by Andy Tanner
This is a chart of the 2008 IYR, the Dow Jones Real Estate Index. On the top it shows how the value of real estate dropped with the meltdown in 2008. Virtually all real estate lost value during this time period.
By comparison, the bottom half of the chart shows how during the same time period a positive cash flow of $500 from your real estate income totals $6,000 in that year. This is a prime example of a really good investment: even though the underlying value sunk, your wealth continued to rise through cash flow. This is the sign of a true investor —when he or she is still making bank deposits from positive cash flow—even when the underlying asset decreases in value.
This points to a very important concept for investors. There are sometimes two sides to an investment: the capital-gain side, and the cash-flow side. As we have shown, the capital gain side of an investment is speculative. You have no control over whether the market goes up or down, so you have no control over the value of the investment. That’s one of the reasons why I’m not convinced mutual funds or 401(k) plans are always all they’re cracked up to be—you have no control over what will happen to the market during the time of your investment.
With the cash flow side, however, we’ve shown that you have almost total control over the time decay. The example of the rental house showed that you can deposit substantial amounts of money in your account from rent, even while the value of that house is dropping. This is what I call a good investment, because it pays you money no matter how the market is affecting the value of the underlying asset.
Cash Flow from Selling a Covered Call Option
Now let’s shift from real estate examples into actual ways we can use this cash-flow strategy to make real money with options in the markets. This is especially useful in difficult markets where buy-and-hold investors are suffering from crazy up and down conditions.
As a quick reminder, an option is a promise by someone to sell a certain stock at an agreed-upon price until a certain date. In return for this promise, he receives a premium as income. This premium is not just based on the movement of the stock price, but on the movement of time.
As a teacher, I’ve seen how hard it is for many people to grasp the ideas of time decay and cash flow in the stock market. I know it certainly took some time for the light to come on for me. So a few years ago I made a small trade just for the purpose of teaching. I chose to hold a stock for a long time regardless of the fluctuation in its value, just as real many estate investors hold their rental property regardless of fluctuations in the price.
To show my students the similarities between stock investors selling options and real estate investors collecting rent, I bought an ETF and held it for a year. It’s not my usual practice to hold stocks that long, let alone buy anything that is heading down. But my goal was to prove that it is possible for a falling stock to generate income just as a house that is declining in value can still generate rent. This is not hypothetical. This is an actual series of very small trades I did during the subprime meltdown of 2008.
My first step was to buy 500 shares of an exchange-traded fund called the Spyder Trust (SPY), which mimics the S&P 500. I was going to hold it for a year, come what may. After buying it, I watched it closely to see if it going up, down, or sideways.
Since I owned the shares, I was positioned to be the seller of an option instead of the option buyer. (If you think back to our earlier example, it was as if I were the tailor who was selling the option to layaway the $1,000 tuxedo.)
After buying 500 shares of SPY, I then sold five one-month call option contracts on the SPY at a premium of $2.15. I promised the buyer that he could buy the Spy for $154 (which was more than I paid for the SPY) at any time before the expiration date.
The stock could now go in one of three directions.
•If the stock went up and he wanted to buy at $154, I would have made money since I bought it at a lower price.
•If the stock went sideways and stayed below $154, the option would expire worthless, and I would have kept my $2.15 (multiplied by 500) premium in cash flow. This is just like a house where the value remains the same. I would still be getting that rent as income.
•If the stock went down, the option would expire worthless, and I would keep my $2.15 premium (multiplied by 500).
You can see that I have set up a scenario where no matter what happened, I would generate income from an asset I had purchased. To me, this was a very attractive way to generate my own income. I bought 500 shares and then I sold those options. That’s five one-month contracts of 100 shares, each at a premium of $2.15. When you do the math, you’ll see that I created an income of $1,075, less the brokerage fee, so I received a net $1,061.
Even though the stock was falling in value, I continued to sell options on my shares of the SPY month in and month out for a whole year. Why? Because I am not much different than a real estate investor who sees the value of his rental house decline for a season. He is receiving his rent each month and I am also receiving my income every month from options. This income flows in even as we both wait for the underlying value of the assets to bounce back. I get to keep the stock while the time decay is bringing in cash.
This shows you how simple it can be to own stock assets and generate an income from them.
True cash flow investing is when the underlying asset, whether it’s a house or stock, can go down but cash flow stays fairly consistent.
Covered Options
You may have noticed that I talked previously about a covered call option. This is another new term for you to learn. When I sold those 5 call options on the SPY, I promised the buyers that they could buy the shares from me for $154. If the buyers wanted to buy the shares, I owned the shares and would have been able to sell them. That is, I would have been able to deliver in the case of a call option because I actually owned the shares. I was covered by the stock I owned. I could keep my promise.
