Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

institutions,” they said, which is the standard reply of Wall Street brokers who don’t want to tell you what’s really going on. In the end, it turned out that much of the exposure was held by Japanese financial institutions that were so confident their market would never go down that they wrote these multiyear contracts and took the entire premium into income immediately. Ultimately, the Japanese market collapsed, and my then employer, along with many other U.S. investors, profited handsomely as the puts soared in value.
    More recently, the derivatives market in asset-backed securities of subprime mortgages offered a similarly distorted risk-reward equation in the form of credit default swaps (CDSs). These securities are a series of puts on bonds backed by subprime mortgages on residential property. When the bonds were issued, they were viewed by both investors and the rating agencies as safe (that is, investment grade) because of the assumptions about how these mortgages would perform. However, some astute investors realized that the underlying collateral was much riskier and subject to far more downside than the buyers originally assumed when they purchased CDSs on subprime bonds and indexes. When the subprime market collapsed in 2007, some of these securities increased in value more than 50 or 60 times the amount at risk. Every trade always has two sides, so it helps if you can figure out the thought process of the person on the opposite side of the trade. Warren Buffett once wrote: “If you’ve been in the poker game for 30 minutes and you don’t know who the patsy is, you’re the patsy.”
“Work It Out”
    Like Graham and Dodd, my own initial approach to the derivatives market was rather simplistic, and I well remember the day my young eyes were opened to the perils and pitfalls of my naiveté.
    It was the early 1980s and I was just starting out on Wall Street. Derivatives were still a mostly nascent market, and stock options were among the first of these instruments to attract much attention. Like Graham and Dodd and many others on the Street, I grasped the leveraged nature of stock options and how they could be used to magnify the gains (or losses) of an individual stock position. But my knowledge beyond the basics was scant. I was working in the risk arbitrage department of a firm that did a lot of options arbitrage. And although I didn’t yet understand what that meant, I did understand that the guys sitting next to me were making a lot of money doing it. What is more, they seemed to come in just before the market opened, left promptly right after the market closed, and never even glanced at the
Wall Street Journal
, preferring instead to read the gossipy
New York Post
. My curiosity was aroused. So one day I asked Ira, the head of the firm, to explain to me what he did. The two-minute conversation that followed forever changed the way I looked at derivatives and profoundly affected the way I’ve approached unfamiliar areas in finance and business ever since.
    Ira pointed to a stock (I can’t remember which one, although it could easily have been IBM since, in those days, the sun on Wall Street literally rose and set on whatever IBM was doing) and asked me this question: “What if you buy the $35 calls, sell the $40 calls, buy the $40 puts, and sell the $35 puts all at the same time?” My first thought was, “You’ve got a mess,” but I didn’t say that. I simply looked baffled. Seeing my confusion, he said, “Work it out. What’s it worth at expiration?” After a few minutes with pencil and paper, I looked up, still a bit confused, and said, “It’s always worth $5.” “Right,” he said. But still the light did not flicker in my brain until Ira asked, “What if you could buy it for $4.50?” Bingo! I finally got it. Even though I was new to Wall Street, I had done enough arbitrage to understand what Ira was saying. Typically, the most liquid option contracts are those with expiration dates relatively close by;which means that if you could buy this “box,” as it is called, consisting of two pairs of options for $4.50, you would make a guaranteed 11% on your money in less than six months.
    It was my turn to pose a question. “Can you really buy them for $4.50?” I asked. “Sometimes,” he said. And then I realized who had been the proverbial patsy in the poker game. It was me. By relying on Graham and Dodd’s overly simplistic approach to the options market and not fully