Warren Buffett calls Options “Weapons of Mass Destruction” but still indulges in them
Warren Buffett spooked an entire generation of investors and traders by describing “derivatives” (i.e. futures and options) as “weapons of mass destruction” in his letter of 2002.
“I view derivatives as time bombs, both for the parties that deal in them and the economic system,” the Billionaire said in a stern tone.
“In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” he added.
Later, in his letter of 2008, Warren linked the collapse of Lehman Brothers and the ensuing financial catastrophe to the misuse of derivatives.
“Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks ….
… The Bear Stearns collapse highlights the counterparty problem embedded in derivatives transactions, a time bomb I first discussed in Berkshire’s 2002 report,” he said.
However, the fact is that Warren Buffett has himself been using options to rake in big bucks for himself and his shareholders.
He disclosed in his 2008 letter that Berkshire Hathway has “put contracts” totalling $37.1 billion which are spread among four major indices such as the S&P 500.
The said contracts have earned premiums of $4.9 billion (which has been invested).
The total amount at risk is $37.1 billion.
Warren suggested that the risk of a loss is remote.
“One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028.”
Warren also stated (in 2008) that there was an “estimated loss” of $10 billion which required reporting of a mark-to-market (MTM) loss of $5.1 billion from the put contracts.
Presumably, the estimated loss figures may be enhanced now given the steep collapse in the Indices due to the Covid-19 pandemic.
Warren provided an explanation about the fate of these contracts in the 2020 meeting.
Option buyers always lose money: Option sellers
A young trader named Mitesh Patel has become the cynosure of all eyes in Dalal Street because he has been repeatedly boasting of massive earnings from options.
In addition to posting weekly screenshots, he has claimed to have earned a mammoth amount of Rs. 3 crore in just 19 months from options. The return in FY 2019-20 is said to be a mind-boggling 428%. The return over 26 months is said to be an unbelievable 1694%.
“A new definition of multibaggar return in trading … Catch me if u can,” he said, evoking admiration and envy from his followers.
Started full time trading in Dec 2017 with 45L.
Crossed today 300L.
Just 19 months.
Will change the definition of intraday and option trading.
— Mitesh Patel (@Mitesh_Engr) June 18, 2019
Nifty at 2 years low.
My return is at all time high.
Total 428% net return in this financial year with capital 1.24 cr
A new definition of multibaggar return in trading
Overall return since full time trading carrier ( 2 yes 4 months) is 1694% with 45 L capital.
Catch me if u can
— Mitesh Patel (@Mitesh_Engr) March 12, 2020
He has claimed that “option buying” is a tool to “lose money slowly” and that “option selling” is the road to riches.
In a trading world option buying is the simple tool where you can lose money slowly.
One trade will give you profit put 3 trades will take your full capital.
Only 0.5% option buyers with skills can survive.
— Mitesh Patel (@Mitesh_Engr) May 23, 2020
However, this sweeping statement has not gone down well with other traders who have made a fortune out of “options buying“.
Asit Baran Pati, a trader who reported an earning of Rs. 77 lakh a few days ago, argued that while option buying has limited risk, option sellers are “dipping into the river of risk” and may not be able to come out “without drowning“.
Any idea how many % of sellers lose..and a seller (a normal retail with modest capital), would he make money consistently without dipping into the river of risk..and how many times he will come out of it without drowning?? And even if he makes it, what would be his return??
— Asit Baran Pati (@asitbaran) May 24, 2020
He also claimed that an option buyer who knows “how to catch the trend with momentum” can make a fortune from option buying.
An Option buyer must know how to catch the trend with momentum and when to trade and when not to, option buying is probably a better strategy than people been led to believe (and I strongly believe that).You lose money as a buyer cause of you are wrong in direction, trend, 5/
— Asit Baran Pati (@asitbaran) May 23, 2020
He also argued that option buying returns are unmatchable to option selling, given that it is without any leverage, and risk management is easier.
Both strategies have their place in a trader’s armoury
Other experienced options traders pointed out that it is fallacious to label either strategy as good or bad.
One has to adopt the appropriate strategy depending on the market conditions and other circumstances.
It's a fallacy that buying options is a losing game compared to selling options.
The two trades just carry different risks and are not necessarily on the opposing side of the trades.
1/n@MoversQuant @QCAlphaOne #Movers & #Solvers
— Prashant Mullick (@VohiCapital) May 24, 2020
TBH, both buying and selling can make money. Just that seminars made option selling fashionable in trading.
