There is an oft-used quote from Warren Buffett's Berkshire Hathaway (BRK.B) annual letter from 2002: "In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

While the letter does, in fact, say this, the exact same letter also says: "Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."

Essentially, while acknowledging the risk of derivatives like options, Berkshire Hathaway went on to say that they are a useful product in which the firm is heavily engaged.

How does Buffett use them? The same way you, I or the average investor likely uses options: he sells puts. The only major difference is that while you or I might trade options in the listed market, Berkshire trades heavily in the over-the-counter market. The OTC market is where dealers trade directly with each other, instead of using an exchange.

If you are interested in learning about the trades in detail, I would highly suggest reading Russell Rhoads' walk through on the Cboe Global Markets Blog, Update on The Warren Buffett Put Trades (I relied heavily on Russell's work to summarize what Buffett is up to).

However, I will give you a quick synopsis of some of the trades they are doing at Berkshire.

2004 to 2007

From 2004 to 2007 Berkshire sold puts in just about every major index... in effect Buffett went long the world (he probably wishes he has waited a few years). He sold long-term OTC European-style puts that expired in as little as 15 years, but most were in the 20 years to expiration range. The main idea of the sale of these puts was that while the market might have a downtrend here or there, over time it just goes up... and he has been right.

In total, Berkshire collected premiums of around $4.5 billion dollars on the puts it sold. The bet: the markets worldwide would not completely tank for the next 20 years. Not a bad trade.

2008

In 2008 as the market was tanking, Buffett sold more of these puts in SPX and a few other indexes. In addition, during the financial crisis, Buffett again engaged in derivatives -- notably buying $5 billion preferred stock in Action Alerts Plus holding Goldman Sachs Group, Inc (GS) that had warrants (options) to buy Goldman Sachs common stock.

The Bottom Line

The moral of the story here is don't buy into the headlines around Warren Buffett and options contracts. The truth is the exact opposite -- you might say that Warren loves Warrants.

This investor education first appeared on TheStreet's sister publication RealMoney. Learn more here.

Mark's fund is almost always carrying positions in VIX and SPX

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