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Wisdom of Warren Buffett: Defuse Derivatives’ Risks

June 19, 2011 | About:

Derivatives were covered in Buffett’s 2008 and 2009 shareholder letters. Although derivatives are extremely dangerous, Buffett trades them in a way that major risks are defused. Like an insurer sells insurance policies, he sells derivatives contracts to collect premiums upfront, invest them, and pocket investment return. Individual investors can trade stock options with a similar strategy to earn extra yield.

There are three key risks of derivatives: counterparty, collateral, and leverage. When counterparties are linked together, a so-called “weapon of financial mass destruction” is in the making. Like a nuclear bomb, when triggered a chain reaction of collateral posting ripples through all linked counterparties in a split second and collapses the entire system. Even worse, leverage multiplies the catastrophic outcome.

Among the three, counterparty risk is the root, collateral posting is the trigger, and leverage is the multiplier.

A derivatives contract is like an insurance policy. The “seller” of the contract receives a payment upfront, and promises to pay the “buyer” when something bad happens. Often a contract last for years. Risks are during the time a seller becomes insolvent and couldn’t fulfill his promise. This is the counterparty risk a buyer faces. The problem is, in a financial system a seller of a contract could be a buyer of yet another contract. Now three parties are chained together: buyer A and seller B in the first contract, and seller C in the second one. C’s solvency matters not only to B, but also to A, because B’s solvency matters to A. When everyone starts to trade derivatives, the situation gets complicated rapidly.

To compensate his counterparty risks, a buyer can require his seller to post collateral when things start to go sour. It is designed for good purpose because the buyer is guaranteed to receive at least something --- the posted collateral --- if the seller eventually busts. But in reality it creates another convoluted issue. When everyone is chained together, a round of collateral posting makes everyone worry about the situation and thus it begets another round of collateral posting, which in effect accelerates the worsening. In a crisis it leaves less time for government and central bank to plan for any interference.

When Buffett initiates a derivatives contract, he makes sure that neither counterparty risk nor collateral posting is involved.

“Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk.”

Buffett sells contracts to others. There is counterparty risk associated to the contract, but the risk is left to the buyer of the contract. Meanwhile, like an insurer sells insurance policies and receives premiums, Buffett invests the received payments and pockets the investment return. At the end of 2008, Berkshire’s derivatives “float” --- the investable sum of payments received from selling derivatives contracts --- totaled $8.1 billion.

Besides, because Buffett never plays as a buyer of derivatives, the chain of counterparties is severed at Berkshire. Berkshire’s solvency does not depend on any counterparties of its derivatives contracts. Thus Berkshire could have acted in the 2008 crisis as a firewall to stop the spread of anxiety. At the same time, it poured $15.5 billion liquidity to stabilize the system.

Without a feedback loop of counterparties, collateral posting wouldn’t ripple back to Berkshire itself. But still it would tie up a portion of Berkshire’s capital and would diminish investment return. For this reason Buffett also minimizes collateral posting when handling derivatives.

“Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year’s (2008) fourth quarter, we had to post less than 1% of our securities portfolio.”

Moreover, when Buffett posted collateral, he posted securities not cash. The securities were deposited with third parties and Berkshire still retained the investment earnings on them.

Leverage is only a multiplier among the three key risks. Without counterparty risk and collateral posting, a multiplier has limited impact. And leverage is natural in an insurer’s life, as he receives a small amount to shoulder a big risk. In aggregate an insurer expects to pay out less than what he receives. As long as it goes as expected, the insurer makes profit. Plus he can invest the received money to generate extra return. There is nothing to complain about.

Still risk management is highly important. Buffett insists that risk control is a CEO’s job. At Berkshire, Buffett personally handles every derivatives contract. He enters a contract only when he believes it is mispriced at inception and Berkshire would end up with profit. In his 2009 letter, Buffett reported that losses incurred by derivatives contracts were well covered by the payments Berkshire received, and Berkshire generated significant investment profit from the received payments.

With major risks being defused, Buffett has turned a potential “weapon of mass destruction” into a profitable garden variety insurance business. Nothing is prohibitively risky in the world of investment. It all boils down to how well an investor understands the business and how skillful he is at risk management.

