Buffett On Derivatives: 'A Fool's Game'

marcus · #1 23rd May 2007, 08:18 AM

N.B. - This is Mr. Buffets opinion not mine so please don't flame

Buffett On Derivatives: 'A Fool's Game'
Posted on May 7th, 2007 with stocks: DIA, SPY

Michael Panzner submits: Warren Buffett, the billionaire investor and long-time chairman of Berkshire Hathaway Inc. (BRK.A), is a man who speaks his mind. I'm not sure whether he's always been that way, or whether it is his exceptional wealth or his age -- or both -- that emboldens him to cut through Wall Street B.S. like a hot knife and expose the bloody truth about the foibles of modern finance.

Whatever the case, his comments on derivatives, in particular, have been always been especially enlightening -- and entertaining -- because they expose this supposed risk-sharing panacea for the house of cards it has become. In Derivatives Cause 'Mass Destruction', the Wall Street Journal reports on the 'Oracle of Omaha's' latest thoughts on the subject.

Earlier Saturday, Mr. Buffet repeated his warning on the dangers of derivatives, saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets.

In fielding a question about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants.

"The introduction of derivatives has totally made any regulation of margin requirements a joke," said Mr. Buffett, referring to the U.S. government's rules limiting the amount of borrowed money an investor can apply to each trade. "I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but...at some point some very unpleasant things will happen in markets."

Mr. Buffett has expressed similar bearish sentiments about derivatives in previous meetings and in his widely read annual letters to shareholders. He had first-hand experience with the difficulties of derivatives after Berkshire acquired General Re, the reinsurance company, in the late 1990s, and spent several years unwinding its derivatives portfolio at a loss to reduce the subsidiary's exposure to risk. He noted, however, that Berkshire currently has several dozen derivatives positions -- such as futures and options contracts on stock indexes and foreign currencies -- and added that "derivatives aren't evil."

Charlie Munger, Berkshire's 83-year-old vice-chairman and Mr. Buffett's droll sidekick during the six-hour annual meeting, said that the accounting of derivatives contributed to the risks they pose to the financial markets.

"The accounting being deficient enormously contributes to the risk," said Munger, lamenting that executives and shareholders were getting paid on "profits that don't exist."

Mr. Buffett noted that existing accounting conventions allow parties involved in derivative transactions to value the same contract differently, leading to an inadequate or incomplete picture of the contract's risk. "I will guarantee you, if you add up the marks on both side, they don't add up to zero," Mr. Buffett said, referring to the accounting of a single derivative contract.

Exacerbating the problem of derivatives and leverage is the short-term trading mentality and high turnover in the stock and bond markets, Mr. Buffett and Mr. Munger added. "There is an electronic herd of people around the world managing an amazing amount of money" who make decisions based on minute-by-minute stimuli, said Mr. Buffett, adding, "I think it's a fool's game."

Based on how markets have been acting lately, it would seem that most investors believe it is Mr. Buffet who is the fool. I guess we'll just have to wait and see.

RSI · #2 23rd May 2007, 03:22 PM

It is worthwhile to remember that Mr. Buffett was bearish on U. S. dollar since last several years, at a time when none was bearish on U. S. dollar other than Mr. Buffett. Now most of the traders are bearish on U. S. Dollars. No wonder, Mr. Buffett visualises things much earlier than others. That is why he is still no. 1 and he will be.

uasish · #3 23rd May 2007, 04:35 PM

Trading in Derivatives is "Risky" & the Reward (being leveraged) quite enormous ! & definetly calls for High precision & nimbelness with very sound TA base,requires a Robust Money mgmt & Risk Mgmt system in place.
Here in this select Herd ; Survivours are pretty thin.Outside India just giving 'Managing Fee' to a 3rd party Banker one can continue holding (loosing positions like a new POA a/c type- introduced in Indiabulls for Cash mkt)whereas here roll over is Satutatory.
Wealth created on speculation never contributes to GDP directly.
The best example of "Leveraged Money" disaster was the Barckley bank dibacale in south east asia,few yrs back.

“I can calculate the motions of heavenly bodies, but not the madness of people”

- Isaac Newton, upon losing £20,000 in the South Sea Bubble in 1720

See i was not the only losser 'SIR' was also !
Even after this WE try to find out ?

