Gamblers Anonymous: Stocks are crack cocaine

Investment Analysis Clubs Macro Economic Trends and Risks
21

The same applies to casino gambling in that case. If you conflate two things (like you do with stock trading and option trading), for example, a guy plays blackjack against others, and sometimes wins and sometimes loses, but also writes a book about playing blackjack and earns $25,000 a year from the book. If you add all his “blackjack” cashflows together, they aren’t a zero sum game. Because you added in the blackjack book income.

You’re also making a genre error here in the numbers. You are accounting for cashflows of the seller of the option and of the buyer of the option. That part is correct. But you are accounting for the cashflow of the buyer of the stock at the start of the trade BUT NOT THE SELLER OF THAT STOCK. And you are accounting for the cashflow of the seller of the stock at the end of the trade BUT NOT THE BUYER OF THAT STOCK. If you don’t account for those cashflows, of course you can make any trade appear to be “not zero sum”.

The thing to understand regarding zero sum or not zero sum, is when the value of something can change without it having traded hands. For an option, there is ALWAYS a buyer and a seller, in fact, when you sell an option, it is sometimes called “writing” an option, because you are creating it (a contract) and selling it to someone else. Every penny that you gain on that contract, the person (or persons or assignees etc) will lose on that contract. That is zero sum. But with stocks, it is quite different. If a company issues 1000 shares at $10 each, and then a few months later, 100 shares traded at $11 each. The remaining 900 shares are also accorded a value of $11. That is where the non-zero-sum comes in. Sure each of those 100 traded shares were zero-sum, in that the buyer paid $11 to the seller, and the seller received $11, no net charge in the total money in that small universe. BUT the remaining 900 shares also now have a higher value, and THAT gain (900 x $1, or $900) is a new gain of value (hence, not zero sum) that has entered that little universe of that stock and its owners.

Now you might claim that an option that has 1000 contracts outstanding could behave the same way. But that would be incorrect. Because even if 100 options trade and go up by $1, the remaining 900 options also change value, but there is still a person at either side of the option contract, and they all terminate (expire) at some point, usually pretty soon, and in the end all that change of value comes from one hand to another (hence zero-sum). Of course that brings up an interesting question that surely has been answered before, but I can posit an answer here. What if an option has no expiration date? My answer would be if an option has no expiration date is is essentially equal to a stock itself because the owner of it has interminable rights to the asset, and of course has the right to sell it at any time for an amount agreed upon between a seller and a buyer. So I would say that an option without a termination date is equivalent to ownership of the asset itself. If it goes up by X, the owner of the interminable option value goes up by X. There is no decaying time value either, so it is pure value … like any other held asset.

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22

Give me a break!

The Captain

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23

This is not correct, or at best is a very incomplete statement about options trades and markets.

Any trader can place a single leg options trade (long/short call or put) with an options dealer (market maker) and regardless of whether the trader profits or not from the trade, the dealer makes money and hence the trade is not zero sum (the business of being an options dealer most likely wouldn’t exist otherwise).

Options dealers do not take directional equity risk and hence the trader’s directional gain/loss is not the dealer’s loss/gain, and thus not zero sum. Instead dealers make money on the option’s bid-ask spread which has as its foundation a delta-neutral option pricing model based on the underlying stock’s price (which is of course a price that is set in the underlying stock’s market).

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24

You’re using a different definition of “zero sum”. Zero sum has nothing at all to do with individual trades, it has to do with the total trades of a particular thing. It means that considering the buyer and seller of an item, no new value was added, and any gain by either one of them ONLY comes from the other one.

This is absolutely true! In fact, if you bring the market maker into the equation, then you are describing a [slightly] negative sum game which is [slightly] worse than a zero sum game. Because the market maker takes a small slice (bid/ask, fees, commissions, etc) out of the trade leaving a total of slightly less than zero for the buyer and seller of the option.

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25

I don’t follow most of what you wrote, so I’ll respond to one element for now.

