A lot of people may not know this, but Warren Buffett has made millions by selling put options on major stock indices. We’ve written about this before, most notably by telling the story of how Buffett sold put options on well-known Buffett favorites like Coca-Cola (NYSE: KO).

So why would the Oracle of Omaha mess around with options? After all, he once famously called derivatives “financial weapons of mass destruction.” And options are a type of derivative…

It may have something to do with the fact that selling puts is unlike many of the riskier options strategies out there. In fact, it resembles one of Buffett’s all-time favorite businesses: insurance.

As you may know, the insurance business enabled Buffett to fuel his major stock purchases over the years. By taking in premiums from policyholders who want to protect themselves against an unfortunate event (however unlikely), Buffett & Co. are free to invest this capital unless and until a payout on a claim is needed.

Selling Insurance To Fearful Investors

This isn’t all that different from selling puts. Buffett is collecting income by essentially selling insurance contracts to other investors. This also allows the world’s most famous value investor the chance to purchase stocks at the price he wants to pay — not what the market is asking.

This is what makes selling puts an ideal strategy for value investors.

Selling puts bears a striking resemblance to the insurance business in that it provides investors a certain amount of protection. In return, we receive compensation in the form of the options premium. This is the cash that we receive when selling the put contracts.

To understand how this trade works, consider how the put buyer views the transaction. By purchasing a put option, the buyer now has the “option” to sell us 100 shares of the underlying stock at the designated strike price.

We, the put sellers, are obligated to buy the stock should the owner of the put contract decide to sell it. No matter how far the stock drops. So, for all intents and purposes, the buyer of the put contract has insured himself against a substantial loss.

Always Buying At A Discount

For put sellers, we set up a trade that results in potentially buying the stock at a discount to the current price. This is why the put-selling strategy is particularly appropriate for value investors. (It’s also why we recommend selling puts on stocks you wouldn’t mind owning.)

As an example, let’s say there is a stock trading near $38.50. We’re interested in buying, but only if we can purchase shares below $35.

To have the chance to buy shares at a discount, we sell a put with a strike price of $36. Let’s say the put expires eight months from now for $1.30. If the stock is below $36 when the puts expire, we are obligated to buy shares at $36.

Of course, this price is above the $35 level we were willing to pay. But keep in mind that we received $1.30 for selling these puts in the first place. So our net cost for buying the stock is actually $34.70.

(Note: This strategy can generate income in a regular taxable brokerage account. It’s also offered for IRA accounts by most brokerages. Remember that you’ll need to set enough capital aside to purchase the stock if the put contract is exercised.)

Bringing It All Together

By approaching put-selling trades this way, we have the advantage. If the stock does not fall below the strike price before expiration, we get to keep the premium free and clear. Again, this is much in the same way an insurance provider gets paid for insuring property that never gets damaged. If it does fall below the strike price, we get to purchase the stock at a discount to the original price. That’s where the value approach comes into play.

If you think about it this way, it’s no wonder Buffett has used this strategy. If you consider yourself a value investor at heart, this may help to reframe and understand the appeal of selling put options. (Plus, the extra income always helps…)

So if you have a list of stocks that you would like to own at better prices, this strategy may be perfect for you.

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