Use this strategy to build your wealth in the stock market
When most people think about Warren Buffett’s investing strategy, they think of buy and hold. Pick great companies and hold onto them forever.
While Buffett does have a reputation for holding onto companies for many years, that’s not the only way he’s built up his wealth.
Warren Buffett trades options from time to time to collect premiums while waiting for stocks he loves to hit certain price points.
Rather than buying options, Buffett sells options. Selling options turns you into the casino rather than the gambler.
When selling options, you have two choices: the covered call and the cash secured put. For a covered call, you already own 100 shares of the stock. You can sell a call and collect premium just for the stock sitting in your account.
If you sell a call for stock XYZ with a strike price of 50, you are only obligated to sell your 100 shares of XYZ stock if XYZ stock breaks past $100/share. However, if the stock stays under $100/share, you keep all of your shares and the premium.
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Even if you end up selling the shares, you will get appreciation along the way. If you bought XYZ stock at $95/share and are forced to sell it at $100/share, you get $5/share in addition to the premium.
This is a great strategy to reduce risk for your existing positions and collect extra income. Many investors use this strategy to boost their portfolios, but this isn’t the strategy Buffett used to make $7.5 million in under 5 minutes.
Years ago, Buffett sold puts for Coca Cola back when it was $39. Buffett loves Coca Cola stock, but he didn’t want to buy the shares at $39. Instead, he wanted to buy them for $35/share.
Rather than create a limit order that went through whenever Coca Cola’s price hit $35, Buffett decided to sell 50,000 Coca Cola puts with $35 strike prices.
Since each option is for 100 shares, Buffett’s 50,000 Coca Cola puts were a bid to buy 5 million Coca Cola shares at his desired $35 strike price.
These 50,000 put contracts provided a $1.50 premium for each share which resulted in an instant $7.5 million windfall.
You can immediately use the money you earn from premiums to invest in other stocks or pay off expenses once the money settles. In the meantime, you’ll get shares of your favorite stock at lower prices than what it’s currently trading for.
The only two risks of this strategy are this:
#1: The stock can go lower than $35 but you are still obligated to buy it. This isn’t a problem if you planned on buying the stock and holding it for the long-term anyway.
#2: The stock never hits your strike price. This isn’t entirely bad as you still get to keep all of your premiums and you can keep doing it all over again until the stock hits your desired price target.
Not everyone can sell 50,000 put contracts of Coca Cola. Cash secured puts require that you have enough cash upfront to make the purchase should you be obligated to buy the shares.
At a $35 strike price, a single cash secured put contract would require you having $3,500 in liquid cash available for the trade. You don’t get access to this cash again until the put is exercised, gets expired, or you decide to buy the same put to close out the contract.
Even so, a single Coca Cola put would have resulted in $150 in premiums which is good for an instant 4.3% gain and the possibility of buying Coca Cola stock $4 below the current price. That 4.3% gain is more than Coca Cola’s dividend yield, and you receive the money upfront rather than waiting for 4 quarterly dividend payments.
Buffett frequently uses options and other derivatives to build up his portfolio. While the majority of his strategy is buy and hold, derivatives can allow for otherworldly gains or a steady stream of passive income that protects you from some of the potential downside.
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