You write,

Your statements related to the above quote are not convincing. You give what amounts to more of an assertion or claim than an explanation or justification.

My example above provides a direct counter example to your assertion, which logically disproves your assertion. My example provides the logical foundation for a basic trade not being zero sum. The logical foundation is the theory of asset pricing and how options dealers use that theory every day to price options, construct delta neutral trading books, and provide daily liquidity to options markets.

Can you support your assertion with any theory, reasoning, data, or any other supporting evidence on how options trades or markets are always or ”only” zero sum and reconcile your claims with how options are actually priced and traded by dealers every day?

Or, can you provide a specific reason on why my explanation based on asset pricing above could be incorrect or perhaps incomplete?

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26

It is simple arithmetic. If I sell you an XYZ strike price 100 call option for $10, you send me $10, and I send you the call contract. When expiry date approaches, there are 3 cases:

  1. If the stock is 100 or lower, the option expires worthless, I keep the premium and am up $10, and you are down $10 (and maybe the market maker took out a penny or two, and there’s a regulatory fee of a few cents).
  2. If the stock is 105 (or anything between 100 and 110), you exercise the option, you pay me $100 for the shares, I buy shares for $105 and send them to you, I am up by $5 ($100 + $10 - $105), you sell the shares for $105, and you now have $5, and thus you are down by $5 ($10 + $100 - $105).
  3. If the stock is $120 (anything over $110), then you exercise the option, you pay me $100, I buy the stock at $120 and send it to you, and I am down $10 ($10 + $100 - $120), you sell the stock at $120, and you are up $10 ($120 - $100 - $10).

Really case 2 and 3 are the same, but I leave it here for the sake of illustration where the end result is somewhere above worthless, but below the original contract price.

In each case, you can see that the person who is up, is up exactly the same amount that the other person is down. And that is literally the definition of zero sum.

Screenshot 2025-01-02 at 7.16.11 PM
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You can also find a more long-winded explanation here - Zero-Sum Game Definition in Finance, With Example

The salient excerpt from the above link is -

Options and futures trading is the closest practical example to a zero-sum game scenario because the contracts are agreements between two parties, and, if one person loses, the other party gains.

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27

Your example of one kind of trade between specific counterparties doesn’t prove that all (or even most) options trades are zero sum and your example ignores how options prices are calculated (theory of asset pricing). Also your example ignores (and doesn’t refute) my example in any way, so my counter example remains.

Here’s a specific logical recap.

You assert in this thread

and

and in another thread

In order to refute these assertions of “every penny”, “truly”, “always” and “only”, one need only provide one example of a non-zero sum options trade. I provided an example upthread of an options dealer as counterparty to a trader long/short a call/put - a very material example because the options dealer is the primary liquidity provider in the options markets.

Starting to repeat myself now:
The dealer’s trading book is near delta neutral, the dealer earns a bid-ask spread based on a replicating portfolio, and on average the dealer makes money regardless of the directional equity risk of the trader counterparty.
The long run outcomes of the dealer’s business for these kinds of trades are:

  • dealer makes money on spread, trader makes money on directional option
  • dealer makes money on spread, trader loses money on directional option
  • Either way dealer makes money (and hence stays in business)
  • The dealer’s economic outcome is materially independent of the trader counterparty’s directional equity return
    These two bullets are directly counter to your assertions (“every penny”, “truly”, “always” and “only”): these economic outcomes are not zero sum.

My above example (not yet countered by you, instead you created a new example) disproves your zero-sum assertions about “every penny”, “truly”, “always” and “only”.

Now, for your argument to support your assertions, you give the example:

So in this example my desired trade exactly complements MarkR’s desired trade: I happen to order to buy the exact option (underlying, strike, expiry) at about the same time and nearly the same price as MarkR happens to sell the same option and our respective brokers route our orders to the same dealer who happily holds both offsetting positions and collects the spread without having to execute an additional hedging trade. This happens in the market, but for every single options trade? Even for most trades? And all calls, puts, strikes and expirys for every underlying are always perfectly in balance over the investor universe?

