The Warren Buffett Approach: What Selling Put Options Can Teach Investors

Warren Buffett's Genius: Selling Options and Building an Empire

Maya, let me explain you a hidden story about Warren Buffett, he is widely considered one of the greatest investors of all time. What many people don’t realise is that he made a significant portion of his fortune using a strategy that’s essentially the same as selling put options. I am not doing anything different from what Buffett did. I am simply copying his model and instead of selling insurance, I am selling put options. To have an insurance company you need team of lawyers, compliance etc virtually impossible for an individual to setup an insurance company and sell policies. Luckily on the stock market we can setup our own insurance company and sell policies albeit Put options.

When you hear the headline news about Buffett buying companies like Coca-Cola, American Express, Apple or Google, you might wonder, where did he get the money to make those massive investments? The answer lies in his insurance business. Selling insurance premiums that never get claimed is exactly like selling put options. He used premiums generated through his insurance company as capital to invest in other companies. I am doing the same using the premiums to buy property and accumulate ASX 200 shares (Stock code STW).

Understanding Put Options

A put option gives the buyer the right to sell a stock at a predetermined price before a specified expiration date. When you sell a put option, you collect a premium upfront, and you agree to buy the stock if the price falls below the strike price. If the option isn’t exercised, you keep the premium as pure profit.

Selling put options is like selling insurance. The option seller takes on the risk, and in return, they receive a premium. If the “disaster” (in this case, the stock price falling below the strike price) doesn’t happen, the seller keeps the premium without any further obligation.

Buffett’s Strategy with Insurance and Options

Buffett applied this same principle in his insurance business through companies like GEICO and General Re. Here’s how it worked:

Collecting Premiums: Insurance companies collect premiums upfront, creating a pool of money known as the float.

Example: A homeowner’s policy might generate $1,000 in premiums annually, which the company holds until a claim is made or not made.

Investing the Float: Buffett didn’t let that float sit idle. He invested it in high-quality, undervalued companies and assets.

Example: He used these premiums to acquire stakes in household-name companies like Coca-Cola and American Express.

Managing Risk: Just as a put seller carefully selects strike prices, Buffett’s insurance businesses assessed and managed risk meticulously to ensure that claims payouts wouldn’t exceed collected premiums.

Selling Put Options: The Modern Equivalent

Selling put options is no different from selling insurance premiums. Here’s how it works in today’s market:

Premiums as Immediate Cash Flow: When you sell a put option, you receive the premium upfront. This is akin to an insurance company collecting premiums from policyholders.

Risk of Exercise: If the stock price falls below the strike price, you are obligated to buy the stock at that price, just like an insurer must pay claims if a disaster occurs.

Capital Allocation: If the options expire worthless, you keep the premium and can reinvest it, just as Buffett reinvested float into profitable businesses.

Example: Selling Put Options on Blue-Chip Stocks

Here’s a practical example to show how this strategy works:

Stock: Apple (AAPL)

Current Price: $175 per share

Put Option Sold: Strike price of $165, expiring in one month

Premium Received: $3 per share (or $300 per contract since one contract covers 100 shares)

If Apple stays above $165:

You keep the $300 premium as profit.

If Apple falls below $165:

You are obligated to buy 100 shares at $165 each, totaling $16,500.

However, your effective purchase price is $162 per share after factoring in the premium collected.

This is exactly what Buffett does. He sells insurance policies or in our case, put options, and uses the premiums collected to buy more assets. The beauty of this strategy is that you don’t need to overcomplicate things. It’s simple, boring, and highly effective.

Example: Selling S&P 500 Put Options

Another practical example is selling put options on the S&P 500 index. Let’s say the S&P 500 is trading at 4,500 points.

Index: S&P 500

Current Level: 4,500 points

Put Option Sold: Strike price of 4,400, expiring in one month

Premium Received: $15 per point (or $1,500 per contract, since each contract covers 100 points)

If the S&P 500 stays above 4,400:

You keep the $1,500 premium as profit.

If the S&P 500 falls below 4,400:

You are obligated to buy the index at 4,400 points, but your effective purchase price is 4,385 points after factoring in the premium.

This strategy works well because the S&P 500 tends to rise over time, making the likelihood of significant drops less frequent. Selling index puts can provide consistent cash flow and help you build a portfolio of diversified assets.

Just like Buffett uses insurance premiums to invest in valuable companies, we can use the premiums from selling put options to buy more assets and grow wealth over time. It’s about taking calculated risks, managing them carefully, and staying disciplined.