Individual investors may not be able to trade the derivatives Buffett is trading. They can trade stock options with a similar strategy to earn extra yield.

Stock options come with two flavors, call options and put options. A buyer of a call option pays a premium upfront and gains the right but not the obligation to buy (or “call” away) the underlying stock at a predetermined price --- the strike price. A buyer of a put option gains the right to sell (or “put” away) the underlying stock at the strike price.

Options are like insurance policies. A put option guarantees its buyer a fixed sell price of the underlying stock no matter where the market price is. Thus an investor can buy put options to protect stocks in his portfolio from downside risks.

But more often than not, speculators use options as a leveraged directional bet on price movement, because the premium is only a fraction of the price of the underlying stock. For example, SPY’s July call option with strike price $130 is priced at $1.22, while SPY closed Friday at $127.05. Speculators pay a premium less than 1% of SPY’s price to gain exposure to SPY’s upside. If SPY rises above $130 before July’s option expiration, call buyers can execute their options to buy SPY at $130, immediate sell it at market price, and pocket the difference as a profit. The downside is if SPY fails to appreciate, buyers of the call option lose the premium of $1.22. But again, that’s a tiny amount comparing to SPY’s spot price.

Leveraged directional bet is vastly speculative and is not for prudent investors. Prudent investors can employ “covered call writing” strategy to squeeze extra bucks out of their stock holdings. The covered call writing strategy is similar to Buffett’s handling of derivatives contracts.

If an investor plans to hold a stock for a while, he can sell (write) call options of the stock. The investor needs to make sure two things: the strike price is higher than spot price and the call option is “covered” by the stock in his holding. When both requirements are met, the buyer of the call option agrees to pay the investor a premium upfront to buy his stock at a higher price. No wonder it’s a profitable business.

For example, if an investor holds 100 shares of SPY, he can write SPY’s call options for up to 100 shares. If SPY rises above the strike price, his 100 shares of SPY will be called away. But as he will sell them at the strike price that is higher than spot price, he’ll still make a profit. Plus he pockets the premium paid by buyers. If the stock fails to appreciate, he pockets the premium anyway.

Like what Buffett is doing, a seller of call options receives payment upfront, so he assumes no counterparty risk. Theoretically the seller automatically posts his stocks as collaterals because the buyer of the call options can call away the stocks at anytime. But as long as the options are covered by the stocks, he doesn’t need to post anything else. Thus the risk of collateral is minimized. Plus if the price rises but below the strike price, the seller still enjoys the appreciation.

Options incur much smaller counterparty risk than that of Buffett’s derivatives contracts. Stock options are cleared in a centralized options exchange, which stands behind every option trade. If an option seller couldn’t fulfill his responsibility, the exchange would pay for it.

Covered call writing incurs smaller leverage risk than that of Buffet’s derivatives contracts as well. In either case a call writer makes no payout to his counterparties. What Buffett does is equivalent to naked put writing. In the worst case a naked put writer needs to make payout to his counterparties at a much bigger sum than what he receives.

As always, risk management is highly important. Chances are an investor wants to hold a stock for a long period but the stock is accidentally called away. And he needs to go through the trouble of buying it back, probably at a much higher price. Investors need to evaluate risks on a case by case basis. We list some conventional suggestions as a starting point.

  • Shoot for a higher strike price. A higher strike price is associated with a lower premium. But that is OK because investors’ goals should be to earn extra yield on top of their long term holdings, not to make big profits by outsized bets.
  • Pick stocks with low historical volatility. Generally historical volatility correlates to expected volatility. Prices of stocks with low historical volatility are expected to move slowly.
  • Avoid catalysts that may cause big price swing. Options usually last for a couple of months. Investors want to avoid events such as earnings reports, new product announcements, and conferences for analysts or shareholders.

About the author:

Author of ETF Ranking Newsletter.

An amateur trader / investor that tried many methods including buy and hold, technical analysis, quantitative analysis, day trading with pattern, and finally settled with fundamental analysis to discover undervalued quality stocks.

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