That’s very far fetched, even if I squint, really hard.

It seems to me that most trades are routed to the dealer, the primary liquidity provider, and sometimes can be balanced out over time as trades open and close and sometimes not, depending on many factors in the market (e.g., bullish/bearishness, volatility, corporate events, macro events, etc).

But your example is not the only kind of trade, and thus does not prove that options trades and markets are generally (“every penny”, “truly”, “always” and “only”) zero sum (by generally I mean “almost always”).

So you have not proved your assertion because you give one example of one kind of trade, and you have not shown that all options trades are zero sum.

I think we can clarify this discussion with one question, if you would kindly offer an answer.

Is your claim that single leg trades with options dealers, the primary liquidity providers, per my example in this thread, are always/mostly (insert your favorite caveat word) zero sum?

If yes, please explain how a dealer with a delta-neutral portfolio gains/loses the loss/gain of directional equity return of its counterparty? (by definition a delta-neutral portfolio has no directional equity return, so I don’t see how this can be yes)

If no, then your assertion is false per my counter example.

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28

As I said upthread, I didn’t follow most of what you wrote.

For the above, you write “if you bring the market maker into the equation” which suggests the market maker would sometimes not be involved in an options trade.

Under what kind of scenario would retail investors trade an option that didn’t involve a market maker?

I also am still curious on your reply to my prior question.

If we can close this out, we can focus on all of those other highly important threads and posts, like enumerating all future Tesla scenarios.

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29

If you and I take a piece of paper and write an option contract on it. This isn’t commonly done for trading stocks, but it is always done for non-trading stocks (those that don’t trade on an established stock market [yet]), and is often done for real estate and sometimes even for businesses.

It is simple arithmetic that shows that options are zero sum (options alone, not options in combination with stock purchases/sales obviously). It’s also something that has been discussed as nauseam by people much more educated than I am, and that is also their conclusion. I’m sorry if you can’t see that fact.

But this conversation educated me about something very important. I’ve been trading options since 1986 and there is something that I have had trouble understanding through all the decades. Why is it that sometimes people will buy options that appear to be almost “free money” being given to the seller of that option? Now I finally understand! There are a sufficient number of people out there that believe that options are not zero sum, and thus they are willing to enter into certain option trades in which they are essentially giving away their money. So I thank you for that!

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30

I appreciate the answers.

But, I have to laugh, now you mention a bespoke make-believe paper option trade even though I am talking about options dealers, market makers, replicating portfolios and retail investors in real world options markets. Is this the kind of pretzel twist needed to answer a basic question, you and I trading on a sheet of paper?

Wow, apparently I need double precision here.

I should have explicitly said listed equity options to keep us focused instead of distracted with, shall we say, “edge” cases.

This scenario you offer is really a make-believe one: you, I, a paper contract for an option, that has never happened between you and I and is very implausible to ever happen.

You even say yourself “This isn’t commonly done for trading stocks”. I strongly agree. (How often does MarkR trade equity options on paper? Me? Never.)

Although I can add that there is an OTC equity derivative market for institutional investors (not retail) that has dealers and replicating portfolios like the listed market.

May we talk about scenarios that are “commonly done for trading stocks” for retail investors? Something super obvious, like listed equity options?

Here’s my understanding of your answers to my questions.

Question 1

I think your answer is yes, because above you said

You are saying zero sum, but then you qualify your answer by saying “options alone.” But dealers create replicating portfolios containing stock and other positions. The stock positions are not separable from the options positions because this combination with the replicating portfolio concept is the foundation of the dealer business model - which also, by the way, fits within a regulatory regime. This options market does not exist without the replicating portfolio: it is the foundation for how options are valued.

Said another way: your “options alone” concept doesn’t represent the economics of the dealer and by extension the total options market of dealers and investors. Options dealers measure p&l on their entire portfolio: replicating portfolio and all options positions and other positions used to manage risk and p&l.

