Warren Buffett is famous for being a master of value investing. He looks for companies with strong, lasting advantages and buys their stocks when the price is right. But here’s something many investors don’t know: Buffett also uses options in a smart and strategic way. While some assume he avoids derivatives entirely, that’s far from the truth. His approach is careful and fits perfectly with his focus on managing risk and making the most of his capital. Buffett’s method shows how options can be a powerful tool to grow wealth without stepping away from solid investment principles.
Selling Put Options to Buy at the Right Price
One of Buffett’s go-to strategies is cash-secured put options writing. A put option gives the buyer the right to sell a stock at a specific price, known as the strike price, before the option expires. When Buffett sells a put, he’s agreeing to buy the stock at the strike price if its market price drops below that level. In exchange, he earns an upfront premium. This strategy allows him to target stocks he already wants to own but at more favorable prices. If the stock price stays above the strike price, the option expires worthless, and Berkshire Hathaway keeps the premium as pure profit.
A great example of this strategy happened in 1993 when Buffett wanted to buy more shares of Coca-Cola (KO). At the time, KO was trading at $40 per share, but Buffett thought $35 was a better price. Instead of buying shares outright, he sold put options with a $35 strike price and collected $7.5 million in premiums. This approach let him earn income while waiting for the stock to possibly fall to his preferred price. For Buffett, selling puts is never about speculation – it’s a thoughtful, calculated way to acquire great businesses at a discount.
Buffett’s Bold Move During the 2008 Financial Crisis
One of Warren Buffett’s most remarkable uses of options took place during the 2008 financial crisis. As described in his 2007 and 2008 shareholder letters, Buffett sold long-term put options on major stock indices, including the S&P 500, FTSE 100, Euro Stoxx 50, and Nikkei 225. These contracts, with expiration dates ranging from 2019 to 2028, allowed Berkshire Hathaway to collect a massive $4.5 billion in premiums upfront – an enormous sum that could be invested immediately.
In his 2007 shareholder letter, Buffett explained the logic behind these trades:
The second category of contracts involves various put options we have sold on four stock indices (…). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion. The ultimate value of these contracts will depend on the future level of the indices, some of which are outside the U.S. I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
By the end of 2008, the stock market had plunged, and the estimated liability of these contracts increased. Buffett explained the mechanics and risks in his 2008 letter:
Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019, and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black-Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date.
Buffett emphasized that the final outcome of these contracts depended on market conditions at the time of expiration, not interim fluctuations. He clarified:
One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates.
Even with significant market declines, he expected Berkshire to profit from the premiums and investments made with the cash upfront. This bold strategy demonstrated Buffett’s confidence in the long-term resilience of global markets, his ability to capitalize on volatility, and his skill in turning panic into opportunity.
Volatility as an Opportunity
Warren Buffett views market volatility not as a problem but as an opportunity to make smart investment decisions. His strategy thrives during turbulent times. In his 2008 shareholder letter, Buffett explained his perspective on market declines:
We enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
Furthermore, when volatility increases, option premiums rise, allowing to earn higher upfront payments when selling put options. These premiums provide immediate income and flexibility to reinvest while waiting for the contracts to expire.
By embracing volatility, Buffett aligns with his belief in the market’s long-term upward trajectory. While many panic during market downturns, he takes advantage of the fear, seeing it as an opportunity to buy into strong businesses or write lucrative options contracts. This patient, disciplined mindset turns volatility into a valuable tool for building wealth.
Managing Risk with a Cash-Rich Balance Sheet
One reason Warren Buffett can confidently sell put options is because Berkshire Hathaway maintains large cash reserves. This financial strength allows him to meet any obligations without the risk of liquidity problems. Many traders, however, could face a margin call if they sell puts without enough cash to back it up, especially if the market crashes.
In his 2007 letter to shareholders, Buffett highlighted that Berkshire’s strong capital position allows the company to stay opportunistic, while others might find themselves forced to sell or unable to act. This flexibility is a crucial part of his approach to risk management. It shows why having ample cash reserves is key to trading options successfully, helping to avoid being caught off guard when markets get volatile.
A Conservative Approach to Derivatives
Warren Buffett’s approach to derivatives, including options, is grounded in his careful, long-term philosophy. He only sells put options on businesses or indices he deeply understands and deems fairly valued. Unlike speculative traders, Buffett ensures the odds strongly favor him before acting.
Buffett has expressed concerns about derivatives, famously calling them “financial weapons of mass destruction” in 2002 due to their complexity and systemic risks. However, in his 2008 letter, he clarified that Berkshire’s contracts were thoughtfully selected, stating: “If we lose money on our derivatives, it will be my fault”.
Despite their risks, Buffett sees derivatives as tools that, when used responsibly, can serve long-term goals. His focus remains on deliberate, strategic decisions, avoiding the pitfalls of short-term speculation while managing risks with precision.
Key Lessons for Investors
Buffett’s approach to options provides practical guidance for investors aiming to refine their strategies:
- Sell Options, Don’t Speculate: Prioritize selling cash-secured put options over speculative trades like buying calls. This approach generates steady income and opens opportunities to acquire stocks at favorable prices.
- Align with Core Strategy: Use options only when they complement your long-term investment philosophy and involve stocks you genuinely want to own.
- Maintain Strong Cash Reserves: Always ensure you can meet obligations without overextending your portfolio. Keep position sizes small.
- Adopt a Long-Term Perspective: Long-dated options (LEAPs) suit patient investors by leveraging time decay and reducing short-term market noise.
Conclusion: Options as a Value-Adding Tool
Warren Buffett demonstrates that options can be a valuable addition to even the most conservative investment strategies. His approach highlights discipline, patience, and a clear alignment with long-term goals. By selling put options, Buffett leverages market volatility to secure favorable entry points while generating income. As he stated in his 1987 letter, “Risk comes from not knowing what you’re doing”. For investors willing to understand the nuances, Buffett’s methods showcase how options, when used judiciously, can enhance a value-driven approach and create lasting opportunities.