The One Conservative Investing Strategy Every Investor Should Use But Hardly Any Do
One of the biggest fallacies about Warren Buffett is his slow and steady long-term approach to investing. Let me tell you something, there is nothing slow about Warren Buffett. Steady yes, slow, not a chance.
Investors think when Warren Buffett buys a stock that hes in for the long haul. Well, thats only partly true. Hes in for the long haul on only a handful of stocks. The others are actively added, reduced or eliminated like middle managers.
Most investors are so wrapped up in Warrens stock picking strategy that they fail to see the real secret to his success. Brokers and armchair investment gurus have been shouting Invest like Buffett for years now. They also yell By, hold and forget about it. Well, let me tell you my investing sports fans; youre only hearing part of the story. What is the other part CASH FLOW.
Thats right! Tons and tons of cash. If Warren Buffett is a Buy, hold, forget about it type guy, then where does he come up with the cash to buy more stock...Cash flow! Very rarely, if ever, do you hear Warren Buffett talk about cash flow. You hear him say, Our problem is we have too much cash and very few places to put it. But, investors ignore comments like these, and choose to only focus on what the Master is buying. I have not heard a single investor ask the billion-dollar question, Where did you get all that cash? It wasnt from dividends. Warren doesnt care for dividends due to the tax liability. He wants to own companies who reinvest their earnings, instead of paying it out and be double taxed. Warren Buffetts Berkshire Hathaway owns a cash flow cow called GEICO. To add to his vast hoard, he purchased another insurance heifer called General Re. Combined, GEICO and General Re are mega cash flow vehicles that spit out greenbacks like a Federal Reserve Bank. The one thing Buffett understands extremely well is Cash Flow.
Buffett wannabees are fooling themselves if they think they can mirror his total investment strategy. They simply dont have the cash flow. Warren Buffetts cash flow gives him the luxury of not panicking during a market decline, and gives him the ability to add to his portfolio any time he chooses.
Since you and I do not own a repetitive cash flow machine, well have to build one for ourselves. We have often heard the saying cash is king, but Id like to expand this and say that cash flow is king. You can start building your own income engine by using strategies once only known by the mega rich. The strategy Im referring to is options.
The Options Market
Options give investors the right, but not the obligation to buy or sell a particular security at a predetermined price, at a predetermined date. There are basically two sides to an option:
1. Buyer - the speculative side
2. Seller - the conservative side
The buyer is taking money out of their pocket hence speculative. The seller is putting money in their pocket hence conservative.
Buyer - A buyer of an option is best described as a gambler. Similar to someone putting coins in a slot machine, the option buyer is hoping for the big payoff. When purchasing an option, the odds of losing are 80% ｱ. The buyer is betting a stock will rise or fall to a particular price within a particular time frame. If the buyer is wrong about the direction or the time, a loss will result. While some investors buy options to hedge their portfolios, others gamble.
Seller - A seller of an option is interested in cash flow. The seller basically accommodates the gambler. Since the buyer puts money in the slot machine, the seller plays the role as the slot machine. When an investor sells an option, the odds are they will win 80% ｱ of the time. The seller is not looking for the big payoff, just a smooth steady income stream. The seller is willing to sell stock that they own at a higher price than is currently quoted, and is willing to buy a stock at a lower price than currently quoted. Makes sense doesnt it?
Definitions
1. Put Options - Puts give an investor the right to sell or put their stock to someone else. A put value increases as the price of the underlying security falls.
2. Put Buyer - The put buyer is betting that a particular security will decline in value. Since options expire the 3rd Friday of every month, the buyer must be right about the price the security will fall to, and the time frame of the decline. The buyer makes a cash payment for this right.
3. Put Seller - The put seller is hoping a particular stock will decline in value to a particular price so they can purchase it. To take the risk that they may have to buy a security at a price in which they want to own it, the seller receives a cash payment.
Example: Lets say you want to buy 100 shares of Coca-Cola at $40 a share. But the current price of Coke is $45/share. You go into the options market and sell 1 Coca-Cola (1 option = 100 shares) 40 put that expires in one month. You receive 1 point or $100.00 in cash. If Coca-Cola falls to 40 or below, you keep the $100.00 and buy the stock. Your cost of 100 shares of Coke is now $39/share. If Coke never reaches $40/share within the month, you keep the $100.00 and repeat the process.
The risk in this strategy is only if a dramatic decline occurs in the stock. If you sell a 40 put, you are agreeing to pay $40.00 for the stock within a given period of time. If the price of the security falls to $30.00 before expiration, and you decide you no longer want to buy the stock, you can buy the option back at a loss. It is important to use this strategy with high quality companies you want to own. Do not get in a habit of buying an option back when the first stiff wind blows. Stick to the strategy and youll be amply rewarded.
4. Call Options - Calls give an investor the right to buy or call a stock from someone else. A call increases in value as the price of the underlying security rises.
5. Call Buyer - The call buyer is betting that a particular security will increase in value. The buyer must be right about the direction and the time frame of the price increase. The buyer makes a cash payment for this right.
6. Call Seller - The call seller is hoping a stock they own will go up, and in some cases do nothing prior to expiration. To take the risk that the owner of a stock may have to sell the stock at a profit, the seller receives a cash payment.
Example: Let's assume you own 100 shares of Coca-Cola at a cost of $40/share. You are willing to sell your shares at $45/share. The current price is $40. You go into the options market and sell 1 Coca-Cola 45 call that expires in one month. You receive 1 point or $100.00. If Coca-Cola rises to $45/share, you must sell the stock and you keep the $100.00 (a gain of 15%). If the option expires and the stock never reaches $45, you can repeat the process the following month.
The risk in this strategy is only risk of further gain. If Coca-Cola rises to $50/share within the month, you would have to sell the stock at $45. If you decided you wanted to hang on to the stock, you could buy your option back at a loss and close the option. Like I had mentioned in the Put example, we do not want to get into this habit. Our strategy here is cash flow and profits.
By implementing a strategy of selling options, you too can create your own "Cash Flow Machine". Remember, selling options is a conservative strategy, and by sticking to the strategy, you will greatly increase your total return potential.