Further, the replicating portfolio is delta neutral so the dealer earns the bid-ask spread regardless of the directional equity return of the investor counterparty, so the trade is not zero sum. And the market is the sum of all such trades, so the market is in general not zero sum. In fact, dealers can have an economically sustainable business because the market is not zero sum and they can minimize directional equity risk.

It’s a non sequitur to speak of dealers trading “options alone” and say that this reflects the economics of any single options trade or the dealer business in total or the options market in total.

If you are claiming that because a single leg “options alone” trade is zero sum, then all options trades and the aggregate options market are zero sum, then this reasoning fails because the economics is not based on “options alone.”

Question 2

I don’t think you are able to provide an example for listed equity options. Maybe another edge case of some sort?

Instead, in fact, you said that two retail investors would somehow find each other off exchange, they would somehow amazingly happen to want to take exactly opposite positions on a call or put contract with the same underlying, quantity, expiry and strike and happen to want to write a paper contract to execute this agreement.

Rather unlikely.

To make this process easier, we have some innovations like “exchanges” that have centralized, standardized, and automated processes for executing such trades. But a weird paper trade was your answer, an unlikely edge case at best, and that’s probably being very generous.

Based on the above, my conclusion is that you are unable to show that the listed equity options business is “truly”, “always”, “only” zero sum. I’ve countered your examples in a detailed way and you are unable to do the same for the explanations I’ve given.

In fact, you really don’t answer my questions directly, though they seem pretty straightforward to me, the first one is just yes/no, lol.

Perhaps it’s a definitional thing, you have one definition in mind and I have another - which is very common on this board. I tried to be very explicit in my explanations and definitions, but even then it’s easy to misunderstand one another.

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31

This was the case before they managed to standardize option trading through the use of the Black Scholes option pricing model.

CBOE

Founded by the Chicago Board of Trade in 1973 and member-owned for several decades, the Chicago Board Options Exchange was the first exchange to list standardized, exchange-traded stock options, and began its first day of trading on April 26, 1973, in celebration of the 125th birthday of the Chicago Board of Trade.[3] In 1969, the vice chairman of the Chicago Board of Trade, Edmund “Eddie” O’Connor, developed the idea for an options exchange.[4] At that time, options on stocks were traded in a New York-based,[5] over-the-counter market which required a direct link between the buyer and seller and complex terms of sale.[6] The options exchange that O’Connor imagined would use a central clearinghouse to facilitate trades and stand behind contracts.[6] The Chicago Board of Trade established a committee to evaluate the concept.[7]

o o o o o o o o o o o o o o o o o o o o o o o o o o o o

I’ve been following this discussion. The answer lies in ignoring the incidentals, like the market makers and concentrating of the option premium.

The option premium has two components:

  1. Time value is a depreciating asset that goes to zero at the market close on the expiration date. It is very volatile depending on the underlying stock’s volatility. It is a zero sum game because the seller makes what the buyer pays.
  2. Intrinsic value is the difference between the underlying stock’s price and the option’s strike price. This is the confusing part. When you buy a call you buy the right to buy the stock at the strike price. You buy the right to pay the intrinsic value. The call seller is selling the right to the intrinsic value. This is also a zero sum game, one party gets the intrinsic value the other party loses it.

The complication is the value of the asset the seller is using to back the call he is selling, but, is that part of the option game? Not so in my opinion but certainly an important consideration in the player’s option trader’s strategy. Selling calls have two alternative,

  1. Covered calls What is the value of the stock the sellers puts up as the security? The street price of the stock at the moment he sells the call. The price he paid is irrelevant to the option game itself even if it is an added risk for the seller.
  2. Cash secured calls The stock broker has control over the seller’s cash in the amount of the underlying stock’s street price.

In effect there is no difference making option trading a zero sum game. What varies is the risk profile for the players but that’s not part of the options game itself. This is what I mean by “ignoring the incidentals.”

