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Deadly Derivatives: Warren Buffett Uses The Ones He Understands

Deadly Derivatives: Warren Buffett Uses The Ones He Understands

Warren Buffett famously stated in his 2002 letter to shareholders “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”The growth over the last 15 years in the derivatives market has been startling, with most retail investors now indulging in directional bets (calls and puts) before earnings as well as volatility selling strategies. Selling volatility was what led to the downfall of LTCM in 1998 and requires knowing two key variables, the price of the underlying asset and the future expected volatility of the asset until expiration (implied volatility). Implied volatility is a more important variable in my opinion for pricing options. (A general heuristic is the lower the IV, the cheaper the option; most assets’ price and volatility have a negative correlation.)

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