Warren Buffett's GENIUS Options Strategy... (The Wheel w/ @PetersonCapitalManagement)

2020 is shaping up to be a record year for stock options. Options are the kinds of bets where you can lose everything. Options are riskier than stocks. I'd wake up to 20, 30, 40, even a 60,000 loss. Options activity hit a record high in 2021. Individuals have often taken to social media, Wall Street Bath forum on Reddit, Wall Street Vets, Wall Street Bets, Wall Street Battles, Wall Street Bets futures, fords, swaps. Options, they are called a derivative. Usually, these financial instruments are associated more with the gambling side of the stock market. I somehow made 110,000 this morning and I'm not sure how.

Rather than with value investing, and in recent years particularly, derivatives like options have just gained tremendous popularity as the stock market has been more and more casino affirmative. Volatile trading frenzies have led to congressional hearings around the gamification of the markets. But what's really interesting is there is a really cool strategy which includes options that can be used by the value investor. Surprisingly, this option information has not been written about extensively, and it's actually fairly straightforward and it's very, very cool. So that's what we're going to talk about in this video.

But if we start at the start, first, let's just do a quick recap over stock options. There are two main types of options: there are calls and there are puts. These are contracts that are written and sold by one investor, and then they are bought by another investor. So let's imagine we've got a stock that's at around say a hundred dollars. Someone writing a call option might say, "Dear sir/madam, you have the right but not the obligation to purchase XYZ company's shares off of me at any point across the next 12 months for a hundred dollars per share."

In this case, if the share price rises, then the person that has bought that call option is able to go back to the option writer and say, "You know what, I'm going to exercise this option." They're able to buy the shares off of that person and then sell them on the open market for more. Now, on the flip side, someone writing a put option might say, "Dear sir/slash/madam, you have the right but not the obligation to sell your shares to me at any point across the next 12 months for a hundred dollars per share."

In this case, this is essentially insurance in case the share price fell lower, and if that happened, if the share price did fall lower, then the writer of the put would see themselves taking on that other person's shares for a hundred dollars per share, which is a problem because the share price might have gone lower in the open market. So that's calls and puts; they're the basics. If you buy a call, you have the right to buy stock at a predetermined price. If you buy a put, then you have the right to sell your stock at a predetermined price.

If you write a call and sell it to someone, they might end up buying your shares off you for cheaper than the market price if the stock prices moved up. And if you write a put and sell it to someone, then you might find yourself having to buy the shares at a price that is higher than the current market value. But of course, that's the risk, right? As the person that is writing the option contract, the risk is the stock price moves in the opposite direction of what you need it to.

If you wanted to get your hands on one of these very valuable agreements, well, that will cost you money. You have to buy these put option or call option contracts off of the underwriter, so the writer of the option contract will always collect a premium. That always happens. And then the last thing to know is the option contracts do expire. If you've bought an option contract and the share price hasn't moved in your favor during the length of time that contract is open for, then that contract will expire worthless. In that case, you've essentially paid for a piece of paper that's worth absolutely nothing. The person that wrote you that contract keeps your premium and doesn't have to do anything else. They don't have to follow through with anything.

Now enter Matthew Peterson. He is a very funny, very cool guy from Austin, Texas. He's the one that taught me this options strategy for value investors. He's just a value investor like both you and I, but he uses this option strategy to enhance his returns for his fund. His fund's very successful. He started with a hundred thousand dollars; he's gotten like 18 returns per year for the past 10 years, and his fund's now with like 20 million dollars plus cash inflows. And he's actually very good friends with guys like Bier and Phil Town.

I got the chance to sit down and have him explain this strategy to me just the other day. So, let's start at the start—can options be used effectively by value investors? Absolutely, they can. I mean, I'm a value investor at heart. They are used by value investors; in fact, they're even used and utilized when appropriate by Warren Buffett himself. There's many ways to skin a cat; there's a lot of ways to use these products. A lot of people are out there speculating with these products. I tend to flip everything around and I use them in a different manner.

You can use these contracts to buy securities for less than they cost to the retail investor. So what Matt does is he will write a put option contract in order to buy the stock that he already wanted to buy. I find that really interesting! It's like the best broker you've ever had, right? Because now when he enters a position, he doesn't have to pay a brokerage fee; he actually gets paid. Remember, he gets paid the premium for writing the put option.

So what this effectively does is it lowers your cost basis on whatever investment you're making. So it's not speculation at all; it works very, very well for people that are value-minded. Anyway, as a value investor, we want to buy when shares are extremely cheap. So after I've done my analysis, especially if there's a lot of volatility in the shares, you can find that these option premiums become systematically overpriced. There is usually a larger demand to purchase these contracts than to sell or underwrite these positions.

