Warren Buffett, Derivatives Speculator?

There are nice safe hedgy options, and then there are dangerous, volatile, and prone-to-blowing-up options, the kind of things which have a habit of biting Victor Niederhoffer in the ass. It's these kind of options which Warren Buffett famously referred to as "financial weapons of mass destruction". So you can imagine my surprise when I read this, this morning:

This year, Berkshire Hathaway Inc., the Omaha, Neb., holding company headed by Mr. Buffett, has collected premiums of about $2.5 billion from selling insurance on stock indexes and bonds in the form of derivative contracts, which guarantee payment to the buyer in the event of a specific loss in an underlying entity of the contracts.

Sounds to me like Buffett has been making billions of dollars doing one of the riskiest derivatives trades there is: selling out-of-the-money puts.

Now this trade does sometimes (often, actually, during market panics) make sense, and a lot of money. And one can usually make much higher risk-adjusted returns selling out-of-the-money put options on the stock market than one can buying structured products from investment banks. What's more, Warren Buffett has the first thing that anybody needs if they're going to play this game: very, very deep pockets. But still. Buffett? We always thought you nobler than this.

Comments

[ikkyu:]

Hey my friend,

Buffett typically sells calls to pay for puts (i.e. collar). This is just about as conservative as any strategy gets! He has been invovled with derivatives for years and years( and that is not a bad thing).
Cheers from osaka,
john

2007 Nov 06 07:09 AM

[winanga:]

I thought this was old news? He sold very long-dated (10+ years if I remember correctly) puts against four global indices sometime last year as a form of insurance for pension funds. I think history will show it was a prudent move on the funds' parts and a profitable one for Berkshire. Besides, if markets really drop between now and their expiry, it will be a good opportunity for him to invest his huge cash pile at better prices.

Just as an aside, isn't it time the online WSJ lost its subscription policy?!

2007 Nov 06 09:05 AM

[K. Ramesh:]

What is wrong in selling selling out-of-the-money puts? As an individual who has lot to take credit for in the insurance industry, Buffett knows his risks.

2007 Nov 06 10:33 AM

[Greg H:]

The risk profile of selling puts is the same as selling a covered call - the most conservative option strategy - so you might want to do some study/ refresher course on option trading. I don't see any problem with WB selling puts - often quite a good way to slightly enhance /even out returns. I do this all the time myself in a mostly low risk way.

Regards

Greg H

2007 Nov 06 06:15 PM

[Investor Nirav:]

How do you know he wasn't selling Calls?

a bear call spread doesn't sound too risky to me. especially if you've
been investing for 50 years and have seen all the different aspects in
the market.

2007 Nov 06 06:33 PM