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Be More Like Buffett: Buy Fear

by Steven M. Sears
Monday, August 22, 2011

 

 

The stock market's volatility has some investors on the sidelines just when the famed investor would tell them to leap in—and options could be a good way to do it.

Everyone likes to quote Warren Buffett. He's rich. He plays bridge with Microsoft founder Bill Gates, who is even richer. And he has simple, solid ideas about investing.

He buys good stocks. Forever is his favorite holding period. Buy fear. Those are just some of the pearls that Buffett gives away, though he also sells pearls at Borsheim's, a jewelry store that he owns in Omaha, Neb.
As oft-quoted as Buffett is, few people have the guts to actually do what he says. Whenever people have the chance to be greedy when others are fearful, another Buffett bon mot, they tend to be too terrified to do anything.

Now is a Buffett moment. Fear is widespread. Many good stocks can be bought for decent prices, and Buffett has been active. He reportedly bought more Wells Fargo (NYSE: WFC - News) stock, and created a new position in Dollar General (NYSE: DG - News). Contrast that with stories of people dumping stocks because they are scared. One woman with a multimillion-dollar stock portfolio recently sold everything, and is sitting in cash, because she has grown tired of the stock market's incessant volatility.

But it is precisely because of volatility that long-term investors should summon their inner Buffett and buy quality stocks, or add to positions in blue-chip stocks, especially those that pay hefty dividends.

The fear of a stock-market decline, or another sharp whip up and down, is so high that the volatility premiums in many bearish puts, and even bullish calls, are unusually high. Investors with long-term horizons can buy stocks and sell puts, or calls.

Selling a put obligates investors to buy more stock should the stock price dip below the put's strike price. If the stock market plunges lower—and two major macro-economic events will occur in the next few weeks—put sellers could be buying stock at sharply lower prices.

The Institute of Supply Management August report is scheduled for release on Sept. 1. The report is widely followed by major investors, who view it as a key factor in determining whether economic growth is accelerating or slowing. And before that looms Ben Bernanke's Aug. 26 speech at the Federal Reserve's Jackson Hole retreat.

Selling calls obligates investors to sell their stock should the stock price rise above the call's strike price. If the stock market plunges, and the stock never rises above the call's strike price, the money received for selling the call is like an extra dividend payment. In fact, the money received for selling puts or calls and buying stock can be thought of as conditional dividends. If the stock doesn't cross the strike price of the put or call, investors can keep the money.

Another strategy rising in popularity is the "risk reversal." By selling a put with a strike price that is below the stock's price, and buying a call with a strike price above the stock's price, many investors are finding they can get paid by the options market to speculate on stock prices. If the stock surges higher, moving past the call's strike price, investors can sell the call bought for free at a profit. If the stock price declines below the put's strike price, investors are obligated to buy the stock.

The key in these options strategies is to use them only on stocks you want to own. If the stock pays a dividend, even better.

Some people will criticize all this options legerdemain as unworthy of value investing. They will think that larding up a good stock, trading at or near its intrinsic value, with the clockwork complexity of derivatives is to head down a tortuous path. But the simple fact is that few places let you take advantage of the fear of other investors better than the options market.




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