In our previous article we said that the market is still overvalued and you can now expect 6% a year from the stock market in the coming years. To expect a higher return, you need to hold some cash and wait until the prices of the stocks you want to buy decline to the level you want to pay. We further estimated that for an annual return of 12%, the market needs to be about a third lower than it is now. The waiting is frustrating. It is more frustrating than during any of the previous over valued markets, such as 2000 and 2007. In those years you could buy bank CDs or Treasury bonds that yielded more than 5%. But now you have nothing to invest. Cash yields close to nothing. Everything from bonds to gold seems to be too pricy to justify the risk. In the meantime, your dollar is destined to devalue, thanks to the politicians in Washington.
What can you do to your cash?
If you are Warren Buffett, you can put your cash in the deal that he just struck with Bank of America (BAC, Financial). You can buy the preferred stocks that yield more than 6% and get stock purchase warrants in the next 10 years at rock bottom strike prices. Of course none of us is Warren Buffett. The only way to participate in the deal is to buy shares of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
If you don’t want to do any of those, and you want to hold the cash to buy the stocks you really want to buy at lower prices, there is again something to learn from Warren Buffett.
In the fourth quarter of 2008, about a year before Warren Buffett made his offer to buy out Burlington Northern Railway at $100 a share, Warren Buffett sold put options on Burlington shares. The market was in extreme fear and VIX was at historical high. Put contracts that protect the downside of the share prices were at historical high premiums. Two-month put contracts were sold about 7-8% of the stock prices. Warren Buffett consistently sold puts on Burlington shares.
This was how it worked. On Oct. 6, 2008, when Burlington was traded at $85 a share, Buffett sold put options on the stock with the strike price of $80 and expiration date of Dec. 8, 2008. The premium on this two-month contract was $7.02 a share. If Burlington was traded at above $80 on Dec. 8, 2008, Buffett would pocket the $7.02 a share, which is a return of 8.775% in two months on his cash collaterals. If Burlington traded below $80, Buffett would be obliged to buy the Burlington shares at $80 a share. Since he already received $7.02 a share with the puts, his share cost was lowered to only $72.98.
By Dec. 8, 2008, Burlington was traded at $76.55 a share, and Buffett had to buy the shares at $80. But with his premium on the put options, he reduced the cost per share by about 5%. Since he wanted to buy Burlington shares anyway, he got a better deal by selling puts.
In the fourth quarter of 2008, Buffett sold a few more puts on Burlington and lowered the cost of his purchase on all the transactions except one, on which he lost a little over 1%. Eventually those puts lowered his cost on Burlington shares by at least $20 million.
Now let’s say you want to buy ABC Corp’s stock at $80. The stock is currently traded at $100 a share. You can sell puts of ABC Corp’s stock with the strike price of $80 a share and pocket a $5 in premium. By the time the contract expires, the stock is sold above $80, you pocket the premium and have earned a decent return on your cash. If the stock is sold below $80, you will be obliged to buy the stock at $80. Your actual cost will be just $75 a share. Of course ABC Corp’s stock can go below $75 when the contract expires. That is the risk you take for selling puts.
This works well when VIX is high. The premium with the puts is expensive.
Before acting on this, please make sure you understand at least these three things:
1. The stocks you sell puts on are really the stocks you want to own.
2. The strike prices for the puts are indeed the prices you are willing to pay for the common stock.
3. You have the cash to buy the stocks when the contract expires.
What can you do to your cash?
If you are Warren Buffett, you can put your cash in the deal that he just struck with Bank of America (BAC, Financial). You can buy the preferred stocks that yield more than 6% and get stock purchase warrants in the next 10 years at rock bottom strike prices. Of course none of us is Warren Buffett. The only way to participate in the deal is to buy shares of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
If you don’t want to do any of those, and you want to hold the cash to buy the stocks you really want to buy at lower prices, there is again something to learn from Warren Buffett.
In the fourth quarter of 2008, about a year before Warren Buffett made his offer to buy out Burlington Northern Railway at $100 a share, Warren Buffett sold put options on Burlington shares. The market was in extreme fear and VIX was at historical high. Put contracts that protect the downside of the share prices were at historical high premiums. Two-month put contracts were sold about 7-8% of the stock prices. Warren Buffett consistently sold puts on Burlington shares.
This was how it worked. On Oct. 6, 2008, when Burlington was traded at $85 a share, Buffett sold put options on the stock with the strike price of $80 and expiration date of Dec. 8, 2008. The premium on this two-month contract was $7.02 a share. If Burlington was traded at above $80 on Dec. 8, 2008, Buffett would pocket the $7.02 a share, which is a return of 8.775% in two months on his cash collaterals. If Burlington traded below $80, Buffett would be obliged to buy the Burlington shares at $80 a share. Since he already received $7.02 a share with the puts, his share cost was lowered to only $72.98.
By Dec. 8, 2008, Burlington was traded at $76.55 a share, and Buffett had to buy the shares at $80. But with his premium on the put options, he reduced the cost per share by about 5%. Since he wanted to buy Burlington shares anyway, he got a better deal by selling puts.
In the fourth quarter of 2008, Buffett sold a few more puts on Burlington and lowered the cost of his purchase on all the transactions except one, on which he lost a little over 1%. Eventually those puts lowered his cost on Burlington shares by at least $20 million.
Now let’s say you want to buy ABC Corp’s stock at $80. The stock is currently traded at $100 a share. You can sell puts of ABC Corp’s stock with the strike price of $80 a share and pocket a $5 in premium. By the time the contract expires, the stock is sold above $80, you pocket the premium and have earned a decent return on your cash. If the stock is sold below $80, you will be obliged to buy the stock at $80. Your actual cost will be just $75 a share. Of course ABC Corp’s stock can go below $75 when the contract expires. That is the risk you take for selling puts.
This works well when VIX is high. The premium with the puts is expensive.
Before acting on this, please make sure you understand at least these three things:
1. The stocks you sell puts on are really the stocks you want to own.
2. The strike prices for the puts are indeed the prices you are willing to pay for the common stock.
3. You have the cash to buy the stocks when the contract expires.