One really good use of these contracts is looking at the underlying holdings, analyzing the business, figuring out the stock that you want to incorporate into your portfolio, but then checking the option market. If there's a put contract, you could actually write a cash-secured put and get paid a premium just before someone puts you their stocks. So that's the basic concept.

But let's take it one step further. Let's really cement how the strategy works by going through a full example. And it's actually an example of a stock that currently sits in Matt's portfolio, which is Cerritage Growth Properties. Let's say that the Cerritage stock price is about 10, and we believe it's worth about 25 or so. Instead of buying it for 10 a share, we can go to the Chicago Board of Exchange; you can write a put contract committing yourself to buying it for 10, going out seven or eight months from now.

Today you're able to pick up about 25% of the underlying equity price, which means you'd pick up two dollars and fifty cents in premium with a ten dollar commitment to buy. And then in our case, we hold seven dollars and fifty cents as collateral. So we hold seven dollars and fifty cents; we're paid two dollars and fifty cents—that's our ten dollars in cash. And we're just waiting to hopefully buy the shares.

The shares will either be in the money or out of the money at the end of the contract. If they're out of the money, then we keep the premium, and the contracts completed. So we've earned two dollars and fifty cents on our seven dollars and fifty cents of collateral, which means we make thirty-three percent in seven or eight months, which is an astronomical return.

Preferably, if the shares decline a little bit below the strike, so just below the 10 position, we now have the opportunity to buy for 10. If the shares are trading at nine dollars a share, the only cost our net cash outflow is actually only 7.50 because 250 came from the counterpart, and that price may not have ever existed in the New York Stock Exchange. So we're able to use these to buy the underlying position for less than the market price.

And then when the shares do finally appreciate to some expected price, let's call it above 22.50, instead of buying for 10 and making sort of 125, we're buying for 750. Now we make 200 percent, so it's pretty insane. But if you have a fairly volatile stock, you can actually add quite significant extra return on top of just the appreciation of the stock price through selling a put to get in and then selling a call on the way out. As Matt says, if the stock is at 10 and you get paid 2.50 to buy it, then if the shares appreciate to say 22.50, well, you're going to make a 200% return instead of a 125% return.

That is fairly significant. But as Matt's about to describe, it doesn't always work out as perfectly as what we might like. So here's Matt discussing the four possible outcomes of this approach. The first is generically your analysis is wrong, and the shares go all the way to zero. So instead of buying for 10 and having the shares go to zero—this is a terrible scenario—but you'd buy for seven and a half and the shares go to zero. So on an absolute basis, you will lose less. So this is a true risk reduction technique.

Ideally, the best scenario is the shares decline just below your strike. We want the underlying position to be just under 10. If it goes to 9.95 and then the shares are put to us, we only pay seven dollars and fifty cents, and day one we've already made 30-plus percent unrealized gain. The third bucket is that the shares are just above the strike price, and in that scenario, instead of say owning the stock for 10 and having them appreciate to 11 and making 10, we own it for 10. The contract's finished, and in seven or eight months, we've made 33 because we've earned the premium 2.50 on top of the 7.50 of our cash collateral.

The final example, which is the second worst from a professional fund manager perspective, it bothers me more than my LPs. Our analysis is so correct; their shares go from 10 a share all the way to 25, and we only capture a 33% gain. It's not the worst scenario, but it's an unfortunate one because we could have made 150%; instead, we only made 33.

But if you think along those four buckets and you can look at the probabilistic outcome of each, and if you're extremely certain that it's not going to go to zero, you can find yourself in a very good situation with this strategy. So in all four outcomes, obviously, you still make money from the premium by selling the put, so there's definitely that risk reduction no matter what.

But obviously, the ideal scenario that we want is that we collect the premium, we get the shares, and the shares revert back to their intrinsic value over a period of time—that's obviously the ideal outcome. But now let's turn our attention to not just buying, but also selling. Because just like what we're talking about, how you can buy a put option to get into the stock, if that stock has then gone up a lot over time, you can then sell a call option to help you get out of the stock and collect a premium on the other end as well.

We're talking about Cerritage, and if Cerritage were to then appreciate into something above far above the intrinsic value, let's say it ran up to 30 very quickly, we would probably look to exit that position by writing a covered call. We would then write it a little out of the money and out a few months. So six or eight months down the line, we might write a call with a strike of 35 and pick up another five dollars because if the shares run from 10 to 30, there will be a lot of euphoria. There will be volatility in the shares, and the premiums on the calls will go up considerably.

So if we write a call with a strike of 35 and pick up five, if the shares go up above 35, somebody will call our shares away from us, and our net cash outflow will be 40. So if you put both of those parameters in play, we have a scenario where we're buying in for 750 instead of 10, we're selling for 40 instead of 35, and we're picking up pretty significant IRRs on either end.