— Angel Parikh (@ContextMatters4) May 24, 2020
Hi Asit… with due respect, debating between option buying vs option selling, is like debating between Index FUT vs Stock FUT or F&O vs Cash or Equity vs Commodity…these are all different instruments of making money… (1/2)
— Gordon Gekko (@GordunGekko) May 24, 2020
However, some veteran traders like Peter Brandt are unhappy with both strategies. Presumably, he prefers “futures“.
I have some basic problems with options
Being short naked options, a strategy called being short gamma, is successful year after year after year, until you go broke
I do not like buying options because I don't like paying premium that erodes with time.
— Peter Brandt (@PeterLBrandt) May 17, 2020
The merits and demerits of the two strategies have been explained in an objective manner by Projectoption, with a number of real-life examples.
OTM Options are a “Hero Ya zero” Game
Most traders have a fascination for buying “Out of the Money” options because they are dirt cheap.
These options can generate a massive fortune if there is a sudden and sharp movement in the Indices or stock.
In fact, a trader was able to convert a paltry sum of $766 into a fortune of $107,758 due to buying OTM Put Options in a volatile stock named ‘Roku‘.
A guy on Reddit turned $766 into $107,758 on *two* options trades https://t.co/zHWk0W7jhC
— Bloomberg (@business) October 19, 2019
There are a number of other examples where options costing only a few paise have surged multifold.
Today is the day of option porn . How some Bank Nifty and Nofty calls went 10X to 40X in 1 hour . #NirmalaSitharaman
— Rajiv Mehta (@rajivmehta19) September 20, 2019
Rs.50K in Banknifty Call options would have fetched you 1Crore plus today.
— E. (@EngineeRoholic) September 20, 2019
Nifty Bank Call options up more than 10x today
30600 up 14x
30400 up 13.6x
30500 up 13.4x
30700 up 12.1x
30300 up 12x
— Jayesh Khilnani (@jayeshkhilnani) September 26, 2019
That's brutal 3 RS to 680 ?#BankNifty #OptionsTrading pic.twitter.com/bQVsHKmxpn
— Vishvesh (@Vishvesh03) September 26, 2019
However, other experienced traders claimed that “OTM options” are a way to lose money and that only “ITM Options” can generate huge returns.
People buy OTM options and loose money!…. Always buy ITM options mainly ITM Puts with strict SL and you'll make huge money!…..
— Raman Pathak (@RamanPa93849244) May 24, 2020
Options Seller loses $150 Million and goes bankrupt
Warren Buffett’s warning that derivatives are “weapons of mass destruction” is obviously not without substance.
A well-known trader named James Cordier lost $150 Million of his clients’ funds because the crude oil prices plunged below the put strike prices and created unmanageable risk.
https://t.co/bblhnDBrMT appears to have lost all client money on short options strategies on energy markets.
Watch the full video , I have been there 🙁
James Cordier to 290 clients here on YouTube. https://t.co/AxX5gh5KNu#shortvol #options #black_swan
— Subhadip Nandy (@SubhadipNandy) November 17, 2018
It appears he indulged in “Short Strangles” which is said to be “the most dangerous strategy in a trending market“.
To 95% of Option Sellers, Option selling means "Short Strangle"
In fact, that is the most dangerous strategy in a trending market.
Both Nick Leeson and James Cordier did Short Strangle.
— P R Sundar (@PRSundar64) February 6, 2020
A number of other options sellers have reportedly gone belly-up such as Karen “the SuperTrader” and Victor Niederhoffer.
Use risk-defined options strategies only
It appears that if we are inclined to dabble with options, we should always confine ourselves to “risk-defined” strategies which have a limited loss potential.
Some of these strategies are Iron Condor, Iron Fly, Butterfly, Vertical Spreads, Call Calendars etc.
This way, even if things go haywire and there is a Black Swan event, the risk is within limit of tolerance.
I do not 'sell options' ( undefined risk ), I do not carry naked futures. I carry only options ( naked options buys or risk defined strategies)
— Subhadip Nandy (@SubhadipNandy) May 20, 2020
It also appears that SEBI has loosened the margin requirements for these strategies, which makes them worthwhile from a ROI perspective.
Here are some sample calculations for F&O positions in the new margin framework. Iron condors require 70% lesser margins. Now, trying to figure out how to nudge customers away from high risk naked trades to low-risk spreads. https://t.co/FxrUb3d1H3 https://t.co/NWeZD5ErRe pic.twitter.com/AewTaDyi6P
— Nithin Kamath (@Nithin0dha) May 19, 2020
So, it is better if we also gear up to learn the new tricks of the trade and start making money like the others on Dalal Street!
Those who understand options can play well, then it is one of the best ways to generate regular income.