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Warren Buffett Derivatives Speculator

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by Felix Salmon
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Nov 05 2007 12:00am EDT

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.

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