Ask HN: Why be an option/futures/day trader when it is zero-sum?
Nicholas Taleb talks about jobs that "scale well". But isn't it more important to have jobs that are non-zero sum? If you have a job that is zero-sum, you have to keep working to stay ahead, whereas if you have a job that is less competitive you can relax. There will always be jobs available even for bad programmers because they at least create some wealth, whereas bad speculators would quickly lose their money and bad baseball players would starve in the streets.
I think it is as a rule irrational to enter a zero-sum game. When you enter the game, you are assuming that you are better than at least half of the other players. But everyone else is thinking the same thing. Clearly someone has to be wrong, and is going to be sorry. Is there any reason to believe that it is not you?
What do you think about this? I have been thinking a bit about getting into option trading, if you have any experience with it, please share.
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[ 3.7 ms ] story [ 147 ms ] threadExample: Mark Cuban used options to guarantee he would be set for life no matter what happened to Yahoo's stock after they bought Broadcast.com for $5 billion (in stock mostly).
Care to explain further, or point me to where I can read more?
Edit: I think the "equity collar" article linked below sorted me out.
"The basic worry that comes with having lots of money is no different from what worries everyone else. Whether you've got $100 or $100 million, you don't want to lose it. After we sold Broadcast.com, I hedged my stock with synthetic indexes, in case the market cratered in the six months before I could hedge my actual Yahoo shares. It cost me $20 million, but I protected what I had. Todd Wagner and I had a credo: "Pigs get fat; hogs get slaughtered.""
Also you have to remember that when options mature in the money they will be exercised resulting in transactions in the actual stock market which is more obviously not zero sum.
So suppose I think Yahoo is under-priced at the moment. I could 1. Purchase a share of Yahoo on the open market, exerting buy pressure on the stock driving up the price
2. Purchase a call on Yahoo; Yahoo's price appreciates some if I'm right putting my call option in the money. If the option writer was naked, they have to go to the open market to purchase a share for me to buy, resulting in buy pressure on the stock driving up the price.
Obviously the link in #2 is not as direct, but potentially prices in the actual stock market can move to incorporate information in the purchases and sales of option contracts as they are exercised. And one step further removed a long equities trader might use the size of the outstanding call and put options market on a stock to forecast price changes.
Accident frequency is a power law distribution - a large percentage of crashes are caused by a small number of drivers who habitually violate traffic laws, drive drunk, or otherwise engage in risky behavior. One of the distinctive features of power law distributions is that there's this long tail of people with very small values, and then a few people who make up most of the curve. So (made up numbers) you might have 60% of the population who has never gotten in an accident, then 35% who has gotten in one, then a tiny fraction of 1% who's been in a dozen. Over an 80 year lifetime, that 6 million accidents/year results in 480 million accidents, or 2/person, so with the hypothetical percentages above, 95% of people are above the mean and 60% are above the median.
Just goes to show that you can't assume everything is a Gaussian. ;-)
A similar phenomenom occurs in many, many other fields. The average (median) wage-earner actually makes below average (mean) wages, because the existence of Bill Gates and Carl Icahn skews the distribution upwards. The median sale price for a startup is $0, because over half of them fail. The average test scores in Palo Alto or Weston, MA or Hunter College High School really are above average, because those places already preselect for bright kids. It's quite possible for Lake Wobegone to exist: you just need to compare your kids with someone else's average.
And none of this invalidates SSB, but you picked a bad example to illustrate it. When 90% of drivers think they're in the top 50%, they're right.
Risk hungry people will pay a premium for increased upside. For example, they will prefer a win 20-lose 30 game over a win 10-lose 0, because 20 > 10.
Gambling on anticipating/creating the future is not an easy way to make money. However I agree that there is no wealth creation resulting from this (the increased liquidity of the market due to new kinds of derivatives may increase the efficiency of the market, but I think you are talking about "simple" trading.)
Bona fide hedging is a lucrative business for the companies involved, whether that's hedging against currency or commodity price fluctuations. It's also more "buy side" than "sell side" - you're dealing with companies rather than 'raising money' from new clients who get blown out over the course of 3 months.
I know a few successful options traders. It's highly lucrative (high 6 figs base after a few years), you just need the pedigree and the intellect to pull it off. If you're in a position to do that, though, you might try to get an analyst job, get on a path to assistant portfolio management, portfolio management, keep a good track record and start a hedge fund. That's all buy side and would allow for some flexibility in the strategies you implement.
Second, there are two types of players in this game. The first group is the speculators. They play the game for profit from the game. The second group is risk managers. They play the game for risk reduction. Speculators serve the risk managers. The speculator's strategy is starkly different than the risk manager's strategy. The speculator can profit by optimizing his strategy.