(we cant be better than god)
Now i will give here another different approach to Mr Warren Buffet's statement:=
In the mind set of 'Scientific approach' to Mr Buffet's statement it can be reasonably concluded:=

His statement does not provide a visual and formal mechanism for recording and testing this subjective probabilities. This is especially important for a risky event where you do not have much or any relevant data about this 'Forecasted Event'.
Simply read off the marginal probability values for each risk event given your current state of knowledge. This will rank the risks in order of probability of occurrence. (this tells you which are most likely to happen given your state of knowledge of controls and triggers);
• Set the value of each risk event in turn to be true and read off the resulting probability values of appropriate consequence nodes. This will provide the probability of the consequence given that each individual risk definitively occurs. The risk prioritisation can then be based on the consequence probability values.
• Introduce ‘dashboard’ type features by identifying key consequences, setting thresholds below wich they should not fall and then building traffic light(Red warning light) components based around that.
This infact reflects my present 'Confussed' state of mind.

hitesh sabharwal · #4 23rd May 2007, 05:27 PM

hehe,gr8 thread,amazing posts by all.

marcus · #5 10th June 2007, 01:09 AM

Quote:

Originally Posted by rajak1981

"The introduction of derivatives has totally made any regulation of margin requirements a joke," said Mr. Buffett, referring to the U.S. government's rules limiting the amount of borrowed money an investor can apply to each trade. "I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but...at some point some very unpleasant things will happen in markets."
Best summarized as a paranoid statement.

Leverage or borrowing is a double edged sword
Those who don't know how to wield it cut themselves.
They don't really cut up the system.
You do know why right??
Derivatives don't come out of thin air
There is a counter party/stabilizing influence who has the opportunity to take profits
Don't believe me??
run an analysis of smoothness of trend of fno stocks vs eod trading punter stocks.
Fno stocks there are more buyer/sellers/liquid moves less spikes.

Short selling adds to stability of the markets.
The professional derivatives trader usually is both borrowing and lending..
he might be intraday short on something that is correcting/declining/downtrending or just pulling back and eod long from a positional perspective.
Not all people are crazy and go 100% long with 10x leverage.
Those who do go 10-20-100x leveraged in one direction usually end up cutting themselves so deeply that they never recover. Infact they are out of the game so quickly before the market can even move that the impact on the market is near 0. reason a 5-10% move in spot will kill a derivatives trader who is 10-20 x long.
The weak members of the herd are culled through natural selection.
Buffet need not worry.
Natural selection has worked for millions of years , it will continue to work.

If anything a mechanism for easy borrowing/lending of money IMPROVES the 'efficiency of markets'. Any student of capm/market efficiency will know that one of the requirements for truly 'efficient markets' is the ability to borrow/lend insane amounts of money for the market to be truly efficient.

If someone borrows 10x leverage because he has no brains that is his fault
But imagine i am a sophisticated investor
i have 40 crores in the bank. 40 crores in shares
and with 20 crores i play long/short in the market.
I am not always truly borrowing from the market. I have already lent 40 crores @ 8-10% fd
the 20 crores is only subjected to exposure when a market inefficiency arises.
Sometimes i might use the 40 crores to hedge by shorting stocks i already own in cash if there is too much premium. The hedge might only be in place for a few months with a purpose of saving me brokerage/liquidity cost of entry/exit and also taxation on FULL profit vs taxation on 3-5% profit. Basically by holding my delivery position for 1 year on all occassions in good funda stocks i allow myself to fall into 0 tax bracket while still participating in market swings WITH LOW COMISSIONS AND IMPACT COST.

At other times.
I would declare my intention to buy a stock by buying a future and borrowing cash from someone @ cost of carry ideally below or at the rate of my fd. (P.S Ideal entries/rollovers are at discounts so my borrowing rate is not even as much as my earnings from fd!! though that will be tough to find in stocks. just check nifty it manages to go into discount once every month...)

IF at end of the month some punter wants to muscle me out of my position
I have 2 options..
I can a) rollover position by paying cost of carry and borrowing again
or b) convert position to cash. by either selling other shares that i own or breaking the fd!!
I may choose to continue rolling over since cost of breaking fd balances with cost of rolling over. these two are negating each other to some extent.
If my futures just never moves into a profit and my funda view is intact and my fd is now expiring
I move my fd into cash and buy the stock
or if i have profits in another stock which I can book and my funda view on new futures position is intact i can take a cash position.

