what is called “a float”, a form of value that exists between two transactions. If you write a check to someone and they deposit that check into their bank account, it may take 1-2 days for that check’s value to be withdrawn from your account. The time that the check’s value remains in your account creates a “float” for you. While you cannot legally spend that money you can still earn interest on it (assuming you have an interest-bearing account). Berkshire Hathaway thus invests its insurance float in order to make money that it does NOT have to pay back to customers (unless they experience an unusual spike in claims, of course).
The derivatives that Berkshire Hathaway sell are built on extended maturity dates set as much as 15-25 years in the future. These derivatives guarantee that buyers will have the right to take ownership of certain assets (contracts, stocks, bonds, etc.) at a pre-determined fair market value. Berkshire Hathaway only sells what are called “European Puts” options, which means the buyers must wait until the contracts mature (they cannot call for the sales to close before then) before the sales happen.
To sweeten the deals Berkshire Hathaway writes guarantees into the contracts so that they provide their buyers with discounts or price credit if the assets’ market value falls below the contracted price. So while Berkshire Hathaway may take a loss on those sales they have as many as 15-25 years in which to use the value of those assets to leverage other investments. In the process of managing their derivatives portfolio, Berkshire Hathaway may agree to early sales (for a fee).
Other Facts about Berkshire Hathaway’s Portfolio
One of the important considerations that goes into buying derivative options is that the seller is taking on obligations (they have to provide the buyer with certain value). If the buyer walks away from the sale at maturity date there is no problem, but investors may want to look at the credit-worthiness of the seller in most cases. Berkshire Hathaway, according to the research just cited, structures its derivatives so that credit-worthiness is less important to the buyer.
Not everyone is in a position like Berkshire Hathaway to leverage their current business revenue into derivatives. What is important to know about investing in options (or selling them) is that the transaction should be based on leveraging value for both buyer and seller. When money changes hands you both need to be sure you have a good chance of coming out ahead.
But in simple terms it is often better to sell the option than to buy it unless you have really good information about the potential future value of the asset. Investopedia has an introduction to options basics if you want to read more on the topic.