OAP 060: Warren Buffett’s $5 Billion Dollar Options Trading Strategy That Everyone Ignores

Download The "Ultimate" Options Strategy Guide

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).

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.

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.

Warren Buffett Options

2. Sells short index put options when volatility is at it’s 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.

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."

2015 Letter: http://www.berkshirehathaway.com/letters/2015ltr.pdf
Q2 2016 filing: http://www.berkshirehathaway.com/qtrly/2ndqtr16.pdf

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy ?

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Dan

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week's question comes from Dan who asks: If we know that implied volatility overstates realized volatility over the course of time, what are some underlying’s that overstate this more than others? Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our short call strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to filter quickly and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

Thank You for Listening!

I'm humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you'd like to hear me cover, just add your thoughts below in the comment section.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.