Warren Buffett is quick to remind investors that derivatives have the potential to wreak havoc whenever the economy or the stock market hits a really rough patch.

In fact, he first warned his shareholders about the dangers of derivatives as early as 2002, stating:

'Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.'

A derivative in its simplest form is merely a financial instrument that is dependent or 'derived' from the price of another financial instrument. Companies enter into derivative contracts almost every day -- we just call them by different names. If an airline is worried about the rising cost of jet fuel, it can purchase oil futures contracts that will actually pay them if oil rises in price.

This kind of hedge against possible future risk is a smart -- and stabilizing -- way to run a business. If Procter & Gamble (NYSE: PG) is worried that the dollar will rise in value and diminish its foreign-earned profits, it can buy currency related contracts that shrink or rise in value in the opposite direction of that currency. As a result, Procter & Gamble's planners can run their business without paying too much attention to currency markets.
Those futures contracts for jet fuel prices derive their value from what eventually happens to jet fuel prices in the spot market. Currency derivatives are impacted by the future direction of changing currency values.

Options: The Simplest Form Of Derivatives

If you've ever traded options, then you're already familiar with derivatives. puts and calls are nothing more than a secondary (or derived) play on a common stock. As is the case with other forms of derivatives, options can be used for a variety of purposes, including:

Speculation: If you think that stock such as Ford (NYSE: F) is going to increase in value, then Ford's options can make you even more money. For example, a rise in Ford's stock from $15 to $20 yields a 33% gain, yet Ford's call options would likely increase in value by a far higher percentage if the stock moved by that amount.

Hedging protection: Investors often buy options against a stock, but which move in the opposite direction. For example, buying Ford's stock and also buying Ford put options would shield your losses if Ford's stock dropped in value.

Income: Investors can 'write' covered calls or puts to use option premiums as a source of current income As an example, you would sell call options on Ford's stock (and get paid for it) if you believe that shares of Ford are unlikely to move in the near-term.

The Problem With Derivatives

Trouble is, Wall Street saw a different opportunity. Starting in the 1990s, Wall Street firms began to avidly pursue academics with a PhD in mathematics. These math whizzes were hired to figure out how asset prices moved in relation to each other. For example, what happens to Indonesian stocks when oil prices rise? Or how is the value of the dollar impacted by reports about inflation? Once they found cause-and-effect relationships, they could start to anticipate the eventual moves in secondary assets that were impacted by the movement in a primary economic or financial indicator.

So they created financial products that were actually a bunch of different assets cobbled together. In many cases, these secondary assets moved in the opposite direction of the main asset, so the derivative seemed 'safe.' These Wall Street pros naively assumed that these products were guaranteed to make money and were also guaranteed not to fail. (They eventually failed in a spectacular fashion.)

Giddy with their newfound prowess, Wall Street executives went even further. They started creating derivatives to speculate on the future direction of certain assets -- without even trying to hedge their exposure.

For example, suspecting that the value of bundled mortgage loans were selling too cheaply on the open market in early 2008, some Wall Street firms drew up contracts that would pay off handsomely if those mortgage bonds rebounded in value, often on the order of five to one or ten to one. Of course, mortgage bonds eventually tumbled, and a stampede to the exits caused these mortgage derivatives to fall in value to less than zero.

The buyers of these contracts ended up owing vast sums of money to parties on the other side of the trade. Sums so vast that years' worth of profits were wiped out at some firms. Venerable investment firm Merrill Lynch needed to run to the ai of Bank of America (NYSE: BAC) simply to pay back its own bankrupting bets.

In the most drastic example, the U.S. government had to inject $85 billion into American International Group (NYSE: AI) after the insurer had invested vast sums in derivative contracts. The ostensible purpose for AIG's efforts was to hedge against losses in insurance policies that it had underwritten. The real purpose was to fatten up profits by making side bets on existing contracts. That strategy can work well when times are bad. As we now know, that strategy is lethal if the economy stumbles.

There are a wide range of factors that led to the Wall Street meltdown in 2008. But one thing's for sure, when the markets and the economy started to plunge, many investors simply had no idea how it would all end.

Major Wall Street banks started to admit that they really couldn't get a handle on the value of many of their investments, and confusion led to chaos. These banks had entered into so many complex derivative contracts that their trading systems started to freeze up as conflicting information poured in.

This is why Warren Buffett considers derivatives to be 'time bombs, both for the parties that deal in them and the economic system.'

The Investing Answer: Sadly, little has changed to tame one of the most dangerous aspects of the stock market, and you should wonder why these practices continue. Although efforts have been made to better regulate derivatives -- for example, derivative contracts, known as swaps, now trade on a central platform that can be monitored by regulators -- but most other initiatives to corral the derivative market have been squashed as Wall Street lobbyists have outwitted legislators at every turn.

In the current era, with a President intent on reform, many believe we may have missed our best opportunity to help tame this risky part of the market. Future presidents may be even less inclined to go up against Wall Street.

Now all we can do is sit and wait for the next major financial crisis to remind us of the dangerous role that derivatives can play in our economy.