Take Advantage Of This Opportunity

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Most value investors shy away from options. They perceive them as speculative financial instruments that eventually lead to financial ruin and not to financial success. But there is a much safer way to trade options, the value investor's way. This method is practiced daily by many of the world's legendary investors, such as Warren Buffett.

On options and reputation

There are two main reasons why options have such a lousy reputation as legitimate financial vehicles:

  1. Most people purchase options rather than sell them. Because an option has a specific time frame, after which it expires, investors are forced to be right not only on the price but also on the timing. As we all know, getting the timing right is practically mission - impossible. No one can make money consistently over a long period of time trying to time the market. Put simply, option buyers are participating in a losing game.
  2. People over-leverage their accounts. Leverage, by definition, is embedded in options because each option represents 100 shares. Rather than take 1/100 of their original position, investors take the whole dollar amount they intended to invest and put it all into options. They forget that leverage can easily wipe out their accounts. Any novice trader can attest to that.

As you have probably figured out, both reasons are attributed to our faulty human nature. There is no inherent fault in options, just in us humans.

How to trade options, the value investing way

Most people think of Warren Buffett as a good old grandpa that only buys shares when they trade below their intrinsic value. Well, that is not really the case. Buffett's Berkshire Hathaway (NYSE: BRK-A) holds a large portfolio of derivatives. Specifically, this portfolio consists of long- dated puts that Berkshire has been selling to eager option buyers.

The secret to making consistent profits in options is to follow 2 simple rules:

  1. Never buy options, only sell them. This has been Berkshire's approach to derivatives since its inception. By selling options, the investor defines a predetermined price at which he is willing to step up and purchase those shares. For the trouble, this investor is rewarded with a nice cash premium upfront.
  2. When you sell, only sell long dated options. These are options that expire at least a year from today. the thing is, long dated options suffer from a slight mispricing. Due to the excessive time frame of long- dated options, investors are willing to pay fat premiums for them. Actually, the price of LEAPS (long equity anticipation securities) is usually much higher than the price determined for them by the Black&Scholes common pricing model. And, this of course, is where Buffett steps in and sells these put options.  

In order to implement this principle successfully, you must also fight the trend of short- term trading. It seems that also in options, people always want 'fast and furious', i.e, more options with expiration dates as early as a week. This is the reason why stock exchanges around the world are now offering options with a short term expiration date. You do not want to sell short- term dated options.

How to properly implement this strategy

We'll use a few specific examples from today's market on how to sell long-dated put options.

  1. Selling the January 2015 put options at the $37.5 (at-the-money) strike price on The Coca-Cola Company (NYSE: KO) will land $583 in your pocket for every option you sell. Of course, this also comes with the obligation to actually purchase Coke shares should they trade below $37.50 come January 2015.
  2. Selling the January 2015 put options at the $20 (at-the-money) strike price on Intel (NASDAQ: INTC) will land $395 in your pocket for every option you sell. Of course, this also comes with the obligation to actually purchase Intel shares should they trade below $20 come January 2015.
  3. Selling the January 2015 put options at the $28 strike price on Microsoft (NASDAQ: MSFT) will land $570 in your pocket for every option you sell. Of course, this also comes with the obligation to actually purchase Mr. Softy's shares should they trade below $28 come January 2015.

The Fool's bottom line

This is just the starting point for your own diligent research on this field. Selling put options could be a highly lucrative endeavor but it must be done correctly or not at all.

shmulikarpf has no positions in the stocks mentioned above. The Motley Fool owns shares of Intel and Microsoft. Motley Fool newsletter services recommend Intel, The Coca-Cola Company, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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