The options market has been around almost as long as the stock market, yet many investors – including a fair number of seasoned professionals – find its operations and dynamics somewhat mystifying. That has not deterred a considerable number of them from diving in from time to time.
There are numerous options strategies one can employ, including selling naked puts, as I discussed in a recent article. This strategy has appealed to a number of investors in recent years in light of the seemingly unstoppable bull market.
However, while it might seem like a safe way of making some money in the market, things can get ugly fast if the market goes into reverse.
How Buffett does it
In my previous discussion about selling naked puts, I cited a March 4 article by investor Steven M. Sears, in which he observed that Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) has sold naked puts in the past. Indeed, so eager was Sears to attach Buffett's name and reputation to his recommendation to sell naked puts that he even included him in the article title: :Be Like Warren Buffett (Trades, Portfolio). Use This Options Strategy."
Yet, while Buffett has indeed sold naked puts before, he is far from a habitual practitioner of the strategy. Rather, the Oracle of Omaha has turned to naked puts only situationally. As FrontierView Chief Economist Ryan Connelly observed on March 4, such a situation occurred in early 2009:
"In March 2009 Buffett sold a ton of 450 SPX puts. When everyone else was panicking he looked at the market and just said, 'this is stupid.' He went all over Wall Street selling them to whoever would buy them, and sold as many as they wanted....there were also very good opportunities to take advantage of vol spikes when market sentiment was sour. Single names can be dicey during a credit crunch, but the broad index was never headed to zero."
With financial markets gripped by uncertainty and fear in the face of the Great Financial Crisis, Buffett seized an opportunity to sell S&P 500 Index puts that were deeply out of the money.
Not for everyday use
In 2009, Buffett foresaw – correctly – that no financial crisis or recession could be so severe as to drive stocks toward zero. Thus, he was able to book a considerable profit by selling options in volume that carried unusually high premiums due to outsized market fear.
Seen in that light, selling naked puts when he did was a case of classic Buffett and perfectly in keeping with Baron Rothschild's old adage of which he is so fond: "The time to buy is when there's blood in the streets."
I fear that Sears may have misunderstood Buffett's naked put selling during a crisis as a rationale for selling them in more normal market environments. Yet it is exactly such crises, or at least shocks, that represent the greatest danger to investors engaged in the sale of naked puts during bull markets, especially those with exposure to individual securities.
When the market drops, puts start to pay off. If it drops far enough, naked put sellers start to lose money. Indeed, when the market swings in the other direction, it can more than wipe out all the prior gains from collecting premiums. Economist Nicholas Nassim Taleb has likened this practice to "picking up pennies in front a steamroller," and with good reason.
My verdict
The attraction of selling naked puts is obvious. Yet while selling naked puts can offer an investor a steady profit for quite a long time in some cases, the strategy is catastrophically vulnerable to unexpected market shocks. When Buffett sold naked puts in 2009, he was not doing it to pick up pennies. Rather, he was exploiting a market dislocation brought about by fear. To really "be like Buffett" requires patience and conviction, not faith in perpetual market stability.
While most people are familiar with the common Latin phrase caveat emptor ("Let the buyer beware"), few know its sister saying, caveat venditor, or "Let the seller beware." I can offer no better summation of my view on selling naked puts than those two words.
Disclosure: No positions.
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