Why Warren Buffett Trades In Derivatives And Why You Shouldn’t

In Berkshire Hathaway’s 2002 annual report, Warren Buffett said that derivatives are “weapons of mass-destruction”. The annual report had an entire section dedicated to derivatives for two major reasons – the Enron scandal and the Berkshire’s acquisition of General Reinsurance. Apart from Enron’s aggressive accounting practices, the company had heavy derivatives exposure on its books, increasing the company’s financial risk.

During the same period, Berkshire had acquired General Reinsurance, a company with exposure to risky derivatives on its books. The risks became known after the acquisition and the company had to unwind these securities over a long period time, resulting in losses of more than $400 million. These factors led Buffett to warn investors against the use of derivatives and leverage.

Nevertheless, Buffett, on several occasions, has admitted to his own use of large-scale derivatives as a means to execute investment strategies.

Several of his detractors have highlighted the divergence between what Buffett preaches and what he practises in order to discredit him, or push their own agendas. However, a large part of the opposition is unwarranted.

Buffett’s largest derivative trades are backed by fundamentals. Derivatives, like any other financial instrument, can be mispriced and therefore, offer a chance to make a profit.

In his 2008 letter, Buffett highlighted his use of derivatives and the rationale behind it. A major part of Buffett’s derivative portfolio clearly is modelled on the insurance industry – an industry that he had been studying and buying into since his early twenties.

The insurance business model involves accepting premiums, investing in the premium pool, and paying out claims at a later date. The premium is basically free money (assuming no underwriting losses), that the company is free to invest and earn a return on. The derivatives Buffett invested in had similar insurance-like characteristics.

For instance, his equity put option contracts worth $37 billion ensured that he received premiums upfront and the pay-out could wait until 15 to 20 years later. The pay-outs too, would only be made if the market indices ended below a certain figure after 15 years, which according to Buffett was almost impossible. He would have to shell out $37 billion only if all the indices went to zero, which is unlikely. The call turned out to be correct, as indices have gone up multiple times in value since then.

Similarly, the credit default swaps and bond insurances ensure creditors (banks, bondholders, etc.) against any defaults by companies on their debt. According to Buffett, this segment too, had a much lower pay-out rate than estimated, implying that the risk had been overpriced.

Quite obviously, the insurance business is similar to writing options. One receives a premium in advance, and the pay-out depends on certain pre-determined criteria being met. Retail investors are also attracted to derivatives because of the prospect of earning higher returns with low investments.

Probably not.

Here’s why:

Firstly, Buffett’s derivative bets are capped in terms of how much he can lose. In contrast, writing naked options to earn premiums could theoretically mean unlimited risk. The returns are asymmetrical in a negative way which could potentially ruin you. Buffett’s own sister, Doris Buffett, lost her savings while writing naked options during the stock market crash of 1987. Buffett and his partner, Charlie Munger, have dubbed writing naked options as “picking up pennies in front of a steamroller”.

Secondly, Berkshire has access to sweetened, long-term deals because of its strong financial health. In the derivatives markets, counterparty risk is of utmost importance. Therefore, many companies are willing to pay up higher premiums to ensure that in the case a pay-out is required, they actually receive their money. With its immense financial strength, Berkshire is known to take on super-catastrophe risks and insure other risks that no one else is ready to take on. Therefore, it earns much higher premiums than it would in a competitive/efficient market.

Thirdly, the long tenure of most of these derivative contracts implies that the outcome is dependent on the underlying financial/economic situation rather than the whims of the market. Even if Berkshire actually has to pay out the entire money owed to counterparties, the cost of capital would be quite low over the 15 to 20 year period.

In contrast, retail investors have access to short term derivative contracts where the outcome depends on the market’s temporary swings rather than the underlying business fundamentals. Therefore, taking a directional view on the markets in the short term is speculative and could be dangerous.

Fourthly, most retail investors are drawn to derivatives because they can trade on margin, that is, traders are required to put in a small fraction of the entire contract value. Trading on margin allows investors to earn high returns without putting in a large amount of their own money. But in adverse scenarios, margins could amplify losses. In contrast, none of Berkshire’s derivative deals require it to use leverage.

The underestimation of risk, combined with heavy leverage use by optimistic institutional traders while trading in collateralised debt obligations and their derivatives, was partially responsible for the deepening of the 2008 financial crisis. Traders believed that slicing up loans, and pooling them into different tranches would somehow lower the overall risk.

Today, as more retail investors are entering the market, many of them are being subtly encouraged to enter derivatives trading by “financial gurus”, brokers and other parties with conflicts of interest.

In a case of survivorship bias, the ones who survived and were successful are highlighted, while leaving out the millions of retail traders who lost money on derivative contracts. Investors should understand the nuances behind blanket statements like “Buffett invests in derivatives”, and not be carried away by such statements.