The Captain

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32

Thank you for the careful reply.

Perhaps we will just have to disagree on the importance of options dealers in the economics of listed equity options markets. Seems like this might hinge on defining the scope of what’s included or not included in one’s economic analysis.

Because they are the primary liquidity providers, provide offers on all of the options on an exchange, serve as counterparties on customer orders and their business model succeeds or fails on the economics of their trading books, I view options dealers as essential to the existence, function, and economics of options markets, markets that are built on options traded and the economics of the counterparties to those trades.

It’s difficult for me to see how to analyze the economics of a market without considering the core participants in the market. In this economics, an option position is not separable from the replicating portfolio (which could be built with Black-Scholes as part of the pricing model) of the dealer. Dealer profit and loss on the total portfolio determines the dealers’ economic outcome and this economic outcome is designed to be delta neutral (mostly independent of directional moves of the underlying stock), so the dealer’s p&l summed with total customer p&l is in general not zero sum when customers trade single leg options (which they most certainly do quite often).

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33

I mean no disrespect to the marker makers. But consider this: you make an option trade where the premium is north of a thousand bucks and the market fees (not broker commissions) are just a few cents. How much value are they adding? I ignore them when planning a trade.

The Captain

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34

In that case, we agree. Stocks are not zero sum. Options are zero sum. Stocks in combination with options are not zero sum.

It’s kind of an edge case, but for certain things, sometimes what I sold comprises the entire open interest of a particular strike price. Obviously never with widely traded stuff like Apple, but for something like COPX it happens periodically (A year or two ago, I sometimes sold puts on COPX in an attempt to increase my COPX position at slightly lower prices than prevailing). One of those months in late 2023, I think there was a case in which the entire open interest was my trade. I sold a few COPX 31 strike puts for $1.10, and paid the mandated exchange fee of about $0.65 per option contract. As I recall, that contract was purchased in one chunk, so very likely one buyer. A month later, that option expired worthless. So my case flow was $110 per contract minus $0.65 of fees/commissions. And the person that bought that contract paid $110 exactly plus $0.XX of fees/commissions. For that particular trade, on the options exchange, I ended up gaining $110, and the other person ended up losing $110, and the marketmaker/broker/govt received a few cents for the transactions. That is textbook zero sum. Now the fact that the other person might have owned 100 shares of COPX for each contract they purchased from me is immaterial to the options trade. Yes, they may (probably) have purchased those options as an insurance policy against the shares dropping below $31. And they did get that insurance from me for about two months (this is WHY they were willing to play that zero sum game). But the trade itself is still zero sum, there was no value added to the trade, the total of the capital started at $110/contract and ended at $110/contract, it just ended up in someone else’s account. That is the literal definition of zero sum.

Now expand that to ALL the options traded from the day the option begins trading until the day after the option expires. If you add up the total amount of money from the buyers, and you add up the total money the sellers received, you will see that those two numbers are exactly the same (minus fees of course). Also zero sum.

Now you can go even further. If you look at ALL the Jan 17, 2025 options of all strikes, and add up the total money the buyers paid, and add up the total money the sellers received, again you will see that the two numbers are the same (minus fees). Textbook zero sum.

It’s quite likely that that is the case. Earlier in the thread I posted the dictionary definition of “zero sum”.

One of the beautiful things about options is that you can choose (literally) any level of risk you desire with things like spreads.

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35

If you are trading a listed equity option, your counterparty at time of trade is the dealer (market maker). You’ve agreed to a price and contract with that dealer, I don’t see how that is “ignoring” the dealer, but if that’s your mindset, so be it. The dealer makes your trade possible, lol. Thank you Morgan Stanley, Citadel, etc for being economic participants in the options market.

