How Buffett Made $7.5 Million By Failing

Brad Briggs's picture

Thursday, June 15, 2017 - 12:00am

by Brad Briggs

Did you know that for more than 30 years, Warren Buffett has used a special tool that lets him buy high-quality stocks for up to 10% off market price? Even more amazing, if the tool "fails" to get him a bargain, it will pay him cash for his trouble anyway. 

Best of all, any investor -- not just billionaires -- can use it.

So what is this bargain-hunting, income-generating tool that's served Buffett well all these years? 

It's called the stock option. And while around 75% of "buy and hold" investors have never used stock options before, according to a TD Ameritrade survey, it's been the billionaire's secret weapon for reducing exposure to market volatility, preserving capital and even generating income.


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Stock Options: How Buffett Pocketed $7.5 Million By Failing
The King of Buy and Hold first bought stock in Coca-Cola (NYSE: KO) in 1988. At the time, Buffett said he expected to hang on to the shares of this "outstanding business" for "a long time." Today, with more than $15 billion invested in 400 million shares, Coca-Cola remains one of Buffett's top five largest holdings.

But Buffett is not the type of investor who'll buy shares of a favored company at just any price -- not even Coca-Cola.

The world's greatest investor is a bargain hunter. If Buffett likes the company, but believes its share price is too high, then he may wait until the market "cooperates" by correcting lower before he'll buy shares.

And that's where options come into play.

In April 1993, Buffett wanted to buy more shares of his beloved Coca-Cola stock (as written in Chapter 34 of the book Of Permanent Value: The Story of Warren Buffett by Andrew Kilpatrick). 

The problem was, Coca-Cola was trading at about $39 a share (before share splits) -- a price he regarded as too expensive at the time. 

But did the self-made billionaire let his cash sit idle while waiting for a downturn? Not a chance. Buffett used an options strategy that in this case earned him income of $7.5 million -- all without buying or selling a single share. 

Here's how he did it. After deciding $35 would be a reasonable price for Coca-Cola, Buffett wrote put option contracts with a $35 strike price for the 5 million shares he wanted to buy. 

Side note: A put is an option contract that gives the owner the right, but not the obligation, to sell 100 shares of the underlying stock at a specified price (which is known as the "strike price" -- in this case $35). 

In exchange for writing the puts, Buffett in this instance received a "premium" of $1.50 a share from the buyers of the puts. In other words, he was given $7.5 million in cash up front ($1.50 per share X 5 million shares = $7.5 million) for his trouble in writing the contracts.

From here, two scenarios could have played out for Buffett:

1. If Coca-Cola's stock fell below $35 per share before the option contracts expired, the buyers of the options that Buffett wrote would exercise those options and sell their shares to him. That way, Buffett would be obligated to buy Coca-Cola at $35, which is precisely what he wanted to do in the first place. He would get the shares for 10% off.

2. If Coca-Cola's stock instead rose during the life of the contract, the owners of the options wouldn't exercise them. They'd let them expire and Buffett would simply pocket the $7.5 million premium income ($1.50 X 5 million shares). 

The second scenario is just what happened -- Buffett received $7.5 million in instant income (the equivalent of a 3.8% yield -- $1.50 for each $39 share -- over a matter of weeks) for the opportunity to buy shares of Coca-Cola at $35 each. 

The Takeaway
Yes, Buffett could have ignored options and simply waited for Coca-Cola to fall in price to $35 before he bought them -- a strategy that many ordinary investors do every day. 

But by using put option contracts, Buffett sets himself up for as close to a win-win strategy as an investor can get. He either gets to buy a quality stock at the discounted price he wants, or, he gets to pocket the premium income as soon as he writes the put contracts.

The best part is, you can set yourself up for a win-win in your own investing too! You don't have to actually be a billionaire guru to benefit from using an options strategy (in this case, put selling) -- you just have to act like one. 

Want to learn more? My friend Amber Hestla-Barnhart, an options strategist and military veteran, has just finished a report that details who should (and shouldn't) try these strategies and answers the most commonly asked questions about boosting income with options. If you'd like to learn more about generating income using options, then simply click here.


 

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Brad Briggs does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.