Warren Buffett's derivatives strategies

In Berkshire Hathaway Inc.’s 2002 annual report, Warren Buffett described derivatives as time bombs and financial weapons of mass destruction. On the other hand, Berkshire – Buffett’s holding company - has been a big investor in derivative contracts.

How can this apparent contradiction be reconciled? The answer seems to be that Buffett believes that derivatives are risky, but that under the right conditions and for the right payback, the risk is worth taking. He seems to be right – Berkshire has found derivatives useful in stakebuilding, in a major acquisition, and as long-term investments to acquire shares and generate large cash assets and substantial profits.

Coca-Cola stakebuilding

Buffett used a derivative strategy in the course of building Berkshire’s approximately 9 percent stake in Coca-Cola Inc.

In 1993, when the Coca-Cola share price was $39, Berkshire sold put options referencing 5,000,000 Coca-Cola shares. The exercise price of the options was $35 per share, meaning that if the Coca Cola share price fell below $35, the options would be exercised against Berkshire and it would be compelled to buy the option holder’s Coca-Cola shares for $35 each for a total cost of $175 million. For selling the options, Berkshire received premium income of $7.5 million.

As it happened, the Coca-Cola share price increased during the option term, so the option holder did not exercise the options and allowed them to expire. Berkshire kept the option premium, making a gain of $7.5 million.

At the time, analysts surmised that Buffett’s derivative strategy indicated that he was willing to buy Coca-Cola shares for $35 per share even if the share price fell below $35, but if the share price increased and the put options expired unexercised and Berkshire bought no shares, Buffett would still be happy because Berkshire had received the option premium income of $7.5 million.

BNSF acquisition

Buffett used derivatives in Berkshire’s acquisition of US railroad company Burlington Northern Santa Fe Corp.

Berkshire acquired full ownership of BNSF in November 2009 by buying all the BNSF shares that it did not already own for $100 per share. Berkshire had already built a 22 percent stake in BNSF through a series of share purchases over the previous three years, some purchases resulting from the exercise of derivative contracts.

Between 2006 and 2009, BNSF’s share price was volatile, and in 2008 and 2009, with the BNSF share price fluctuating around $70 to $80, Berkshire sold a series of put options referencing several million BNSF shares. Some BNSF shareholders must have been pleased to buy Berkshire’s put options, thereby ensuring that if the BNSF share price fell they would be able to sell their shares to Berkshire for the option exercise price. When the BNSF share price dipped below the option exercise price, these options were exercised against Berkshire, resulting in it being compelled to buy BNSF shares at above their market price.

At the time, the option holders may have felt that they had outsmarted Buffett, having bought Berkshire’s put options and then having forced it to buy their shares at above the market price. But in time, it turned out that they were the losers, when Berkshire bought all of BNSF’s remaining shares for $100 a share, a price much higher than the price it had paid under the option contracts.

Long-term derivative investments

Buffett has made long-term investments in derivative contracts through Berkshire’s sale of equity index put options.

Between 2004 and 2008, Berkshire sold large equity index put option contracts on four equity indexes. Berkshire’s 2013 annual report shows sold equity index options with a notional value of $32 billion. The option contracts expire around 2020, and if at their expiration date the value of the indexes is below the option exercise value, Berkshire will be obliged to pay the difference between the two values to the option holder.

The terms of these put option contracts have been advantageous for Berkshire. It received the option premiums when the contracts were entered into, and therefore it has no counterparty credit risk. It is not required to post collateral under the contracts. The option premium income has been usefully applied by Berkshire as working capital or to fund other investments. Stock markets are currently at historic highs, so at least at present it seems unlikely that Berkshire will have to pay out on the contracts.

Bottom line

What can be concluded about Warren Buffett’s derivatives strategies?

One thing seems clear – Buffett likes to sell put options. The reason for this is probably that selling put options is similar to selling insurance, because by undertaking to buy the underlying asset, the put option seller effectively insures the option buyer against a fall in the price of the asset. Selling insurance is a big part Berkshire Hathaway’s business through its insurance subsidiaries.

Buffett’s derivative strategies appear to have worked well. Although the Coca-Cola options did not result in Berkshire buying any shares, it earned a nice option premium from selling the options. Derivatives were useful in Berkshire’s acquisition of BNSF, helping to accumulate shares at a price that turned out to be cheaper than the eventual cost of the remaining shares. Long-term equity index put options appear to have made nice profits for Berkshire, at seemingly low risk. All round, deals well done.