commentary by: Chris.McKhann
The use of derivatives by Warren Buffett--who once called them "financial weapons of mass destruction"--is back in the news as the cause of his company's losses.
Berkshire Hathaway is down more than the S&P 500 since September, as reported by Bloomberg today. The story puts the focus back on Buffett's use of derivatives, which we have highlighted on a number of occasions.
People have a fear of derivatives as they are at the heart of the recent crash and Buffett has repeated derided them. So it is not surprising that investors are jumping ship as the Oracle of Omaha has revealed his extensive use of the instruments.
In fairness, however, what Buffett primarily uses are simple option strategies. He sells puts, and it is still unlikely that he will take a loss on these long-term positions.
Buffett acknowledged from the start that he might have to show large paper writedowns on these positions, though his timing in with the majority of the trades was awful, and I am sure those writedowns are more than expected.
As the Bloomberg piece points out, some of Buffett's investors understand how the use of options fits into his overall strategy:
"Mark Curnin, co-founder of White River Capital LP, an investment partnership that specializes in financial stocks, says Buffett's derivatives are simply smart ways to do what he's always done: underwrite insurance and buy attractive securities."
Selling puts on the indexes, as Buffett has done, is really writing insurance. And he took in the large premiums with no margin requirements and can put that cash to good use in the meantime. Anyone who understands options understands that this is a pretty safe bet, and certainly this is a better situation than anyone who bought individual stocks at the height of the market.
But I did have to laugh at the comment that, "To lose the full $37.1 billion on the equity puts, the indexes would have to fall to zero--an unlikely event."
I can't disagree that that it is an unlikely event, for it could happen (the mother of all black swans), but if the primary stock indexes in the U.S., U.K., Eurozone, and Japan all go to zero in the next 10 to 20 years, we will have bigger problems and more important things to talk about than Buffett's use of short puts.
(Chart courtesy of tradeMONSTER)
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