Warren Buffett's Options Trading Strategy

What if I told you that Warren Buffett, yes that one, is actually just an options trader in disguise? Actually, he’s not disguising anything since his entire strategy and philosophy is all publicly available and linked below. But, that the $5 billion dollar options trading strategy he is using right now has the exact same core methodologies that we use here at Option Alpha, i.e. option selling.

Unfortunately, this strategy and business setup is not commonly talked about in the media. Everyone ignores the 50,000 short put options he sold on KO or the 3-month short puts he sold before acquiring Burlington Northern Santa Fe. They are big trades that tell us a lot about the way he uses options but the media won’t cover those because it’s not “mainstream” enough to reach the masses. Lucky for you, we’re covering it today for you.

In today’s show, I’ll help you understand why his most profitable business, which grew from $41 billion to $88 billion, is the insurance business and how you can apply the same principles to your own investment portfolio. Plus, I’ll walk through his biggest options trade that occurred during the height of the 2008 market collapse in which he sold short put options on 4 major market indexes around the world. If this show is even remotely helpful today, please consider sharing or sending it to just one friend or colleague you think might benefit from listening.

Key Points from Today's Show:

Some of the biggest players in the world of investing, like Warren Buffet, are using the same types of strategies that we are using here at Option Alpha.
Warren Buffet describes derivatives as time bombs or weapons of mass destruction. Yet he trades them in a very big way — a $5 billion way, specifically with short premium strategies.
Understanding his philosophy on premium, cash flow, investment, and numbers is key to really understanding why he uses his specific strategies in the options trading space the way he does.
The float is all the insurance premiums that come in that can be invested before any claims or liabilities have to be paid out.
With Berkshire, Warren Buffet leverages the float to invest it for Berkshire’s benefit to generate significant investable income because of the assets it allows them to build up and hold — Their float has grown from $41 billion to $88 billion (2015 letter to shareholders).

Example:

If you take out an insurance policy on your car, you pay $500 a year for that care insurance. The insurance company takes in $500 of premium from you that they can then invest and use that float/premium to invest in anything they like. They take that in, knowing that at some point they might have to pay out some liabilities. However, they do not have to pay it out right away, so there is a floating cash/premium that they get to collect and use for their own investment decisions or allocations.

This same strategy can be applied to options trading, the idea of using the numbers and using the math to your own benefit.

Warren Buffet's Options Strategies:

1. Uses naked, short puts to lower the cost basis for purchasing stock or target companies that he wants to acquire.

Example:

In 1993, he wanted to lower the cost basis to purchase more shares of Coco-cola, ticker symbol KO. In April of 1993, he shorted 30,000 contracts of out of the money Coca-cola put options for $1.50 each. This is going to reduce the cost of owning Coca-cola if it ever drops, because he knows he wants to own the stock, and reduce the cost of ownership by $1.50. He then added 20,000 more contracts, shorting the put options again. He was paid $7.8 million in cash for Coca-Cola.

2. Sells short index put options when volatility is at its highest, knowing that volatility is the one factor that is overpriced all the time.

Using his insurance company, he collected money up front in option premiums knowing that implied volatility at the time, during 2008, was at it's highest level in record years.
He sold premium only when implied volatility was at it's highest, and spread the contract out over many years (15 to 20 year), collecting the premium so that money could be invested.

Example:

Berkshire has invested into their portfolio contracts that come due in 15 years, other in 30 years. Neither party can elect to settle early, so it is only the price on the final day that counts. Their contracts total $37.1 billion of notional values. Their first contracts come due on September 9th, 2019 and the last on January 4th, 2028. They have received premiums of $4.9 billion, money that they have invested as float. Meanwhile, they have paid nothing. Since all expiration dates are far in the future, then obviously they do not have to pay out any of this money until the final day.

Most people see too much of the long-term investor, buy and hold type of aspect of Warren Buffet, but it is not the full picture. There is a lot more behind his strategies that people do not understand.
The key is, Warren Buffet has done exactly what we say to do here at Option Alpha: sell over expensive options far out and collect that premium then play the numbers and probabilities.
Overall, when following Warren Buffet’s investment strategies, the key is to ”do what he does, not what he says he's going to do."

"Volatility is the unobservable expected volatility in the future, which is supposed to be or expected to be lower historically than the model suggests."