My Mini-Berkshire Strategy Using Options for Insurance

Using puts and calls to balance portfolio risks

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I view myself as a mini Berkshire Hathaway (NYSE:BRK.A, BRK.B). Every month, I get some cash flow that needs to be invested. My sources of cash flow include money I saved from my day job salary, dividends and some money from side hustles. I used to view my side hustle income as something that is similar to investing in newspapers, but lately the cashflow from it has been similar to what Buffett experienced for 20 years with the original textile mill. My investing portfolio portion is similar to the portfolios of securities that Berkshire owns. I view my salary income as businesses income, since I provide services to a large client, who is my employer.

These three sources of cashflow are exponentially increasing my dividend snowball, which is projected to exceed my expenses in five years. However, I have been missing the cost free insurance float, which Berkshire has leveraged for the past forty-fifty years. For the past four years I have tinkered with a strategy that could essentially generate an additional cashflow for me to invest, by selling insurance. I went live with the strategy last month, and so far the results have been meeting my expectations.

The insurance I will be selling is mostly naked puts. You can read more about selling puts here and selling covered calls in previous articles I have written on the topic. With my strategy, I will be leveraging existing funds in one of my portfolios to sell naked puts. Before you start executing this strategy however, your broker needs to approve you for the highest level of option activity in a margin account. This could be a risky strategy, if you do not understand what you are getting into.

For my strategy, I plan on selling puts on S&P 500 ETF (NYSE:SPY), which trade approximately 10 points below the current price and will expire within 4 to 6 weeks. I found that it would be easier to invest in an index ETF options because of high liquidity, elimination of specific stock risk and low bid/ask spreads. Please remember that these are approximations and not hard rules set in stone. I plan on making a trade once a month, although I keep my flexibility and not make trades depending on market conditions. I will exit options sold either if they expire worthless, I sell them or if I get assigned.

Some investors sell puts against stocks that they want to purchase, and this is a perfectly legitimate practice. For example, if McDonald’s (NYSE:MCD) trades at $100 per share, but I want to purchase it at $80, I could simply sell a put that expires in a few months. I can then collect the premium and if I get assigned I get a stock at a discount. If not, I collect the premium. The issue with this strategy is that that in a $60,000 to $120,000 portfolio, you are exposing yourself to too much individual security risk. In order to minimize that, I am focusing on the S&P 500 ETF.

I have designated approximately 25% of my account equity from one of my brokerage accounts as the portion that will be allocated to this strategy. My account is 100% invested in individual dividend stocks, and I am not adding any additional money to it as part of my strategy to protect myself against broker failures. As a result I am essentially playing with borrowed money.

Let’s assume that my account equity is $60,000. That means that I can sell puts worth up to $15,000. If SPY trades at $150 , I can sell one put contract for 100 shares, and immediately use the premium amount as I see fit. If SPY never falls below the strike price by the time it expires, I would have earned a premium and the liability involved with it will be terminated.

However, if the option falls in value after I sold it, and trades at a low price of say 10 to 15 cents with more time to go till expiration, I would likely buy it back. I could then sell another option at a higher strike, or simply stay put.


Article printed from InvestorPlace Media, http://investorplace.com/2013/05/my-mini-berkshire-strategy-using-options-for-insurance-spy-mcd-brk-a-brk-b/.

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