In a Warren Buffett use simple options strategies to
generate millions in extra income.
And while not every investor can make a cool million or two
using this simple strategy, it is possible to generate a nice bit
of extra income -- and with very little risk.
For more on options trading and income, I'm turning to Amber
Hestla, options strategist at ProfitableTrading.com, a
StreetAuthority sister site.
(Note: To receive a free report from Amber that addresses some
of the most commonly asked questions about generating income with
What was Buffett trying to gain from his options strategy? [See: "
The Difference Between Warren Buffett and You
Buffett seems to want two things in life -- high levels ofcash flow
and value-pricedstocks . He did the math on
and saw that it was close to a price he was willing to pay. Most
investorswill simply buy when price are "close enough" to what they
want to pay, but most people don't get the kind of results Buffett
does. He never loses his head in themarket , and Buffett has
written in his annual reports that he never pays even a penny more
than he thinks astock is worth. Sellingputs lets you set the exact
price that you will pay, as you noted in the example above.
Selling puts also generates income. I target 1% or 2% a month as
the minimum on my trades, although I often find trades that deliver
two or three times as much income. Even with billions of dollars at
his disposal, Buffett probably has more ideas thanmoney at times.
In this example, Buffett generated $7.5 million in income by
selling puts and was able toput that amount into otherinvestments .
Knowing his track record, that money could be worth more than $100
million by now since his average gains are nearly 20% a year.
Selling puts allows us to share Buffett's goals and avoid
overpaying for stocks we want to buy while increasing current
How can investors reduce the risks associated with selling
The best way to reduce risk is to only sell puts on solid companies
you want to own. If you follow this one rule, you're ahead of 99%
of options traders.
When you sell a put on a solid performer, you're basically
betting that a great company won't fall to fire-sale prices in a
short period of time. You receive instant income (known as a
premium, as you explain above) from the buyer of theoption in
return. If theshares remain above what you determine is your
dirt-cheap level, you'll keep the premium as 100% profit and never
buy one share.
Once in a while, however, you may have to buy the shares. But
that's not necessarily a bad thing -- after all, you'll be getting
a great deal on a stock you'd want to own anyway. The premium you
received when you sold the put lowers yourcost basis even further.
Plus, as you get more comfortable with options, you can then turn
around and collect even more income from the stock using a
different options strategy.
What types of stocks do you consider when searching for options
I mostly sell puts on inexpensive blue-chip stocks that are in an
uptrend. Most pay dividends, but they don't have to for me to earn
income on them. These kinds of stocks make great long-term
investments and are perfect for my options strategy.
Just about everyblue-chip stock is "optionable," meaning I can
buy and sell options on the stock. It's also easier to get the
price I want since their options tend to be moreliquid .Liquidity
is one of the ways I reduce risk because that lowers trading costs
and ensures that there will always be a buyer when it's time to
Blue chips are also less risky to own than lesser-known
small-cap companies. The chance of a blue-chip company going
intobankruptcy overnight is small. That does happen, but it tends
to be a process that unfolds over several months. By using
short-term options I have very little risk that a stock will fall
to zero in the time I am trading it. I also reduce risk by buying
stocks that are going up. Bad things rarely happen to large,
well-managed companies when their stock price isundervalued and
rising. There were many opportunities to get out of big banks
during the 2008 financial crisis and traders who ignored the
trend-reversal lost small fortunes. I avoid that risk by avoiding
stocks that are in clear downtrends.
As I mentioned before, I may be obligated to buy a stock from
time to time. That's why I generally sell puts on stocks that pay
dividends; it ensures that if I do buy the stock I continue to
enjoy steady income. It's also why I tend to use lower-priced
stocks. If I were to sell puts on
, I would need to be ready to spend more than $50,000 to buy 100
shares of the stock. Apple is a great company, but it would be
impossible to diversify a small account if I put that much money
into a single position.
Can you give me a step-by-step example of how to earn income
Sure, let's look at an example using one of my favorite
Phillips 66 (
is the second-largest independent oil refiner in the country. It's
also one of the largest pipeline operators, with 15,000 miles of
pipelines responsible for moving oil from fields in remote
locations to refineries. It uses its 10,000 service stations
throughout the country to deliver gasoline directly to
PSX is avalue stock trading with a price-to-earnings (P/E )
ratio of less than 8. Earnings are expected to grow steadily at
about 5% a year. The company has more than $4.4 billion incash and
cash flow from operations of more than $5.7 billion a year. PSX
seems to have more than enough cash tofund its operations, expand
and increase itsdividend . For now, the company is using about 12%
of itsearnings to cover the dividend payments. That's well below
the averagepayout ratio of about 30%, so PSX could more than double
its dividend in the next few years.
Needless to say, this is a company I'm more than comfortable
owning. But rather than buying PSX outright, I can sell puts and
earn instant income. And if the shares move lower, I'll get the
chance to buy shares at a lower price.
Let's use the
Feb $48 puts at $1.15
as an example. That's a put that expires in February that pays
sellers a $1.15 per-share premium, or $115 per contract. If shares
of PSX trade below $48 a share, we'll be shareholders at a cost
basis of $46.85 a share ($48.00 - $1.15, our premium).
(Note: Shares of PSX have moved higher since this interview was
published. Do not attempt to make this trade.)
The $115 instant income is ours to keep no matter what. If
shares stay above $48 during the next five weeks, the options will
expire worthless and we won't buy one share of PSX. Mostbrokers
will require a smallmargin deposit of about $960 when you make this
trade. If the option does expire worthless, we get a 12% return on
that deposit...in five weeks.
Here are two major risks in this trade:
- PSX could fall below the $48strike price . If it does, we may
have to buy shares at a price that's above currentmarket price . We
minimized that risk by selling options on undervalued stocks with a
- The stock price could rise significantly, and we'll miss out
on some of the gains. This does not bother me much because the
premium received when we sold the put, $115 per contract, is a
solid 12% return for a five-week period, and we'll have another
chance to generate income by selling more puts when the option
In other words, the worst case is buying PSX at $46.85, a 7.6%
discount to current prices. We'd own shares at a dirt-cheap P/E of
about 7, and we'd generate additional income using covered
What do investors need to know before they can start selling
options for income?
Amber: They will probably need tocall theirbroker if it's their
first time selling options.
Almost all brokers allow options trading, but there's a catch in
that you might need to request approval first. This can be done
with a form that asks questions about your income andinvestment
A few brokers require minimum account sizes. That being said, I
don't recommend that investors with less than $15,000 in their
account sell options. As I mentioned earlier, there's a chance
you'll have to buy shares when you sell puts. And for eachput
option contract sold, you could be required to buy 100 shares of
the company. This combination can make it risky for investors with
For example, let's say you have an account with $10,000 and you
sell a put with a $25 strike price. In most cases, the options will
expire worthless and the trade ends there. But if you're "put" the
stock, you'll be required to buy $2,500 worth of shares, 25% of a
$10,000 portfolio. Even if you love the stock, that's too large a
position size (as a percent of the portfolio) for one
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