Selling puts in a volatile market is an effective way to generate healthy premium income.

Just about every time the market hiccups, pundits seek to calm investors by evoking any number of Warren Buffett’s homespun aphorisms about staying the course, never selling or building arks instead of predicting rain.  Yet they rarely discuss what he does behind the scenes.  Commentators generally don’t talk about the opportunistic tactics that Berkshire Hathaway employs in its own enlightened self-interest to profit when there’s blood in the streets.  Yet, turbulent markets present a perfect backdrop for investors to use one of Warren Buffett’s deep-rooted trading strategies.

Buffett has long been a fan of selling put premium.

Option Premium as Insurance Premium

Stock options began their existence as insurance policies and they function much like property-casualty insurance.

Property owners buy insurance to mitigate the damage caused by some loss.  The premium they pay obligates the insurance company to cover those losses up to a certain dollar amount.  Investors buy put options to mitigate the damage caused by price declines in a given stock.  The premium they pay likewise obligates the put writer to cover losses up to a certain dollar amount.  The similarity between an insurance policy and a put option doesn’t end there.  They are alike in another important way.

The premium received by both the insurance company and the put seller is nearly 100% profit.  If the insurance (or put) buyer suffers no loss, then premium payments made can be tallied up as the cost of peace of mind.  The buyer is entitled to nothing unless he or she suffers some loss.  Similarly, the insurance company and put seller have no obligation to the buyer in the absence of such loss.  And, more often than not, those losses never materialize.  So the insurance company and the put seller generally get to keep every penny of the premium they’ve received.  This is because the odds are in their favor.

Insurance companies can protect lots of policyholders because only a few of them will ever suffer any losses.  In fact, the majority of them will never file any claims at all.  The insurer collects premiums from thousands of customers knowing that it will pay benefits to just a few of them.  This is a big part of why insurance companies are so wildly profitable.

And if there is one business that Warren Buffett knows very well, it’s insurance.  Berkshire Hathaway owes much of its success to its early investment in GEICO.  Berkshire has long been able to invest GEICO’s premium income – for its own benefit – while only periodically paying out small portions of it to insureds who have actual claims.  Similar dynamics are at work for put sellers.  And Warren Buffet knows how to profit from this.  He knows that collecting premium income is profitable because he understands the underlying statistics.

Statistics, Implied Volatility, and Expected Move

The statistics driving an insurance company’s profits are based on the rule of large numbers that says only a few of its customers will ever suffer losses.  So it keeps most of the premium it receives.  The statistics driving a put seller’s profits are based on implied volatility and expected move.

Stocks trade within known ranges.  Those ranges are typically pretty narrow.  When the market is uncertain about future moves, a stock’s implied volatility will typically spike.  The image below offers a pretty good illustration of this.

Generally, when implied volatility rises, premium follows.  So it is important to understand that implied volatility is the market’s guess at how a stock is expected to move by expiration.  It doesn’t offer any insight into the direction of that move, only its magnitude.  But because implied volatility is just the market’s estimate of expected move, it is often wrong.  That’s why put sellers have a very high probability of success.

Again, stocks trade within known ranges.  Those ranges are determined by the current market price and implied volatility.  For example, in the bell curve shown below, today’s price would represent the “mean” within the two bands to the right and left, which represent the expected move.

This is a graphical representation of how a given stock is expected to move from today’s price.  From a statistical point of view, all stocks will trade within one standard deviation of their mean about 68% of the time.  They will trade within two standard deviations more than 95% of the time.  In other words, the normal distribution of prices will nearly always be within these known parameters.  In fewer than 5% of all instances will a stock trade outside of the outer bands of the second standard deviation.

So selling a put one standard deviation out-of-the-money offers an extremely high probability that it will expire out-of-the-money, and therefore worthless.  Especially after a drawdown like we have recently experienced. The further out-of-the-money the put strike is, the greater the likelihood that it will remain out-of-the-money come expiration.

The analogy between selling a put and selling insurance is that the seller gets to keep the premium collected regardless of what happens to the insured property.  And, as noted earlier, in the majority of cases, the insured doesn’t suffer any loss.  When that happens, the premium collected is pure profit.

Turbulent Markets and Implied Volatility

When markets are turbulent, implied volatility skyrockets.  Because implied volatility is the key component that determines whether the premium is cheap or expensive, the higher it is, the more expensive an option becomes.  Volatile markets like we’re experiencing currently translate into higher implied volatility.  That translates into higher option premiums.

As Warren Buffet knows, it pays to collect premium.  That’s what makes an insurer so profitable!  It is also why Berkshire Hathaway has been one of the largest put sellers in the open market in the last few decades.  Since 2004, it has sold tens of billions of dollars in put options.  Said another way, Berkshire Hathaway has collected tens of billions of dollars in premium income that it hasn’t had to use to satisfy claims or buy shares put to it upon exercise.

The odds are good that investors like Buffet are selling puts in the current market.  It is a very profitable strategy when used wisely.