An Opportunity to Make 14% a Year on Cisco Systems, Inc. (CSCO)

How this plays out

There are three different scenarios that can happen on expiration day on January 2014:

1. Share price of Cisco> $24: You get to pocket the premium and have no obligations.
2. Share price of Cisco= $24: You get to pocket the premium and have no obligations.
3. Share price of Cisco< $24: You get to pocket the premium, but you will also be obligated to buy the shares at the predetermined price of $24. Since this is an excellent price to pay for the shares, we are fine with that obligation. Of course, you need to adjust the number of shares you are obligated to purchase to the trading position size that is right for you. This rule applies to any trade you make, regardless of the use of options .

Mr. Buffett is right beside you

The practice of selling put options on selected stocks and indices has been mastered by Warren Bufett. Many investors may not know this but Berkshire Hathaway Inc. (NYSE:BRK.A) sells options, all the time. You see, it only makes sense for an insurance company to receive fat cash premiums for the obligation to purchase shares in the future for a predetermined price.

For example, in the 2012 annual letter, Buffett stated that Berkshire Hathaway Inc. (NYSE:BRK.A) sold long-term puts on four leading stock indices in the U.S., U.K., Europe, and Japan, for a total float premium of $4.2 billion. In addition, Berkshire Hathaway Inc. (NYSE:BRK.A) earned in excess of $1 billion for writing puts on high yield corporate bonds. Mr. Buffett states that:

“All told, these derivatives have provided a more-than-satisfactory result, especially considering the fact that we were guaranteeing corporate credits – mostly of the high-yield variety –throughout the financial panic and subsequent recession.”

The Foolish takeaway

I recommend that you sell to open the Cisco January 2014 puts, at the $24 strike price, for no less than $155 an option.

The article An Opportunity to Make 14% a Year on Cisco originally appeared on Fool.com and is written by Shmulik Karpf.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Cisco Systems. The Motley Fool owns shares of Berkshire Hathaway. Shmulik is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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