Let’s suppose that I want to sell a put option. I promise the buyer of this put option that he can sell stock to me at the strike price. I have to be able to deliver in this case, which I do by having cash in the trade account. I am covered in the case of a put option by having enough cash there to buy the stock as I promised.
When selling options, either call options or put options, it’s important to be covered so that you can deliver. You don’t want to approach any of these strategies naked—which is the technical term for not possessing the cash or underlying stock to deliver when needed. Selling options naked is a very aggressive strategy and only for the most advanced traders. As a foundation strategy, we should keep all the trades small, keep them very controlled, and keep them covered.
How Warren Buffett Generates Huge Profits with Options
If you follow the world of investing at all, you are probably familiar with the famous investor Warren Buffett. Buffett sells a lot of options. Why? Because he understands how time decay works to the benefit of the option seller. Options provide him with a great tool to generate additional income for his holding company.
As you know, a put option has a time value and an expiration date. The person who buys the put option has the option of selling something at an agreed upon price before an expiration date. This put option is like an insurance policy. For example, if you own a stock that’s at $100 and you buy a put option to sell it at $100 and it drops to zero, you’re insured. The guy who sold you the option has to buy that stock at $100.
Put options can also be a very useful way to buy something you want. Here’s how it works: when you sell a put option, you are making a promise to buy the stock at a certain price before expiration. It is important to remember this key point from the last chapter:
So rather than just buying a stock, you can earn extra cash by promising to buy the stock. This is a method Warren Buffett has used for years.
Let’s pretend that Warren Buffett wants to increase his holdings in Coca-Cola (KO).
Let’s say that Coca-Cola stock is trading at $39 per share. Buffett cond
ucts a fundamental analysis and has decided that he is willing to buy at $35. Let’s say he sells 5 million put options with a $35 strike price for a premium of $1.50. That would be an income of $7.5 million. Now let’s look at three outcome possibilities: up, down and sideways. If Coke shares fell below $35, the option buyer would then sell their shares to Buffett and he would keep his promise to buy at $35. Remember that $35 was the price he wanted anyway! If the share price of Coke climbed instead, Buffett would still be happy with the fact that he collected a $1.50 option premium ($7.5 million). And of course the same would be true if the stock held steady at $39.
Let’s dissect this story in terms of what we have learned about investing so far:
In investing circles, Buffett is known as a fundamental anaylst. After doing this basic analysis, perhaps he thinks, “At $39 the stock is a little steep, but I would be interested if it got down to $35.” Based on his own criteria, he sets a target at $35 at which point he is willing to buy that stock.
Instead of just waiting to see what will happen, Buffett decides to profit from the situation. So he writes (sells) 5 million put options. What this means is that Warren Buffett has made a promise to buy 5 million shares from the people or person who has purchased this contact from him.
For this trade, Buffett has a $35 strike price with a premium of $1.50. This means he has promised to buy the shares at a price of $35 to the investors who pay him a premium of $1.50 per share.
Most people have no idea what this story means. But with the brief education you have received so far in this book, you can fully understand what Buffett is doing and you can appreciate the strategy he has employed to make a profit no matter what happens to the actual price of Coke.
You might be wondering why anyone would buy the put option to sell the shares at $35. For investors who currently own the shares, they are looking at these options as an insurance opportunity. Perhaps they own the shares, and they are aware there is a possibility that the shares may go down. That’s why they might be willing to pay a premium in order to have the option of selling those shares at $35 to mitigate any situation where the stock might suddenly drop even lower. They may have originally bought the shares for under $35, so they might be quite happy to have that insured as their selling price if the shares go down, in order to lock in their profit.
In this scenario, the following could happen:
Share Price Drops—The shares could go down to $35 or below and the people who bought the put options could “put” or sell their shares to Buffett. Buffett would be forced to buy 5 million shares because he made a promise to buy there. But this wouldn’t worry him. If the shares had been at $35 today, he would have bought them. He believes $35 is a good value. If the price then went down below $35, it wouldn’t bother him because he’s often investing for the long term. He was willing to take the risk of holding the shares anyway if the price goes down.
Share Price Rises—If the shares rise, it wouldn’t bother him either because he isn’t interested in them at a valuation above $35. But he would be happy enough because he would collect $7.5 million in premium, just to watch it advance higher than the $35 he was prepared to spend.
Share Price Stays the Same—Similar to the ‘price rises’ scenario, Buffett isn’t interested in anything above $35. But he would still pocket the $7.5 million in premiums.
No matter what happens, Buffett will receive the premium from this trade. This is a cash-flow strategy that Buffett and other educated investors use all the time, not just with stocks but with other derivatives as well. It’s a sharp contrast to the average, less-educated 401(k) investor.
