Warren Buffett once called derivatives time bombs, then bet $40 billion on them. What this says about the legendary investor

Derivative trading has been under market regulator Sebi's radar for a long time now as these futures and options contracts come with substantial risk and often end up erasing a significant portion of investors' wealth. In this context, we remember why legendary investor Warren Buffett once called derivatives "financial weapons of mass destruction" and then bet $40 billion on them a few years later.

In his 2002 letter to Berkshire Hathaway shareholders, Buffett called derivatives "time bombs, both for the parties that deal in them and the economic system." "In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal," he wrote.

Also read | Why Indian retail options traders are having a tough time to defuse what Warren Buffett called lethal time bombs


Being ahead of time, as always, the Berkshire Hathaway Chairman wrote in the 2002 letter, "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."

Warren Buffett's $40 billion derivatives trade

However, this does not mean his portfolio shied away from futures and options contracts. Berkshire Hathaway ended 2007 with a $40 billion exposure to derivative contracts designed to make money if junk bonds stay out of default and stock indexes rise. This was significantly higher than the $24 billion he bet in the previous year.

His warnings however came true during the 2008 financial crisis, when complex derivatives originally designed to protect banks from deadbeat borrowers added to their turmoil. Berkshire Hathaway's derivatives positions also took a hit, with Buffett admitting he did some "dumb things" in 2008. The company's net profit crashed 96% to $117 million, largely due to 'paper' losses on those derivative positions.

What this tells us about Warren Buffett

While Warren Buffett's 2007 derivatives bet did not work out, it was due to the extraordinary financial conditions created in 2008 by the housing bubble collapse. His derivatives trades are typically based on strong research and patience. He also maintained strong caps as to how much he could lose.

Most importantly, investors must assess if they can digest the risk that comes with such trades. Senior officials have noted that many traders continue to lose money even after three to four years of participation, making it important for investors to assess whether derivatives trading is suitable for them.

Also read | Investors should assess if F&O trading works: Sebi chief Tuhin Kanta Pandey after heavy losses

It was noted that regulatory measures in the equity derivatives market have helped reduce aggregate F&O losses, with a recent Sebi study showing that losses in futures and options have declined from Rs 1.12 lakh crore to around Rs 90,000 crore after the regulator's interventions.

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