You can bet the dealer knows the value they add, it’s in their replicating portfolio along with the other side of your option. The dealer earns the bid ask spread on its option trades, or some part thereof. The dealer isn’t ignoring their investor counterparties, that why it’s a persistent, profitable business. Wall Street trading desks just keep hanging around for some reason.

Regardless of your mindset, the economics of options markets and its participants somehow continue, day after day.

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36

When you say “person”, do you mean another investor? Or something else? I’m asking what kind of entity? Retail investor, pension fund? Or just any possible investor that’s not a dealer?

Definitions will help, so starting there.

37

How would I know who took the other side of that trade? All I know is that I really wanted those puts to sell, so I put an ask in lower than the current ask, then I observed the bid/ask movement and basically nothing happened, I also observed the quantity at the ask and it was all mine. So that led me to believe that nobody else was interested in that particular option at that time (COPX options are generally thinly traded anyway). Execution happened sometime later that day, probably near the last hour of trading. Did the market maker open a position suddenly a few hours after I placed the order? Maybe. But more likely it was another person or entity (probably not any major entity because they rarely do such tiny trades). But why does it matter? Either way, they gave me $110 for each option contract, and later the option expired worthless and I kept the $110 per contract.

[EDIT: Found the email with the execution - " Execution Time: 2:50 p.m. ET"]

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38

You do not like the message but that is not a response to the opinion.

39

Again, assuming listed equity option.

Again, you provide one example. You cannot prove a general principle one example at a time, at least not the way you are doing it.

I will also point out that you have not refuted any of my examples, you just raise your own.

But, setting aside those gaps in making a logical argument for your claims, we can look at another case you agree is edge.

Dealers are large liquidity providers. Your counterparty was most likely a dealer, this likelihood is vastly increased by the small implied interest in your example, because, you know, there is very little investor interest in this trade.

Who is more likely to be counterparty to your retail order?
A dealer whose business is providing liquidity all the time,
or
another investor who just somehow amazingly happened to want to trade the other side of the same underlying, same put/call, same expiry, same strike, and same quantity at about the same time as you?

Seriously?

I think you’re just trying to make me go away with these ridiculous examples.

Let’s summarize for listed equity option markets:

  • Dealers account for a large portion of the volume and are therefore meaningful participants in the overall economics of these markets
  • Dealers trade a delta neutral portfolio with minimal exposure to directional equity risk so that their p&l does not depend on the directional equity p&l of their counterparties
  • So any trades with counterparties taking directional risk are not zero sum (as you acknowledge above: “Stocks in combination with options are not zero sum”)
  • We can therefore conclude that non zero sum trades are a meaningful portion of the overall economics of these options markets
40

Does the counter-party change the mathematics of option trading? I never found that even mentioned in the best option text book I ever read. It seems Sheldon Natenberg doesn’t think it matters. The interaction with the market maker lasts an instant, the trade execution. From then on the option market takes over. One watches the stock and the option to decide if action is needed. Since calls are wasting assets I often place a GTC buy order at 10% of the original premium which, if executed, frees up the underlying for further trades. BTW, all my option trades are limit orders. That’s like fishing, put bait on a hook and throw it in the water. Sooner or later a fish bites. If not, find better fishing grounds or better bait.

WHAT EVERY OPTION TRADER NEEDS TO KNOW. THE ONE BOOK EVERY TRADER SHOULD OWN.

The bestselling Option Volatility & Pricing has made Sheldon Natenberg a widely recognized authority in the option industry. At firms around the world, the text is often the first book that new professional traders aregiven to learn the trading strategies and risk management techniques required for success in option markets.

Other good sources are books by and about successful traders. They cover a lot of ground but, again, I don’t recall mentions of market makers. Stock exchanges are to investors what casinos are to gamblers. Both make money on the volume of trades or bets. One of the functions of market makers is to execute trades when there are no other counter-parties.

Understanding Market Makers

Many market makers are brokerage houses that provide trading services for investors. They make markets in an effort to keep financial markets liquid.

Market Maker Definition: What It Means and How They Make Money.

The Captain

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