Shorting Puts

I’ve always thought that shorting puts is a fascinating options strategy. A few years ago, I edited a book on the topic. Here’s part of the intro:

It then occurred to me that there is a great way to acquire stocks without trading what you’ve got or using borrowed funds. Simply stated, the method involves the sale of long-term options on highly rated companies, using the premiums received to further your investment program. There is no interest paid on the funds received; the funds never have to be repaid (because they have not been borrowed); and the equity requirements needed to do this are much lower than those for regular margin buying. Although I adapted and perfected this technique to suit my own needs and situation, it can be used by any investor who has built up some measure of equity and would like to acquire additional stocks without contributing additional capital. As we shall see later, the potential benefits far outweigh any incremental risks, especially when appropriate hedges and proper safeguards are incorporated.
What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected long-term growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn’t matter. With long-term options, however, this oversight often leads the market to overvalue premiums. Taking advantage of this mispricing is the foundation of my strategy.
I have been using this technique for the past four years-very cautiously at first, because of the newness of these long-term options (they were only invented in 1990) and the almost complete lack of information regarding their safety and potential. It was this lack of analysis that led me to start my own research into the realm of long-term equity options. Having determined their relative risk/reward ratio, I am now very comfortable generating several thousand dollars a month in premiums which I use to add to my stock positions. I am often told that what I am doing is much akin to what a fire or hazard insurance company does, generating premiums and paying claims as they arise. A better analogy might be to a title insurance company, for with proper research, claims should rarely occur.

Now I learn that Warren Buffett is using the same strategy:

Buffett arranged his multibillion-dollar positions by selling puts on these indexes. Berkshire will only have to make payments if the respective indexes fall below the levels they were issued at. “In the meantime, the premiums we have received are ours to invest freely,” Buffett says in the quarterly report. At the end of 2007, the conglomerate had $4.5 billion in premiums and $4.6 billion in liabilities.
Berkshire has continued to enlarge its position. In the first quarter, it increased premiums by 8.5%, or $383 million, by selling more puts, and increased its liability by 34.8% to $6.2 billion. Berkshire recorded a first-quarter loss on the contracts of $1.2 billion.
The indexes Buffett is bullish on haven’t fared well in the past year, given the turmoil in the credit markets. Over the last 12 months, the S&P 500 has fallen 7.9%, the FTSE dropped 4.1%, the Euro Stoxx is down 12.1% and the Nikkei has plunged 19.2%. His positions reveal that he is confident that the European, Asian and U.S. markets will move far higher in next 10 years and beyond.
Buffett warned that Berkshire’s earnings may “swing widely because of the accounting regulations that govern the reporting of derivatives contracts,” but that “that these contracts will prove profitable over the 15- to 20-year periods they cover, even if we exclude the investment income we can expect to earn on the $4.9 billion that we hold.” Buffett did not disclose the exact size of this global bet, only remarking that “we’re talking billions and billions and billions and billions of dollars of these things.”

Posted by on May 6th, 2008 at 10:25 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.