This is last part of the series on the “4 Market Strategies”, it is based on the news article featured when we were speaking in Malaysia.
You can read the previous post here:
This final part, we will be talking about …
“#4: Writing Options
Another strategy adopted by Buffett himself, which is unknown to even many of his fans.
Options are traded just like stocks. As there are stock exchanges, there are also option exchanges, with the most famous one being Chicago Board of Options Exchange (CBOE).
I am not sure if you have any experience with options or have heard anything about it. As a fundamental investor, I will write options, on a monthly (or sometimes even weekly) basis to collect cash from the market. This cash is known as premium.
To put it simply, when we write options, we are selling a piece of contract that entails specific promises. When we write a Call Option, we are promising to sell our stocks and when we write a Put Option, we are promising to buy stocks. The other party in the options exchange buys the options we write and pay us cash (known as premium, like paying insurance premium).
How does this whole thing work? Let me give you a classic Buffett style example. For example, I analyzed a stock, ABC and want to buy it at $10. But the stock is trading at $12, so what should I do? For disciplined investors, the answer is to wait for it to drop to $10. But because I am armed with strategy #4, writing of options, I can go to the options exchange and write a “ABC $10 PUT”.
This means I am promising to buy ABC at $10. In return for this promise, I get some cash and this promise usually last for one month. Wait a minute, do you see that? I am getting paid to promise to buy the stock I want at the price I want.
Now, what happens if by the end of 1 month?
One scenario could be that the option expires worthless. This means, the other party does not exercise his rights to make me fuifil my promise of buying the stock. If this happens, I do not get any stocks but would have already collected premium upfront. In this scenario, I can repeatedly sell ABC $10 Puts until it gets exercised.
The 2nd scenario could be that the other party exercises his rights and I am asked to buy ABC at $10, which is what I wanted to do in the first place. So on top of getting the stocks, I also already collected premium upfront. And now that I am holding onto the stock, I can write CALL options which means I promise to sell my stocks, and continue to collect premium for another month.
So here we have the 4 strategies and I do hope you can see that each of them are applicable to fundamental investor, the Buffett way. So depending on market conditions, or individual preferences, you have the choice of making profits using any of the 4 strategies.”
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Mind Kinesis Research Team