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Warren Buffett Explains the Dangers of Using Options

·2 mins read

- By Stepan Lavrouk

At the 1997 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked what they thought about the then-growing trend of speculative activity among retail investors. The dotcom bubble had just begun to grow at that point, and many novice traders and investors were beginning to dabble with financial derivatives like options and futures. Here's what the duo had to say.

Be happy with what you have

The general thinking behind using leverage is that it can get you where you want to go faster. If you are sure that stocks are going to go up, then you stand to make more money by purchasing options or futures that will go up by a larger amount than the underlying stock. Of course, the problem with this is that there is no such thing as a sure thing. This was Buffett's basic point:

"Borrowed money frequently leads to trouble, and it's not necessary. If you have some compelling reason to double your money by the end of the year, you should use the futures market - if you really need to do it. But really you need to figure out how to be happy with the present amount of money that you have...Once people start focusing on short term price behaviour - which is the nature of buying calls or speculating in index futures - you're very likely to take your money off the main ball, which is valuing businesses."

Another problem with options is that they expire over time - the closer to expiration, the lower the price of a put or call will be (all other things being equal). This time decay introduces another problem that ordinary shareholders don't have to worry about - you could be right about the prospects of a company, but still lose money if you are wrong with the timing of the trade.

If you start investing early and conservatively, you are less likely to end up in a position where you "need" to double your money in a single year. Investing this way isn't necessarily easy, but by maintaining a wide margin for error and looking for cheap businesses using tools like GuruFocus' stock screeners, you can build up a portfolio that will - over time - compound your savings and ensure a good retirement pool.

Disclosure: The author owns no stocks mentioned.

Read more here:

  • Jim Chanos Thinks Commercial Real Estate Is in Trouble?

  • The Value Investor's Handbook: 3 More Warning Signs for Investors

  • Jim Chanos on the Challenges of Short Selling

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This article first appeared on GuruFocus.