While many traders say you should never add to a losing position, Warren Buffett is reported to have "doubled down" on equity derivatives trades that have lost billions of dollars.
Last year, near the top in the stock markets, he sold "put options" on four stock indices, which include the S&P 500 plus the indexes from three foreign countries. A put option goes up in value as price declines, so buyers profit from falling markets. As the seller of the puts, Buffett wins only if prices go up.
While option contracts are usually short-term, Buffett's are for the very long-term. These puts had original terms of either 15 or 20 years and were written at the market price. This means that even a one point increase in the value of the index at the end of the contract makes them profitable to Berkshire Hathaway.
Unfortunately, markets fell by more than 50 percent almost immediately after the contracts were originated.
For accepting the risk that stock markets would decline in the coming decade or so, Buffett received premiums of $4.5 billion. If stock markets are higher than they were in 2008 when the contracts expire between 2019 and 2027, Berkshire will keep the entire premium.
The biggest benefit of writing the contracts to Buffett is that he has more than $4 billion to invest for the next 10 to 20 years. If history is any guide, he is very likely to receive substantial income from those investments.
In its most recently quarterly report, Berkshire said that if stock prices remained unchanged over the next 10 years, it would face a loss of $13.3 billion on the derivatives. The worst case loss was $35.5 billion, which assumes all the world's stock markets go to zero over that timeframe.
Bloomberg calculated that Buffett needed stocks to post average annual returns of at least 6 percent just to break even on the contracts.
After suffering steep losses, Buffett restructured his trades. In effect, he sold some of the original contracts at a loss. He will be able to use this loss to offset capital gains for tax purposes, a move which will increase the wealth of Berkshire shareholders.
But, Buffett is still convinced that stocks will move higher in the long-term. So he sold new put contracts which will be profitable if the S&P 500 gains only 15 percent over the next 10 years.
Buffett told CNBC that he didn't pay a "dime" in cash to restructure his derivatives. This means that he sold enough new contracts to offset the losses he realized in the old contracts.
He is confident that the odds are in his favor and he will realize a profit on the new contracts as well as the old ones he still holds.
Individual investors can learn several lessons from this:
The market is always right. Although they are only on paper, Buffett's losses were real. Ignoring them wasn't going to make them go away. Think about using losses to offset gains for tax purposes. The rules say you can't buy the exact same stock or fund that you sold within 30 days, but there are often close competitors worth purchasing. Control your emotions. Losses of more than $13 billion represented about 25 percent of Berkshire's investment portfolio. Instead of panicking, Buffett calmly took action. If you are confident in your analysis, stick to it. Although the recent decline was steep, it is unlikely to alter the long-tem history of the stock market. Buffett probably regrets placing his bets at the high, but he is obviously more certain than ever that stocks will move higher in the long run, just as they always have.Buffett once again serves as a role model to individual investors — in times of crisis, remain calm and analytical.
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