EDIT: The assumptions made by Black, Scholes, and Merton are highly idealized. There is much research to still be done in the area of behavioral finance and the game theoretic approach to derivatives pricing.
I've thought about conducting graduate research in this area because the mathematics are truly fascinating in this branch of finance/economics. When you start exploring this area from a game theory approach, you can start to understand why John Nash won the Nobel.
Why does the money leaking via commissions necessarily make the game sub-zero sum? Is it because we aren't looking at the big picture where everyone wins?
It seems like the risk managers must have a positive incentive to sell their risk on the marketplace instead of assuming it themselves. I.e. hedging another investment like someone else said already.
Commissions are an expense that both sides pay to play the game. Money is not transferred from one player to another, it is transferred to outside the game.
It is true that there is a positive incentive to sell risk from the risk-manager's view. That is the whole reason the markets were initially established, both derivatives and the underlying of the derivative.
If the game is played where the players arrange transfers face to face such as in a home poker game, then the game is zero-sum. Your losses are my gains. No money is created. No money is destroyed. It stays inside the game. The minute we go to a casino to play the same game, the game becomes sub-zero due to the rake. You lose X to me and Y to the rake. I gain your X and lose Y to the rake.
Your cash flows: -X - Y. My cash flows: X - Y. In a zero-sum game your cash flows are the negative of my cash flows. This implies -(-X - Y) = X + Y. This is a contradiction. Therefore, the game is not zero-sum.
Of course, the only reason the IPO can proceed is because people who buy shares know that they can sell them to other people later. So I suppose in that sense they help. However, once the market already exists, no extra value is created by an extra trader entering it.
As others have pointed out though, there genuinely is value created by the options trading market, since the existence of options allows risk to be spread.
Stock trading also provides a somewhat objective measure of the value of the company. For instance, if MS wants to buy Yahoo, how much should they offer? Without the stock market, it's tough to tell if they are lowballing or paying a premium.
http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm
What I believe Taleb's philosophy _was_ (he now remarks in bold text: "Finance is for philistines!" on http://fooledbyrandomness.com/ ) that by exploiting the random nature of markets he could "swing for the fences" by placing many small extremely risky bets that if they paid off -- even infrequently -- would guarantee him a lot of money.
From the little that I know/think I know: Options are a good way to leverage small amounts of capital into potentially large gains. If the price of the underlying security doesn't behave as you expected you can let your option contract expire worthless - meaning you have a defined risk which is what appealed to Taleb. Even in the worst case he knew how much was at stake.
there is a limit on how much total money can be made doing this. the more people do it, the less price fluctuations are available to even out.
but anyway, there are good types of trading.
Trading well requires you to synthesize information that other people will act on. If oil is too cheap, you buy oil, this raises the price and alleviates the problem. The fact that this causes some people to lose money is material, but it just means that trading is a way to redistribute wealth from people who are usually wrong to people who are usually right. I do not see how anyone could believe that this isn't socially useful.
Options trading is zero sum because every dollar made by one options trader is lost to another (or to a commission). There's no net wealth generation.
Here is one incredibly obvious way that you're wrong: if you ran an airline, you might be worried that a sudden spike in fuel prices would bankrupt you. They could use futures to speculate that prices would go up, so they'd be indifferent to price changes -- an increase of $X in fuel costs would give them an increase of $X in futures profits. Suddenly, they are a more stable company -- people are more willing to work for them, banks are willing to lend them more money, passengers are more likely to participate in frequent flier programs, airports would be more likely to consider them for long-term spots, etc. Somehow, everyone on that side of the transaction benefits. And lo! The speculator on the other side, betting that prices will go down, is able to do so directly, rather than by indirect means such as buying stock in an unhedged airline and exposing himself to the vagaries of that industry. Even if he loses money in the end, he has what he wants when he makes the trade. However, I needn't restrict myself even to people making business decisions through the futures markets: even a compulsive gambler trading pork bellies is not a compulsive gambler getting drunk at casinos or playing illicit card games. In short, it's a very sanitary sort of gambling (this was not always the case -- in the 1920's, traders at the then-outdoor American Stock Exchange drank constantly to keep warm. This explains a lot).
It is trivial to declare that some business is zero-sum or negative sum. Even retail is a series of zero-sum transactions: I had $5 and the restaurant had a burger, now I have $5 worth of burger and the restaurant has $5 worth of cash. Even, minus time and taxes. And yet, for the most part, our bias is to quite correctly assume that when people voluntarily hand over billions of dollars, some of them becoming poorer and some of them become quite richer in the process, they may be doing something rational. The fact that rich countries develop stock exchanges, and that the development of stock exchanges correlates with future wealth, is not a coincidence.
It's often not that hard to prove within a reasonable certainty that you are a winner (or at least were one), depending on the variance. I haven't looked into the coefficient of variation of options trading though. I might one day.
