This Is The Closest Thing To Printing Money

Warren Buffet’s little-known strategy can make you rich.

The house always wins.

You might have a lucky streak as a gambler, but over a longer period of time, the casino always has the upper hand, because the probabilities are rigged against you.

Imagine you could manipulate the probabilities in your favor when investing, just like a casino does when gambling. Rigging the stock market, so to speak.

That actually works. With a rather unknown strategy, which is used by Warren Buffet, among others.

Warren Buffet’s Unknown Strategy

The strategy in question is the selling of stock options.

What exactly is an option?

Investopedia explains it as follows:

Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.

A distinction is made between put and call options. Puts fall in value when the underlying asset rises in value, while calls rise in value. If you buy puts, you bet on falling prices, while you bet on a rally with purchased calls.

People who buy options usually do so to hedge their portfolios or to speculate. They are effectively the gambler in the casino since the probabilities are stacked against them, as they have to pay a premium for their options.

Put Options

In the following, we will take a closer look at put options.

Let’s assume you hold a lot of shares of a specific company that is currently worth $100 a share and are going on vacation. While on vacation, you do not want to deal with stock prices. But you also want to make sure that you haven’t lost half your money after your 3 weeks of Mediterranean vacation.

In this case, you could buy puts to protect yourself. They guarantee that you can sell your shares at a certain price, regardless of the share price. So if you buy $90 puts, you can be sure that you will get at least $90 per share after your vacation. Even if the stock has crashed to $60.

Your put options are basically insurance. Of course, you don’t get this insurance for free. You have to pay a so-called premium, which corresponds to the price of the put options.

Selling Put Options

Due to the premium that you have to pay as a buyer of an option, the price must always move in the right direction for the option to be profitable. The odds are therefore stacked against you because of the premium.

That’s exactly why warren buffet takes the opposite side of this trade. He sells options and receives premiums instead of paying them.

You too can do this. Let’s look at the example I just gave. Someone else is going on vacation and wants to hedge the same stock.

You, on the other hand, are a fan of the company and would not mind holding the shares. So you could sell put options to generate income.

By doing so, you would agree to buy the stock in a few weeks, whenever the option expires, at for example $90. The $90 price is called the strike price.

For doing so, you receive a premium. You would have to buy the stock when the price falls below $90. More precisely, 100 shares, since one option always refers to 100 shares. If the share price is above 90$ at the time of the expiration of the option you don’t have to do anything and keep the whole premium.

This is how you get the probabilities on your side. The share price does not have to move at all for you to earn money. It can even fall by a full 10% and you can keep the whole premium. The stock falls by 10% and you still make a profit. If that is not a statistical advantage.

Only at a price below $90 on the date the option expires would you make a loss. If you include the premium, probably at $88 or so.

That’s exactly how Warren Buffet does it. He sells put options on companies he would like to hold anyway and collects premiums for doing so. The worst that can happen is that he has to buy the shares at a higher price. However, he still performs better than if he had simply bought the shares at the time he sold the options. After all, he still got the premium.

“I believe each contract we own was mispriced at inception, sometimes dramatically so.” — Warren Buffett

How Much Is The Premium?

The amount of the premium you get for selling options depends on how far the strike price is from the current price. If the current price is $100, you will get a higher premium for selling $95 puts than for selling $90 puts. This is because the probability of the price falling below $95 is obviously higher.

Also, the premium depends very much on the volatility of the underlying stock. Options on volatile stocks, i.e. stocks with strong price fluctuations, generally yield a higher premium than less volatile stocks.

An Example

Apple stock is trading at $150 at this point. Let’s say I would sell a $146 put that expires in 2 weeks. Then I would get a $213 premium. If the price is below $146 in two weeks, I would have to buy 100 shares worth $1460. If you include the premium my break-even point is $143.87.

If the price is above $146 in 2 weeks, that would be a return of almost 1.5%. Not bad in my opinion.

Coinbase

As mentioned, the premium is significantly higher for volatile companies, such as Coinbase.

If I were to sell a put with the same distance between the strike and the current price as for apple, the following situation would arise

I would even achieve a 7.5% return if the price on the expiry date is not below the strike, which is a good distance from the current price. My break-even is more than 10% below the current price.

Summary:

I think that selling put options is a very good strategy to generate passive income. Since the odds are manipulated in your favor, you can earn much more than the normal 10% per year in the stock market.

Thanks for reading!

Wait a second. You should get my articles in your inbox. Subscribe here. Maybe you also want to start writing on Medium yourself and make money. I made $2300 in my second month! You only need a membership for $5 a month. If you sign up with my link, you support me with a part of your fee without additional costs.

I think you will also like these articles: