There is a relatively unknown story of how Warren Buffett, probably the world’s most popular and successful investor the world has ever seen, wrote naked put options on a company called Coca Cola. But aren’t’ writing put options supposed to be dangerous and risky? The answer is a simultaneous yes and no. It is probably risky if you do not know what you are doing for writing put options naked may result in one making a loss greater than the premium collected from the writing of the put option. Theoretically, if one looks at the payoff profile of a naked put, although the potential loss is a limited one, if the stock price does go to 0 in the event of a bankruptcy, the naked put writer would lose an amount equal to :
Strike Price – Option Premium Collected
Consider the example where the price of ABC Corp trades at $100. An investor writes a put option ( just 1 contract) on ABC. In the event that the price goes to 0, the investor would first be assigned, forced to buy 100 shares at $100 after collecting a $2 premium, which brings the purchase price of the shares to $98 per share and when that is multiplied by 100 shares, the investor would have made a total loss of $9800 not considering commissions incurred in the course of the trade.
So are writing naked puts risky?
Yes. It is risky.
So why did Warren Buffet consider the writing of put options when buying into Coca Cola then. Warren Buffet is by nature, a long term investor and a fundamentalist. At the time of the investment in Coca Cola was looked upon as crazy and completely without merit.
But if an investor is able to read financial reports and make sense of it, therein lies his edge. And that was what Warren Buffet did. Warren Buffet found that the return on equity in the company was in excess of 30%, maintaining a return on equity of 37% on average. It’s long term debt to equity ratio was only approximately 20%. On top of this, Coca Cola was also:
- Performing Share Buybacks – When this happens, the outstanding number of shares decreases. Even without a growing net profit/income, the earnings per share will increase.
- The earnings per share was increasing at an acceptable rate while its dividends per share was also increasing at an acceptable rate then. An increased dividend is a catalyst for an increased share price. Increasing earnings per share is also a catalyst to an increasing share price.
- A low price to earnings multiple
In fact, Warren Buffet made his investment thesis known to the public. People drinking Coca Cola had no taste memory of it. Hence, the first can was as good as the third can. In good times as well as bad times, chances are that people will still continue drinking “Coke”. In terms of valuation, he felt that Coca Cola was being traded at a market price way below its intrinsic value.
He bought it and the rest as they say, is history.
Case in point, if a trader or investor were able to look into the financial reports, conduct some fundamental analysis, and make sense of where the company’s stock price is headed, he would have an edge in the market. So in the case of a long term investment and a very low probability that the price of Coca Cola was going to head to 0 and an even higher probability that the price was headed upwards over the long run, why not own the stock by way of selling put options. Selling put options allows the investor to collect premium and in the even if assignment takes place, the investor is obligated to buy at the specified strike price, which is a good thing for him as well because he intends to hold the investment over the long run.
In the case of Warren Buffet buying Coca Cola, Warren wrote naked puts costing $1.50 each at a strike price of $35. He got to keep the premium, lower his average buy in price of the company, and hold the investment for capital appreciation.
As investors, we can also do the same. My ideas on the subject is this. When the markets are falling, as in the case of a recession, you never know when and where the bottom is. It is at this point where you will get tremendous long term bargains. An investor may have purchased shares at a price of $40 which have an intrinsic value of $100. But the markets are crazy in the event of a recession or depression. One may average down by buying more as the price goes lower. So perhaps, an investor may write some put contracts at a strike price of $30. If he does not get assigned, he would have kept the premium. If not, he would be forced to buy more shares at a lower price which is good for him.