The Options Strategy for Generating Fixed Income
Masayoshi Son’s recent bets on tech stock derivatives may have shocked the investment community, but not options traders. Put and call options are regularly used by retail day traders to speculate on stock price movements. However, sophisticated investors and institutions use these seemingly exotic financial instruments for a much more boring outcome: generating fixed returns.
According to Investopedia, all strategies of generating income from options relies on the premiums traders are willing to pay to hold these options. For example, if an investor owns a stock, she could sell a put option on the stock to a trader. The trader must pay a premium to access this option. If the option expires without being exercised, the investor who sold the option considers the premium a profit.
Perhaps the best example of an options-driven fixed income strategy was deployed by the world’s most famous value investors himself, Warren Buffett. Buffett sells long-duration put options on major global indices to generate a fixed return from the premiums traders pay for these options.
“Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028,” Buffett claimed in a 2008 letter to shareholders.
According to that letter, Buffett’s firm generates roughly $4.9 billion a year in income through this strategy.
The implications of these strategies are clear – investors have an alternative to fixed income instruments like bonds and real estate. By simply writing options, investors can generate lucrative yields on their assets. Sophisticated investors can adequately mitigate the risks to secure their fixed returns.