No. of Recommendations: 4
Hi Jim,
In this reply I reach the conclusion that in real life, buying and selling options does social good comparable to the social good done by buying and selling stock in the secondary market. The only transactions int he stock+options markets that are NOT zero sum are transactions done by the issuer of the stock: paying dividends, buying back stock, or issuing new shares for public offerings or to fill exercise of warrants and options the issuer has previously written. Otherwise, all the stock trading that comprises 99.9..% of stock transactions are just as zero-sum as are options transactions: every share sold for N$ necessarily is matched by a share bought for N$.
You (Mungofitch) write:
What is more interesting to me is that there is no reason to believe that subsets of option trading are zero sum. I suspect that there is a long run net transfer of funds from buyers of options to sellers of options, though it may be modest. The amount gained by one group would have to equal the amount lost by the other group, however, as the boundary around all option contracts is a zero sum game.
I like that you get to the "what is more interesting to me" part. Unless there is something interesting about zero-sum-game vs not-zero-sum-game, then I am just playing word games, or being overly pedantic along the "words matter" axis.
My own "interest" is in determining whether options trading is particularly more-or-less zero-sum compared to stock trading. My interest is driven by the idea that trading stocks on a public market has, ultimately, the fantastic contribution to the public good that it funds productive enterprises which make everybody richer, even non-investors. As opposed to, say, gambling in casinos, which is a "zero-sum game" and doesn't do nobody no good except of course the owners of the casinos.
You write: "If you consider only the set of all standard traded option contracts, that is in aggregate a zero sum game. An option contract can't ever create or destroy the underlying shares, nor ever affect the value of the underlying shares in any way."
If by value you mean Market Value, then this is pretty clearly NOT true. Presumably we agree that Market Value is increased as demand for a stock is increased and decreased as demand for a stock is decreased. Is there a similar causal connection between buying or selling options and the market values of the underlying shares? Absolutely! Market makers hedge the long-ness or short-ness of their options book by buying and selling shares in the underlying. There are actually greek letters that will tell you for a simple valuation model how many shares a given strike price and expiry contract need to be hedged with, it is likely that to first order the connection of options transactions to purchases of shares in the underlying is actually automated.
The implication of this is, that in terms of social good, going long using options is "within a constant" of the same social good as directly buying stock.
If by value you mean Intrinsic Value, then options are no more or less zero-sum than are transactions in the secondary stock market. The only transactions that impact Intrinsic Value involve the underlying company issuing new shares in a public offering or to service the exercise of options/warrants it issued, or buying back shares and putting them in the shredder.
So the thing that was interesting to me about this is: trading in options in the presence of market makers has entirely similar social good to trading in stock. Whether you call one, or the other, or both "zero-sum" doesn't change that in the real world.
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The other thing to consider is how would the options market be different if there were no market makers? Well market makers make their transactions to ENFORCE a model like Black-Scholes or one of its more complicated descendants on the price spread of options. Without market makers, prices on each options contract would reflect the demand of people who are not primarily trying to push prices towards their BS or other model values. This means there would be wild deviations in the spread of prices of differnt options contracts, and there would be wildly profitable arbitrage opportunities generated. That is, without market makers it would behoove me or you to write some code that would spit out the BlackScholes predicted prices based on the price history of the underlying stock, and would build hedged books of approximately balanced long and short options, buying the cheap ones and selling an selling/writing and offsetting number of expensive ones. And when the customer's options trended long, my algorithm would tell me to lay on some number of shares to hedge by options book, just like it tells the market makers now.
