Here's a Chance to Invest Like Buffett

"The most important quality for an investor is temperament, not intellect ... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd."  -- Warren Buffett

Warren Buffett has often claimed that successful investing relies on a calm demeanor, and that it depends on the ability to watch one's stocks decline dramatically in value -- perhaps as much as 50% -- without panicking.  

Priceless advice, but how do I use it?
Buffett's temperament has certainly served him well in the past 18 months. His Berkshire Hathaway (NYSE:BRK-A) lost billions on paper, as its holdings in such companies as Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC) plummeted precipitously. From September 2008 to March 2009, Wells Fargo lost around 75% of its value.

He continued to hold on to the stock, and even later suggested that buying Wells at $9 dollars per share would be an "all-in" investment for him. In other words, at that price he would have put his entire net worth into the company. Indeed, when bank stocks were down and out, Buffett was adding to his existing positions in Wells and US Bancorp (NYSE:USB), a stock that had also cratered, and bought into Goldman Sachs (NYSE:GS) at the height of panic.

Because he didn't let fear get the best of him, Buffett avoided taking huge losses by continuing to hold such bank stocks despite their declines.

So we know that remaining calm in the face of sharp declines in our holdings can help us become successful investors. But just how are we supposed to develop this temperament? One thing we can do is use options to cushion the blow of dramatic declines in our holdings. That approach might be especially prudent given that the S&P 500 has run up over 60% from its March lows and is overvalued, at least according to typical P/E ratios coming out of a recession.

Strategy 1 -- Buy put options
If you own a stock that is undervalued and that you'd like to continue to own if it appreciates in value, but you want to protect yourself from price declines that might occur in the near future, you can buy put options.

Buying puts gives you the right to sell your stock at a set price (the strike price) by a specified date (the expiration date). Buying puts acts as a kind of insurance for your holding. As the stock price declines, the put increases in value, effectively cushioning your portfolio. Buying put options allows you to limit your downside without limiting your upside.

Suppose you own Procter & Gamble (NYSE:PG). The company has experienced earnings declines over the past year or so, as consumer spending has been hit mercilessly. Its premium-priced products have lost some ground to those of rivals. While P&G's management has proven to be adept at maneuvering through downturns, consumer spending nevertheless continues to be a thorn, and it's unclear when consumers may finally return in full force. The stock, however, seems to have anticipated a solid economic rebound and has bounced hard off of its five-year low of $44 in March. Nevertheless, there are many reasons to be bullish on the company in the long term.

Consider put options on the company at a strike price of $60 with a January 2011 expiration date. These options currently cost about $6 per share, while the stock trades at around $62 per share. Now, have a look at the possible outcomes of buying puts on a position of 100 shares.

This put-buying strategy caps your loss on Procter & Gamble such that your position never declines in value below $5,400, or effectively $54 per share. If the cost is worth it to you, such insurance on your stocks can help you to manage your temperament. But it's possible to further reduce the cost of this insurance, perhaps to as little as zero out-of-pocket expense.

Strategy 2 -- Use a protective collar
A protective collar, as it's known, involves buying a put option as above, but also selling a call option to offset the price of the put. For example, take a collar on 100 shares of American Express (NYSE:AXP), which is trading at about $40. First, sell a call option with a strike price of $45 that expires in January 2011 for $4.70 per share. This gives the buyer the right to buy the stock from you for $45 on or before the expiration date. Then use those funds to buy a put option with a strike price of $35 at the same expiration for $4.90 per share.

In effect, you're buying downside protection for a net $20 per 100 shares. But you've also limited your upside on American Express, so that if the stock climbs above $45 per share, your gains are capped there. The following table shows how the collar strategy functions as it nears expiration:

*Your stock would be automatically called above $45 per share.

Protective collars work nicely when you can structure them, as above, to allow you some future gains if the stock continues to run. This collar allows you to profit if AmEx continues to climb as much as 12% higher (up to $45 per share), and it caps your losses at any prices below $35. All for just $0.20 per share!

For little out-of-pocket cost, you can use options strategically to help bolster your temperament, and help you stomach some of those massive declines that have become all too common over the past two years.

If strategies such as this help you sleep better at night, then let advisors Jeff Fischer and Jim Gillies at Motley Fool Options take your investing to the next level in 2010. Enter your email in the box below to receive your invitation!