As I mentioned, Buffett has collected a premium from options as a means to generate income for a long time. He gets paid to make promises. In his car insurance business he collects premiums from people who accept his promises to pay for damages if something bad happens to their cars. But selling put options at a strike price lower than today’s stock price means he gets paid upfront for making a promise to buy things that he wants to buy anyway. And by structuring deals intelligently, he also gets to buy what he wants later at a lower price than what it’s selling for today. And by selling calls with a strike price that is higher than today’s price, he gets paid to sell something he wants to sell anyway at a higher price than today’s price.
Karen Richardson of the Wall Street Journal highlighted the magnitude of Buffett’s income from premiums in a story titled “Buffett Scores with Derivatives.” In that article, she said:
Billionaire insurance salesman Warren Buffett has been selling more derivatives recently.
This year, Berkshire Hathaway Incorporated, the Omaha, Nebraska holding company headed by Mr. Buffett, has collected premiums of about $2.5 billion from selling insurance on stock indexes and bonds in the form of derivative contracts which guarantee payment to the buyer in the event of a specific loss in an underlying entity of the contracts.
It’s easy to be impressed by these large numbers. Perhaps some investors may even be intimidated and think that only big players such as Buffett can profit from these strategies. But smaller investors can easily use these same strategies in more scaled-down situations. In fact, I have used this same strategy of selling options to acquire certain stocks that I want to hold for a long time. All it takes is an understanding of how it works and if it fits your investing strategy.
One example of how I use this in my own positioning is with an exchange-traded fund that tracks the price of commodities such as precious metals such as silver (SLV)) and corn (CORN). As an educator, I refuse to make predictions or recommendations. I do not give people financial advice. I will say that I am very concerned with the sovereign fundamentals around the world, as well as the fiscal and monetary policies that shape them.
As a result, in my own holdings I like the idea of hedging against any devaluing of the dollar and I like to receive income by selling put options that allow me to buy exchange-traded funds that track commodities. I own some gold as a hedge, and also some exchange-traded funds that mimic precious metals. There are many people who debate over which is better: bullion or ETFs. In my opinion, making a blanket statement that one is better than the other is a mistake. Why? Because every investor’s situation is different. One of the reasons I like the idea of taking a position in an ETF that tracks commodities is that I can acquire ownership of the ETF using the same strategies we discussed in the Warren Buffett example above.
Let’s say that I would like to own some shares of SLV and I want to hold them long term as a hedge against the U.S. dollar. Rather than just going out and purchasing the shares, I could sell put options at a strike price that is slightly lower than the current price of the ETF today. By doing so, I place myself in a position similar to Warren Buffett’s in the example we just covered.
If the price of SLV goes up before expiration, I’m happy to get paid for watching it go there. It’s true that if I purchased SLV and it goes up I might have received a large capital gain, but that is beyond my control. I really can’t determine, exactly, where it may or might not go—even with the best technical analysis tools. In essence, I am happy with a bird in the hand rather than going for two in the bush, knowing that I can collect the premium upfront immediately.
To review:
•If the price of SLV remains the same, I’m just as happy to get paid for watching it stay there.
•If the price of SLV goes down below the strike price of my option, I’ll be purchasing my shares of SLV at the price I determined at the outset of the agreement. It’s true that I might be purchasing my shares at a higher price than the market price of SLV at expiration. But the reality is that if I just bought the stock directly, that’s a risk I was going to take anyway. Since I believe that SLV will rise in the long-term based on sovereign fundamentals, it’s really no more downside risk than I would have been exposed to had I simply bought the shares initially.
•So I’m likely to be quite happy with what SLV does during the course of
the option contract. You can see why selling put options is one of my favorite ways to generate income.
In all of these cases I’m free to sell options on the SLV again the following month. If SLV remains the same or goes up, the options will expire worthless and I will keep the premium. That leaves me free with cash that can cover the promises I will make with new put contracts for the next month. If the stock goes down and the stock is assigned to me, I can sell covered call options on the ETF to generate income should I choose to sell SLV at a higher price later on.
It’s quite common that investors can get 2 to 3 percent return on their money for selling one month put options. For example, if you have $50,000 sitting in a bank account, you would be fortunate to earn much interest these days. By holding your money in cash, your main risk is that the value of your cash will go down. However, if you’re willing to convert that $50,000 into silver (SLV shares) at a set price, then you could receive a premium of say $1,000 for a put option. That’s a 2 percent return in a month, and your main risk is that the price of silver will go down. How would you feel if your employer were to say that the company policy was going to change and he was going to pay you in silver instead of in dollars? It’s an interesting thing to think about.
I want to reiterate that I’m not suggesting people go out and buy silver or gold. Your financial statement is probably different than mine, and your goals, age, and tolerance for risk might be different. You might have more or less financial education than I do as well.
When it comes to collecting premiums, the essence of the lesson on covered calls and cash covered puts is you can get paid to buy the things you want to buy, and you can get paid to sell the things you want to sell.