Options

If you read the financial press you would have recently seen billionaire investor Warren Buffett, the president of Berkshire Hathaway Inc. calling derivatives "financial weapons of mass destruction." It's worth a chuckle but from the world's most respected investor the question one has to ask is why does he say that?
After all derivatives were invented to reduce risk and they perform this job highly effectively for millions of people to day. For anyone whose livelihood depends on a market price- stock prices, bond prices, oil prices and so on- derivatives have a useful roll to play. Derivatives, in particular Options, can be traced back to the origin of markets.
When markets were invented derivatives were invented too.
Buffett I'm sure was referring to the cataclysmic collapse in 1998 of Long Term Capital Management (LTCM) which almost precipitated the collapse of the World's top 14 Investment banks. The banks supported the dismantling of LTCM with a 3.5 Billion Cushion to save their own posteriors. So traumatic was this experience that half the world's financial markets seized up in fear. US Federal Reserve Chairman Alan Greenspan arguably the world's most powerful man was forced to take emergency action and cut interest rates to get them working again. It was as if a country had collapsed.
For those interested in the full story, get "Inventing money" by Nicholas Dunbar.
Two of the disgraced principals of LTCM Myron Scholes (No not Paul) and Fischer Black a few decades earlier had won the Nobel Prize for economics with their Black-Scholes-Option -Pricing-Model.
Even though as stated options in one form or other have been a feature of business activity since time immemorial, options on financial instruments became the new phenomenon after publication of the Black/Scholes paper and they expanded into all spheres of financial activity throughout the 80's and 90's.
In modern financial practice options are essentially the most versatile and exciting of the fundamental derivative building blocks. Their inherent flexibility coupled to sophisticated methods to establish their value (Black/Scholes again) has created opportunities for intermediaries to provide tailored solutions to many previously insurmountable risk-management problems.
The terminal products examined last month have the virtue of eliminating price or value uncertainty at some point in the future.
The situation is different when it comes to options. The holder or buyer of the option has the right but not the obligation to purchase at the expiry of the contract.
If the current market price is above the contracted price the holder gains and will take advantage of the right to purchase
If the market price is below the contracted price the holder is not obliged to purchase and can buy cheaper in the market. This is called a call option or buying long.
The other type of transaction in options is called a" put option" or short selling. This allows the holder the right to sell but not the obligation at the pre arranged price (or rate). If the underlying asset of the option falls in price then the holder gains and will take advantage of the right to sell at a higher price than the market price.
Put options illustrate one of the ways how people can make money on falling markets.
There are then two different types of option. American -style options and European-style options.
An American option can be exercised at any time up to and including the expiry date.
European options can be exercised only at the expiry date.
An option derives its value from its underlying asset, hence the name derivative.
Derivatives are now so entrenched in the financial system that despite Warren Buffets criticism they are here to stay.
Despite the LTCM fiasco, Greenspan came to derivatives defense after the Buffett criticism. He stated that financial market participants who purchased derivatives had been able to spread their risks and this had helped to lessen the severity of the 2001 recession. He added "The benefits of derivatives has far exceeded their costs."
So we know what Buffett and Greenspan think. I'd be interested in your opinion.