Derivatives: Weapons of Mass Destruction or Risk Tools?

Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at the Columbia Business School, Greenwald has also authored multiple books, including Value Investing: from Graham to Buffett and Beyond.

Warren Buffett famously described derivatives as "financial weapons of mass destruction." Greenwald explains why that is true, and how investors can defuse derivatives and use them as a risk management tool.

Full transcript below.

Matt Koppenheffer: A lot of our readers, and a lot of the people watching this, are sometimes newer investors and may hear you say "derivatives" -- referring to options -- and think about that famous Warren Buffett quote, "Derivatives are financial weapons of mass destruction."

I was just going to ask, probably instructive to differentiate what Buffett was talking about, versus ...

Bruce Greenwald: OK. What Buffett is talking about is people speculating by using derivatives. A typical call option will be a call option to buy 100 IBM shares at a price ... today it would probably be of $175, say.

There's a huge amount of leverage in that. If IBM goes up to $225, you'll make several times your money. If IBM goes down, you'll just be wiped out.

They're extraordinarily highly leveraged instruments, and I think people who buy them to make money, it's like buying gold to make money. You're really taking on much more risk than you should be, because you can't make a good judgment about what's going to happen in the limited term of the options, and that's not the reason to buy derivatives.

What you want to buy derivatives for is if you own the stock and you want to protect yourself. You could sell a call so that if you thought, at 25% above the current price, you'd be happy to sell it. You can sell a call at 25% above the current price, which gives somebody the option to buy it from you if the price goes up by more than 25%. You're happy with that. You can calculate what the effect is.

If the stock price goes down, you just collect the premium, and you're not in any trouble. If it's a covered call, you just sell your stock at that price, and you don't have any risk.

I think people exaggerate the sophistication that's required if you think about buying options that are tied to your existing portfolio and insure against adverse movements in that existing portfolio. Stock market goes down, the call expires worthless, and you've collected the premium.

You have a put at $200, the stock market goes down, you make the difference between the, say, $150 price of IBM and the put price of $200. You pay something for that. Maybe you can finance it with a call.

But if you look at it in terms of an explicit risk management tool, I think you'll do much better than if you say, "Hey, this is a complicated way to make really good money."

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