Even if this is an eight or a ten-year holding period, we'll end up enhancing our annualized IRR by two, three, four, five percent by doing this on either side. So at this point, it seems pretty clear this is a very intelligent strategy, especially for a value investor that is always going long and really makes sure that they are buying quality companies. Before they enter into anything, obviously, Matt has implemented this strategy incredibly successfully himself over a long period of time now.

But of course, like everything in the stock market, it isn't without its own risks. It would be silly of us not to talk about the risk. So let's hone in now—what are the risks out there when we're talking about this options approach to value investing? If you consider it as an exposure to your underlying equity, you have the same risk fundamentally as a holder of the underlying equity. There could be a liquidity issue and it could go to zero.

However, there's all sorts of subtle risks that those engaged in this strategy experience over time. There are corporate events that suddenly alter your strike, or there are special dividends that would shift your strike, or there are spin-offs and mergers. Any sort of activity like this can change the fundamental nature of your contracts. It happens oftentimes very quickly, so there are some risks and exposures that are not really seen on the surface.

That said, there are some really subtle benefits to implementing the strategy also. One very clear benefit in my mind is that in a rational mindset, you set something in place that might unwind over the course of six months, a year, even two years. And you know fundamentally, you want to own those shares. When the shares then decline and are suddenly under your strike price, in the money, and you're now going to be put shares, it’s often quite a fearful time because the macro environment might look uncomfortable, the micro environment could look uncertain.

But yet you're put the shares, and so it's actually a trigger that forces you to buy when you might feel uncomfortable. And it also forces you to sell. If you sell a covered call, and everything runs up, portfolio managers are not immune to their emotional biases. So you can become too greedy and forget to sell. But if you put this in place, you actually are more likely to sell at the right time and buy at the right time.

I really like that point—not only is this a great strategy to help you improve your returns, but it also kind of sets you up with a plan of attack, like a rigid plan that you can cling to. So that when the stock gets really volatile, maybe it starts falling a lot, it really helps you stick to your evaluation and stick to your trust in your entry and exit points.

But this led me to one question that I had for Matt, which I didn't know: can you literally apply this options strategy to every stock? The shares need to be listed by the Chicago Board of Exchange. The option contracts need to be made available in the public markets through the Chicago Exchange, and they just run an algorithm to determine which equities are eligible. It has to do with volume and market cap and a lot of other factors. But ultimately, it needs to fit within their parameters to be listed.

A lot of foreign firms, and even some ADRs, are not available. Some smaller cap companies are not available, but you can find real nuanced niche situations where the volume of some security goes way up and then options are suddenly listed, and you have a brief window to write or get involved. You could have a large cap company that becomes a micro-cap, but the options still exist because they were available prior to the major decline.

So you get some nuanced situations that become pretty opportunistic. So interestingly, no, you can't always apply this strategy because you need those options to be available. Sometimes the options just aren't available on these stocks. And that led me to one last question that I had: would you always want to implement this strategy, or are there times where it actually doesn't make sense?

You need to have some sort of guidelines when you're using this strategy because there are times when the premium is insufficient for the risk. If you're only going to pick up sort of a low single digit annualized IRR on a security, it's probably not worth engaging in this process because you're locking up your collateral for a really low IRR. So you may be better off just owning the underlying security. If there isn't sufficient volatility, essentially to increase the price and give you an adequate IRR, so your premium needs to compensate you for the fact that you're locking up your capital over a period of time.

So I thought this was really interesting. Sometimes the stock just isn't very volatile, and if it's not very volatile, then the options premiums just aren't very enticing. So it might just make sense if you just wanted to hold the equity, then just hold the equity. Just go and buy the stock; maybe adding a one or two percent extra return on whatever it might be isn't actually worth it.

But anyway, I still think this is a really, really interesting strategy, and I hope you've really gotten a lot out of this video. Big thank you to Matt; very much appreciate the time he gave me and helped. You know, he was totally fine with just sitting down and explaining this little investing hack that he's figured out with all of us here on the channel.

So I'll just leave a plug. You know, if you wanted to learn more about Matt, he's a very, very bright investor; then this is where you can find it: petersonfunds.com. People can find my email address, Twitter, etc. there. They can also search Peters Capital Management on YouTube, and we have quite a bit of content listed there. Of course, leave a like on the video if you did enjoy it, guys. Subscribe if you're new around here if you want to see more. All the extra links to the stuff I do beyond the channel are linked down in the description below, so you can check that out.

But guys, that'll do us for today. Thanks for watching; I'll see you guys in the next video.