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Warren Buffett and his financial WMDs

Chris McKhann (chris.mckhann@optionmonster.com)

Is Warren Buffett done playing with weapons of mass destruction?

The Oracle of Omaha has come out with his annual Berkshire Hathaway letter, and while its section on his derivatives position is relatively light, it is instructive.

Derivatives, you say? Didn't Buffett once famously call them " weapons of mass destruction "?

Well, yes. But his annual reports detail how he uses those WMDs extensively, as we have reported over the years. Most notably he sold billions of dollars of long-term puts on equity indexes around the world. (As a side note, retail traders have not had easy access to these, but the CBOE is in the process of rolling out long-term contracts so you can mimic Buffet's actions more closely.)

One line in this year's annual report caught my attention in particular: "Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions."

So it seems that Buffett is getting out of the WMD business, at least in terms of new contracts, as he doesn't want to have to post collateral. Most of us have to deal with margin requirements, but Buffett apparently dislikes those rules.

"We shun contracts of any type that could require the instant posting of collateral," he writes. "The possibility of some sudden and huge posting requirement--arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack--is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength."

We may not care what Buffett is doing with his billions, and it isn't very realistic to build a portfolio like his. But his action and admission do potentially highlight a bigger issue for those of us in the option market.

Are new financial rules leading to a dearth of volatility sellers in the markets? It has been shown that there is a volatility premium in index options, as the implied volatility tends to be a few points above the eventual realized volatility most of the time. That's what attracts the sellers.

There are, of course, occasions when volatility explodes. This usually hurts the volatility sellers and even puts a few out of business.

At such times the volatility premium often increases as people are willing to pay more for portfolio insurance in the form of index puts or VIX calls and futures, and there are fewer volatility sellers to meet the demand. But it also possible that the new financial rules could have the same effect.

The volatility markets have been significantly out of whack for the last month. The VIX, at 18 is more than 100 percent above the actual volatility of the SPX.

The VIX futures carry huge premiums, going up above 29 in the later months. This is highly unusual, and there are likely a host of causes. One piece of this puzzle may be a lack of sellers.

There are a lot of reasons that volatility sellers might want to step away from this market, or at least demand huge premiums. There are the European debt woes; there is that whole U.S. budget issue; the market is at a three-year high.

I certainly wouldn't be interested in selling volatility at 11 percent, at the typical 3-point premium to actual volatility. And while I need to do some more research, it is clear that the new rules are tightening on potential volatility sellers.

Finally, there is the issue of supply and demand. If investors are willing to pay whopping premiums to get the hedges they want, that is what the big volatility sellers will take. The problem for us mere mortals is that it doesn't necessarily make sense to fall into either camp, and taking advantage of the situation is anything but straightforward.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Feb. 29.)

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