I just received my thinkMoney from ThinkOrSwim. In addition to being wonderfully quirky, ThinkOrSwim also provides some very insightful educational material through their website as well as through the print periodical they send out to their clients.
Yes, I am a Swimer…
What got me blogging this evening was a short article found on page 40 of the Winter 2010 edition of thinkMoney. The article, written by Tony Battista, tackles the idea that the options market is a “zero sum game.” What is a zero sum game, you ask?
A zero sum game is one where for every winner you must also have a loser. In the context of trading it means that for every person who turns a profit someone else must suffer a corresponding loss. By way of example, if I sold a call option to you and the market rallied wildly higher, you would have made a tidy profit and I would have suffered a demoralizing loss.
True? Well, let’s consider what Mr. Battista has to add to the discussion…
Tony Battista presents three myth busting scenarios. The first is a situation similar to the one I just offered, and Mr. Battista suggests that perhaps I would not suffer a demoralizing loss despite having sold that call option. If I was a market maker I would immediately buy stock to hedge the risk I took on when selling the option and would have suffered no loss as a result of the market rally. As a retail investor I may have sold that call option as part of a covered call trade; i.e., I bought stock, too. If this were the case we both could make money, no?
What if the market falls? You would certainly lose money on your long call, while I make money on the opposite side of that position. But, I also bought the stock and the losses on the stock may quickly exceed the premium I received from the call sale. In that case, you and I would both be holding our hand in the shape of an “L” on our foreheads…
We could also both be winners if I owned I profitable long call, sold that call to you to close the position and lock in my profit, and then you enjoyed a profit from a continued market rally. But, what of the fella who sold the call to me? Well, if that fella was a market maker she, or he, would likely have immediately hedged that short call position to offset their risk. From market maker, to me, on to you… Who lost money?
Well, that’s not the entire picture and true to his floor trader roots, Tony Battista does hedge his thesis a bit. But, it was an interesting quick read that I thought I would share with my readers. If you would like to read the original story, it is on page 40 of the current thinkMoney magazine and is available in electronic form on ThinkOrSwim’s website.
Christopher Smith
TheOptionClub.com
well, Chris, you probably know my perspective already but i really hate when folks continually dredge up the fantasy that somehow options are NOT a zero-sum game. that point of view can only ultimately be that of a charlatan or – what is the same thing – a spokesperson for the options (or brokerage) industry.
saying that hedging changes the whole zero-sum game is misleading, dishonest and disingenuous. you might just as well say that the person who sells an option and uses the proceeds to buy a bushel of grapefruit can win on the net combination.
zero-sum is irrefutable and, to me, fundamental to understanding options. hedging does nothing but alter your position synthetically or carry the zero-sum logic one, two, or more steps out.
if e=mc^2 in the physical universe it would be more than a bit odd that somehow that law is broken in the fictive world of derivatives.
Buying the stock doesn’t change the zero-sum nature of the option transactions themselves:
Something + Zero = Something
For example, you might tell me not to play the roulette wheel at the casino because each bet has a negative expectation, and the more I bet, the more I can expect to lose. The nature of that expectation doesn’t change just because I claim I have a 9-5 job that pays me more than I lose at the roulette wheel. I’m just playing a second financial game, where the sum of the two is positive.
Glad to see someone is reading this blog! I guess I’ll keep writing….
I did allude to Battista hedging his position in this article, which he does in it’s conclusion. He writes…
“Now, if you look at all the traders and investors out there in aggregate, trading is a zero sum game, minus commissions and fees and all that…”
I guess even the occasional industry spokesperson has to maintain some credibility….