Also, whether or not something is competitive has nothing to do with whether or not it is a zero sum game. It is generally just a factor of how much money can be made. The software industry is not zero sum, but is highly competitive. Low stakes poker tables are zero sum, but are not competitive at all.
1) Serious quant trader types are rarely good at anything other than mathematics. Even if they are, if they are getting $500k+/yr it would be hard to start as an entry-level engineer for $60k. So most people don't really have an option once they get started in trading.
2) It's addictive. The top hedge fund manager in the US is paid to the tune of $1.7 BILLION per year. On January 2nd the next year, he's back in the office. Once you get in the quickpaced environment of trading everything else looks very boring.
3) It's usually a collective game, so your particular performance is not as important as the performance of the firm. You could do excellent, but somebody else could tank the whole bank. Similarly, you could have a bad year, but if the company is doing OK you'll still get a decent bonus.
After all, the same applies for startups. If you don't assume that you are better than most people at what you do, there's hardly a point in doing it.
Long answer: For anyone interested in this stuff I highly recommend the book Trading & Exchanges by Larry Harris. The book is about market microstructure, and the knowledge applies to any market whether it's equities or options or online gambling like intrade.com. It's a textbook, so not riveting reading, but great information.
As other posters have pointed out, it depends on how you define zero-sum. Trading is zero-sum, when you compare it against market returns. However, as a trader you are providing services such as immediacy and liquidity. My AAPL stock is more valuable to me as an investor, since there is an active market, and people are willing to sell it to me and buy it from me on short notice, even though I am losing some money to them through the bid-ask spread and execution costs. The other comments about options being useful for spreading out risk are true as well.
As far as the rationality goes, it's rational if you're an expert, you have better information than the market, if reading the above textbook kept you up late at night, etc. Your intuition about the odds are correct, though, so keep your pessimism handy.
So why is my short answer 'no'? Well if you don't have the patience to read the whole post then you definitely shouldn't do it, since learning all the math behind it is going to be way more boring. You've read Taleb which is a good sign. Now that you're at the end the answer is 'maybe', but your wording concerns me: what do you mean by "getting into" options trading? If you're going to get some intensive training and learn from professionals working at reputable investment firms, then great. If you're going to read a few articles off the internet and then dive in, then that is definitely not a good idea. Trading is all about having an edge against the person you're trading with, so a few articles don't improve your odds much.
As brentr already pointed out, some people trade options for risky gains (such as selling an uncovered call), and some people trade them to offset risk (such as buying an underwater put). Acting in the latter category is like buying insurance: even though your expected return on money is negative, your expected return on utility might still be positive. Acting in the former category is like selling insurance: you run the risk of taking a big hit, but your expected return is still positive.
If you are interested in getting into option trading, make sure you understand it cold. Know what delta, gamma, vega, and theta are. Understand the relationship between these parameters and the price of an option: be able to explain it intuitively, and be able to derive the relationship from an option pricing formula. Understand implied volatility and the connection between vol and option prices. Build a simple Black-Scholes pricer to allow you to compute your own implied vol. Know why the vol surface has the shape it does. Make sure you realize that volatility is directional: vol goes up when markets go down. If you are playing index options vs. single-name options, make sure you understand your correlation risk. The list goes on and on.
Options are interesting, though, because they allow you to trade volatility. Vol is a more complicated thing than simple price movement, so if you understand it well you could have an edge over your competition.
Finally... I think trading is a good job choice for young, ambitious, and numerically minded people. Seems like there are a lot of readers like that here... maybe I'll write a more detailed article about this sort of thing later.
I think the difference is - at what point does that assumption become atleast somewhat provable. Shaquille O'Neal was probably an athletic 6'10" 280 lbs in high school. Just because the game of basketball itself is zero sum, does that make it irrational to think that he would become a decent professional basketball player?
My favorite part of Taleb's book is when he describes the investing world as if all player's had a random 50/50 shot of making money each year. There are millions of investors, by random chance thousands will do really well, a handful will do really, really well over the course of decades. How do you know Warren Buffet is not part of that handful that is successful purely by chance? It's been awhile since I've read the book, but I remember his philosophy being something like if you have a logical investing/hypothesis that gets proven results, then maybe we can say it's not by chance.
So to answer your question, if you think you have an objective theory/algorithm/etc for option trading and have done blind historical tests or have successfully paper traded for a year+, then you might be on to something. If you think you are just smarter than everybody else, or maybe had a couple successful stock trades, it's probably not a good idea.
If the entire stock market does its job like this, money gets to googles more easily than it gets to pets.com. The economy uses capital more efficiently, and grows more than it would otherwise.
Of course, that's all in theory. In practice, being an investment banker is rough.