Investing with Buffett Using Put Options (Beginner's Guide to Put Options)

What’s the deal with option buyers and sellers?

Many people are familiar with buying stocks, but may not understand the role of a seller. Let me explain the roles of buyers and sellers in options trading. An option contract is an agreement in the financial markets (a binding agreement). The buyer pays to obtain the right to buy or sell a stock at a set price, and they can choose whether or not to exercise this right.

The seller, on the other hand, is the one receiving payment and is therefore obligated to fulfill the agreement. This obligation may involve buying the stock at the agreed price or selling their holdings at a specific price, depending on whether it’s a call or put option.

For a put option, the buyer pays for the right to sell the stock at an agreed-upon price within a certain period. Today, let’s discuss selling put options, which means that as the seller, you’re ready to potentially buy the stock during the option’s life if necessary.

For example, in a recent 13F filing, Berkshire Hathaway reported trimming its holdings in Apple, Bank of America, Ulta Beauty, Sirius XM, and Charter Communications during the third quarter, while adding new holdings in Domino's Pizza and Pool Corp, a pool supply distributor. By September 30, Berkshire held 1.28 million shares of Domino's Pizza worth about $549 million, which led to a post-market surge in Domino’s stock of over 7%.

Using Domino's as an example to illustrate selling a put option:

Domino's Pizza’s closing price was $435.97, and an investor could sell a put option expiring on December 20 with a strike price of $430, earning a premium of $1,170 to take a bullish stance on Domino’s.

1. Meaning of Selling a Put Option
   Selling a put option means you, as the seller, agree to buy the underlying asset (such as a stock) at $430 if the buyer decides to exercise the option. In return, you earn a premium of $1,170.

2. Profit and Risk Analysis

   • Current Price and Put Option: With Domino’s current price at $435.97, you plan to sell a put option with a strike price of $430, expiring December 20.

   • Premium Income: By selling this put option, you receive $1,170 in premium, representing your maximum profit, provided the stock price stays above $430 by the expiration date.

   • Scenario Analysis:

     • Stock Price Above $430: The buyer won’t exercise the option, and you keep the full premium with limited risk from stock price fluctuations.

     • Stock Price Below $430: The buyer may exercise the option, obligating you to buy Domino’s stock at $430. After factoring in the premium, your effective purchase price is $418.30. If the stock price drops well below $418.30, there’s a risk of loss.

This strategy is suitable for investors who are optimistic about Domino’s stock price and willing to buy the stock at a lower price. If you’d like to acquire the stock below the current price and earn additional income through the premium, this can be a reasonable approach. However, ensure you understand the potential risks associated with this position.

3. Applicable Situations

   • You have a neutral to bullish outlook on the underlying asset.

   • You believe the asset price won’t fall below $430.

   • You aim to earn income through the premium while being open to holding the underlying asset.

It’s essential to note that the risk of selling put options could lead to significant losses, so it’s suitable for investors with a certain level of risk tolerance.

Advanced Strategies for Selling Put Options

1. Choosing the Right Asset

   • Stable Stocks or Indices: Select stocks or indices with relatively low volatility and strong fundamentals to reduce the risk of falling below the strike price.

   • Assets You’re Willing to Own: Choose stocks you’re comfortable holding within a certain price range. That way, even if the put option is exercised, you won’t mind buying the stock at the strike price.

2. Selecting the Strike Price and Expiration Date

   • Strike Price: Usually, choose a strike price slightly below the current market price. If the market price remains stable or rises, the put option won’t be exercised, allowing you to keep the premium; if it drops, you can buy at a favorable price.

   • Short Expiration Date: Opt for a shorter expiration date (e.g., 1-3 months) to capture premium income faster. Shorter-term options lose time value more quickly, enabling you to lock in profits sooner.

3. Taking Advantage of Market Volatility

   • Sell During High Volatility: Premiums are typically higher in times of high volatility. Selling put options during these periods can lead to higher premium income, especially when market expectations for volatility are set to decrease.

4. Diversifying Risk

   • Sell Multiple Strike Prices: You can sell put options at different strike prices to spread out your risk. For instance, on the same underlying asset, you could sell puts with strike prices of $80 and $85. This approach balances profit and risk through varied strike prices.

   • Diversify Underlying Assets: Avoid concentrating all your put options on one asset. By spreading investments across various assets, you reduce the risk associated with a single asset’s price drop.