Lets use some WMFD's

Derivatives or Weapons of Mass Financial Destruction as they have been fondly called by Warren Buffet (WB). He talked about this back in 2002-2003 right at the same time Alan Greenspan was talking about less regulation. We are lucky that WB was just half right, because I cannot fathom where we would be if he was fully right (mushroom cloud type stuff). Having said all this, he has used derivatives where he found mispricing. It is not in the use of the derivatives that he has a problem with, its the unchecked use, the wild wild west type of environment (read: CDS).

Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.

Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!

Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..

Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..