Writing in Berkshire Hathaway’s 2002 annual letter, the justly renowned “Oracle of Omaha”, Warren Buffett stated that derivatives (options, that is, puts and calls) are “financial weapons of mass destruction.” Nevertheless, Berkshire Hathaway has some major derivatives positions. How can that be? Well, Buffett once defined risk as not knowing what you are doing. By that definition, the Berkshire Hathaway position is not risky.
Here is one example of what Buffett is talking about. More than 20 years ago, investing in derivatives resulted in a $1.7 billion loss and bankruptcy of California’s Orange County. Some 3,000 public employees lost their jobs and services were reduced. Merrill Lynch & Co., the broker involved, made millions in fees, not surprisingly.
There are other examples. Long-Term Capital Management, with some of Wall Street’s major figures as well as two Nobel Prize-winning economists, needed a bailout of billions by more than 10 financial institutions in order to prevent market panic and collapse of the entire financial system. Much of their portfolio was made up of derivatives but the company was too big to fail.
The Monday Morning Millionaire Program way of investing in derivatives is safe. For interested members, the program recommends the following:
- Only sell (write) and never buy puts and calls.
- Do so using our recommended exchange-traded funds and not individual stocks. These are the SPDR S&P 500 ETF (symbol SPY) which has weekly expiry dates and the Vanguard Total Stock Market ETF (symbol VTI), the Vanguard S&P 500 ETF (symbol VOO) and the Invesco S&P 500 Equal Weight ETF (symbol RSP) which have monthly expiry dates.
- Write puts and calls in your fun portfolio only.
Investors always make and never lose money writing puts and calls. However, when writing calls, they do give up the opportunity of making even more money if the underlying ETF rises above the selected strike price. When writing puts, they do give up the opportunity of buying the underlying ETF even more cheaply if it drops below the selected strike price.
In dropping and lateral markets, writing calls outperforms. In rising markets, it underperforms.
In rising and lateral markets, writing puts outperforms. In dropping markets, it blocks option writers from buying greater bargains.
On another issue, we recently introduced Level 2 and Level 3 to the “Our Programs” tab. I just finished the first session with a member who scored 47 on our scorecard exercise. He was tasked with five action steps in preparation for our next session.
Do you see many actionable suggestions in today’s flood of investment writing?