What we are witnessing is no ordinary correction. Even big houses are broke. Heck, even the government is broke. Unless this market quickly turns around, those sellers of naked puts on indexes will be broke.

Here is the biggest shocker to me… None other than Warren Buffet (through his Berkshire Hathaway) is stuck in this derivatives mess. This explains why he is so heavily pushing for the bailout. He called this sell off an “Economic Pearl Harbor.” Now I know why.

Buffett’s Berkshire, meantime, fell sharply last week, as its class A shares dropped over $25,000, or 18%, to $113,100. Berkshire’s equity portfolio, which stood at $69 billion on June 30, is falling in value, although it’s ahead of the major averages this year. Berkshire has written, or sold, long-dated put options on some $40 billion of equity indexes, including the S&P 500. Those put sales, which amount to a bullish market bet, are deep in the red, although Berkshire doesn’t have to post collateral against any paper losses. We estimate those puts could have cost Berkshire as much as $2 billion in the third quarter and several billion more dollars this quarter, with the S&P down over 20%. Berkshire ultimately may score with these puts if they expire worthless at maturity between 2019 and 2027. But the normally savvy Buffett made a mistake investing in financial derivatives, about which he has long warned. Berkshire had no comment.

He did this after giving several lectures on ill effects of the monster called derivatives. There goes my respect for the man whom I thought is the most honest man in America.

I heard rumors about Buffet getting stuck in derivatives trade. But I dismissed the rumors. After reading Barron’s article on this, for the first time, I am really scared on how this will end.

Here is the link to Barron’s article.

http://online.barrons.com/article/SB122369310004425503.html?mod=b_hps_9_0001_b_this_weeks_magazine_home_left&page=2

“Many put options sellers are deep under water. If the markets do not rebound significantly next week, we are looking at an abyss on Friday the 17th or Monday the 20th. One positive note is that option put-call ratios improved during the day on Friday. Delta hedging on the upside actually helps markets stage a rally.”

A put option gives the holder the right to sell an underlying security to the writer of the option, at a specified price, up to a specified date. As I understand it, if the price of the underlying security goes down, the put will rise in value.

So why would the puts be underwater now? And the rest of your train of thought I just don’t get…Please explain!

If you are a long term investor you can gamble with a small position here because NO ONE really knows where the bottom is until months/years after it has happened. This is still a high risk environment and if you are a long term holder I would actually want to pick up a small position of a few choice stocks here. If this is the bottom, great you’ve picked the bottom, if it isn’t then when we get to what looks like a bottom again I would suggest pushing in another small position into those stocks and lowering you’re average cost. I like to do this using dollar value rather than share size as for the same dollar value you’ll get more shares and end up at a lower price entry. The key point here is SMALL POSITIONS, you never ever ever ever ever ever ever ever ever want to take large risk at dangerous points in the market. This is good risk management and regardless of being an investor or a trader or a swing trader if you don’t manage risk properly you are just gambling.

As Michael points out there is lots to support futher downside after this but what we want to find is a tradeable bounce as the early investors get back into the market on perceived value.

Cheers

Excellent, Excellent post. Thanks.

I take one exception to your argument. This market, at this time, is trading on a derivatives melt down. NEITHER FUNDAMENTAL NOR CHARTS MATTER until the effect of derivatives is faded.

One of the most important tests market will face this week is option related selling. GS and other investment houses ried their margin requirements and sent letters to large funds on Oct 1 and Oct. That and some delta hedging bought us this severe selling this past week. If they are able to stabilize the market this week, we can expect a 1-2 month rebound.

In July expiration, they were able to pull the market up by banning naked shorting and in Sept they pulled it up by banning all shorts. This derivatives monster is too big even for the Federal Govt. handle. One should hope some short-covering this week and some other new trick will save the market.

Many put options sellers are deep under water. If the markets do not rebound significantly next week, we are looking at an abyss on Friday the 17th or Monday the 20th. One positive note is that option put-call ratios improved during the day on Friday. Delta hedging on the upside actually helps markets stage a rally.