Derivatives: Financial Weapons of Mass Destruction?

by: Sean Hannon

In Berkshire Hathaway’s 2002 annual report, Warren Buffett described derivatives as “time bombs for … the economic system,” and “financial weapons of mass destruction.” Given the financial and economic distress resulting from Wall Street bankers producing and selling toxic derivatives linked to poorly originated loans, Buffett’s warnings were prescient.

Buffett’s words will cause many to leap to the conclusion that all derivatives should be avoided. However, if we look closely at his entire argument, Buffett is clearly focusing on over-the-counter (OTC) derivative contracts where price discovery is nonexistent and counter-party risk is high. If we turn instead to more traditional derivatives—exchange-traded puts and calls—we can carefully construct portfolios that allow us to express a view while ensuring against large drops in value.

Put options give an investor the right, but not the obligation, to sell an investment at a predetermined price. Conversely, call options offer the right, but not the obligation, to buy an investment at a predetermined price. By paying a premium, both options allow you to create a profit profile that ensures against adverse moves. Doing so protects your portfolio in the short-run and offers great profit potential over time.

An example of the effective use of options can be found in the portfolio I have created via my weekly newsletter EPIC Insights. As a long-term value investor, I aim to buy stocks that are inexpensive and offer great profit potential. This leads me to constantly have exposure to the market as I buy what I find cheap. In a brutal bear market, long biased investors will suffer as cheap stocks become cheaper. However, my portfolio remains positive as the market grinds lower. A key factor to this performance has been the use of put contracts to insure against drops when I become overtly bearish.

Specifically, consider what happened in the markets on January 20. The Dow Jones Industrial Average (Dow) declined 4% and Treasury bonds declined in value as the market suffered the worst inauguration day performance ever. Despite the fact that over 40% of my portfolio is in stocks and bonds, it increased over 1% in value. How? By using puts on the NASDAQ, I was able to increase value while others lost.

Overly aggressive and uninformed use of derivatives has caused mass destruction in the financial markets. However, options remain a handy tool for the investor toolbox. Understand their uses and applications and your future portfolio performance will improve.