Now I am long...
This is an example of how an efficient market can work successfully.
For every secnario of derivatives causing market failiure i can give u a scenario where derivatives work successfully.
Guns? weapons? legal? They can be used to kill people? or enforce the law?
Which way do u use them??
Some people might even use them to commit suicide.
Is a gun a fool's weapon?
Would there be no fools without guns?
Would people not commit suicide/crimes with knives/clubs/ropes/swords?

Buffet is old school maybe he is stuck in his times.
Maybe he never moved forward. History is full of examples of people who fail to adapt. No one is perfect. Some people survive some people go extinct. No one is a 'god'
It will be very interesting to note whether the top performing fund of the 21st century will be a hedgefund or a 'value/sip/buffet/graham type fund'
Of course if u do believe in efficient markets then u will realize that a hedge fund by nature of its existence enforces more efficient markets. i.e the more hedge funds u have the more efficient markets become and the smaller the profit of the hedge fund
So can hedge funds truly create abnormal profits

??
Interesting paradox isn't it??

P.S This is intended to be a thought provoking informative diatribe
pun intended

No flame towards author of post intended. Just trying to enlighten some lost souls who do not understand derviatives.
I speak from experience when I tell you that some people will BUY A STOCK USING MARGIN AND FEEL SAFER. even though the future is available at discount...+ there is no upcoming dividend etc..
People just don't know the value of derivatives.
How many people know that buying a futures contract means borrowing from market @ coc? Thats step 1.. most rookies get it. How many people here honestly know how to avoid capital gains using derivatives and still protect profits??
Think over it.
and please by all means do flame if you like
Leave a comment here
http://fnocharts.blogspot.com

?

dude I don't think you belong in the markets, you should be on the lecture circuit

thomsv · #6 30th June 2007, 10:51 PM

Surprising Buffet has not understood Derivatives!!!!!

ash.investor · #7 1st July 2007, 05:09 PM

Hi Raja,

After reading your threads, it seems that you have been very successful in Derivatives market.

I have been tracking the derivatives market since last six months. By now, I am able to interpret Open Interest. If I see that there is an abnormal increase in the open interest of a scrip then there is sharp move expected soon on the either side. But I am not able to catch the trend. I use 5,10 and 20 EMAs in 10-day chart consisting of candles of 15min.

Please help me with the indicators that I should be looking at inorder to improve my system. Also comment on the leverage, risk management and the money management areas in derivatives segment.

Thanks in advance

Regards,
ash.investor

manish_life · #8 1st July 2007, 10:01 PM

dear all senior members i want to know openintrest. plz tell me how it effect the merket.

manish

ash.investor · #9 2nd July 2007, 01:57 AM

Quote:

Originally Posted by manish_life

dear all senior members i want to know openintrest. plz tell me how it effect the merket.

manish

Open Interest means the total number of options and/or futures contracts that are not closed or delivered on a particular day. In other words it is the count of the total no. of long and short positions.

Regards,
a$h.investor

ash.investor · #10 2nd July 2007, 02:04 AM

Hi Raja,

Great post again. Thanks for your useful tips and highly oblidged for the same.

Quote:

Originally Posted by rajak1981

Other option is to go out there. Find a gr8 mentor someone who knows how to trade and has 4+ years of experience +> 20-30% <b>car</b>. Either pay them or become an apprentice. Take a pc or laptop there. Sit next to them. Practice trading live.

Please answer my stupid question. What do you mean by "car" in your previous quote.

Regards,
a$h.investor

Similar Threads for: Buffett On Derivatives: 'A Fool's Game'
Thread	Thread Starter	Forum	Replies	Last Post
Is trading a zero sum game?	TradingPicks	Risk & Money Management	11	21st August 2008 12:35 PM
Word Game	swagat86	General Chit Chat	21	15th March 2007 08:08 AM
Zero Sum Game	jagjag	Introductions	2	4th February 2006 10:19 AM
New Kid In The Game	kpmahal	Introductions	1	2nd January 2006 12:29 PM
The Warren Buffett Way by Robert G. Hagstrom - A Book Review	Uday	Trading Resources	1	26th October 2005 11:01 AM