Warren Buffett is famous for saying that "derivatives are weapons of financial mass destruction". He doesn't much like the derivatives market. But ironically he trades in options, which are a type of derivative.
One article about Buffett's options trading points out that he lost a lot of money when he sold options at the wrong time. If I understand the deals correctly, he predicted that the stock market would be at a certain position by a given year, and he sold options on shares in the Standard & Poor Index well in advance of that time. The options meant that when it came time to sell those shares he could only sell them to whomever owned the options.
Of course, Buffett didn't actually own the shares. Instead, he had plenty of time to wait for the share prices to drop below what he expected them to be so he could buy those shares then. Or maybe I misread the history and he bought the shares already but the price difference didn't go the way he expected.
What financial gurus like about Buffett's deals is that he plans these transactions (the sale of whatever he owns) so far in advance that he can take years to invest the money people pay him for his options, so that even if he loses money on the actual sales the increase in value on what he was paid for the options makes up the difference.
What analysts seem to agree on is that Warren Buffett thinks of options as investments, not as schemes. He is selling the options but to him they are investments. It takes a lot of thought for me to get my head around that. If he is selling the option, then what is he investing in?
According to this list of options contracts there are many different ways to work with options. And Buffett sells so-called "put" options where he sets the price at which he will sell whatever it is that he is selling. So the investment must be determined by the contract but it is not "in" the contract. In other words, if Buffett says he'll sell you 1,000 shares at $500 each in 10 years then he is planning to buy those 1,000 shares at a time when he thinks he can make a profit on a sale.
The options contract obligates Buffett to buy and sell the shares, but it only obligates him to sell the shares at an agreed-upon price. If he can buy the shares at a lower price he makes a profit. If he has to buy the shares at the same price he agreed to sell them he still makes a profit because someone paid him the option fee.
Where Buffett may lose money is if he has to buy the shares at more than the price he agreed to sell PLUS more than what he got for the options PLUS more than whatever he earned with that option money during all those years.
I can see how thinking that far ahead reduces the risk on Warren Buffett's part but does everyone trade in options this way? Of course not. Some people sell "Call" options when they need money and they believe their shares will increase in value (above what the "Call" price will be). But if you buy the "Call" contract you're banking on those shares increasing in value. What happens if you and the seller are wrong? You end up paying more than market price for those shares PLUS whatever you paid for the option.
When you are buying options you have to factor in the amount of money you pay for the options as well as inflation and reasonable interest. To buy an option you really should be convinced you're going to make a lot of money when the deal closes because whatever you pay up front is added to whatever you pay at the time of the sale.
And sometimes it's just cheaper to walk away from the options contract than to actually buy those shares. So some options buyers just end up throwing money away.
If even Warren Buffett -- the richest and most successful investor in history -- can lose money trading options, what are the odds that other people will lose money on them? Pretty good, I should say. I think I'll take my time about moving into the options market. I will have to learn a lot more before I do that.
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