NEW YORK - A bullish stock market trade embraced by the smartest money is backfiring. And that has investors wondering if what Warren Buffett and Goldman Sachs Group Inc know about derivatives is obsolete.

Goldman Sachs, the world's most profitable securities firm, reported losses from derivatives last quarter after selling insurance that protected clients against stock swings during the Standard & Poor's 500 Index's biggest retreat in more than a year. Buffett, the chairman of Omaha, Nebraska-based Berkshire Hathaway Inc, underwrote $37 billion of the contracts since 2004, filings with the Securities and Exchange Commission show.

The combination of hedging by insurance companies, tighter regulation of bank speculation and reluctance among securities firms to write derivatives known as variance swaps means speculators who sold them are now facing losses, according to Morgan Stanley and Societe Generale SA. Money-losing trades in both rising and falling markets show the hazards of the business for even Wall Street's most sophisticated investors.

"It's as extreme as I've ever seen," said Neil Davies, head of structured equity products at SunTrust Robinson Humphrey Capital Markets in Atlanta. "There's a lot of uncertainty in the over-the-counter volatility market, illustrated by the fact that long-dated volatility levels are reminiscent of October 2008. Rumors abound, specifically that some institutions are closing out short positions."

Goldman Sachs said its bets that stock swings would narrow lost money in the second quarter, according to its earnings statement. While the firm didn't break out the loss, Goldman Sachs said revenue in the division arranging the trades slumped 62 percent from a year earlier to $1.21 billion. Ed Canaday, a spokesman for the New York-based company, declined to comment.

"Primarily in response to our client needs, our equity derivatives business was short volatility entering the second quarter and posted poor results," Chief Financial Officer David Viniar said on a conference call with reporters on July 20. "We took the other side because you know we deal with our clients all the time," he said. "We had that position going into the quarter and volatility just spiked."

The Chicago Board Options Exchange Volatility Index, which ended the first quarter at 17.59, rose as high as 45.79 on May 20 as the S&P 500 lost 8.4 percent. The VIX, a measure of investor expectations for stock swings known as implied volatility, has since decreased to 24.25, or 19 percent above the average over its two-decade history, while the equity index has rebounded 3.2 percent, data compiled by Bloomberg show.

'Consenting adults'

"Either they took the position on purpose or they took it because they couldn't get anyone else to take it," said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees about $57 billion.

"There are two consenting adults to every trade on the over-the-counter market or on an exchange. They consented at some level, and maybe their hedges were bad. Maybe they sincerely believed in the trade and they got hung out to dry."

While demand for insurance against declines in the next 30 days retreated as shares rallied this month, prices for longer- dated protection surged to a record. Ten-year variance swaps, contracts that pay buyers when stock swings increase, are trading at levels that imply S&P 500 volatility is poised to exceed its rate during the 2008 credit crisis, Paris-based Societe Generale's data show.

Sellers' strike

Swaps are agreements between parties to exchange one right for another, while variance swaps let investors speculate on the magnitude of movements by an index. They are a type of derivative, or contract whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or price fluctuations.

Over-the-counter variance swaps have appreciated so rapidly that firms that sold swaps in January at a volatility level of 28.5 and $1 million per point faced paper losses of as much as about $8.2 million this month when swap rates rose to a record 38.5 points, according to data compiled by Bloomberg and Societe Generale. Their expected gain based on past volatility levels would have been about $5 million, according to Societe Generale.

Life insurers, which sell retirement products with guaranteed minimum returns even in declining markets, rely on derivatives to hedge against stock slumps. Variable annuity sales rose 5 percent in the first three months of the year to $32.4 billion, the first quarterly increase in two years, according to Limra International, a trade group.

"Wall Street historically has been able to meet demands for longer-dated volatility products," said Pav Sethi, chief investment officer of Chicago-based hedge fund Gladius Investment Group, which uses variance swaps. "Regulations, tighter risk limits at the banks and a limited number of interested participants have created a large liquidity shortage."

The financial regulation bill signed into law on July 21 by US President Barack Obama strengthens oversight of derivatives and forces banks to take less risk with their own capital. How that will affect banks and insurers isn't clear yet, causing some institutions to scale back their use of derivatives, Morgan Stanley analysts said in the July 15 note.