Broadly, businesses exist and persist because they are consistently profitable. Listed derivatives dealers, such as equity options dealers, are large and important participants in financial markets by providing daily liquidity: they facilitate markets by being available to trade either side of a transaction on the exchange to any other participant in the market, such as the entire investor community (asset managers, pensions, hedge funds, retail investors) as well as other dealers.
The business model of a dealer in the listed equity options market is to make money regardless of the directional movements of the stocks that underlie the options. Dealers achieve this by creating a portfolio of options, stocks and other instruments that is so-called delta-neutral (delta measures sensitivity of the portfolio to changes in a stock’s price). Delta near zero is delta-neutral and delta near 1 or -1 means the portfolio gain/loss from directional stock changes exactly matches the gain/loss or loss/gain of the stock, respectively.
The below 4 bullets provide a summary of the premise and resulting logical outcomes that explain why listed equity options markets are not zero sum. These outcomes are an economic basis for why these markets continue to exist and the dealer business is sustainably profitable without exposing dealers to the directional risk of stock price movements. Directional stock risk exposure would make the dealer business substantially less predictable and therefore substantially less appealing as a business model.
For listed equity options markets,
- Dealers account for a large portion of 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 and therefore their profit and loss (p&l) does not depend on the directional equity p&l of their counterparties.
- From #2, therefore any trades with counterparties taking directional risk are not zero sum because dealers make profit (on average over a period of time) regardless of the gain/loss of each counterparty and therefore the total p&l of all such trades in the market is not zero sum, in general (large majority of cases).
- From #1 and #3, we can therefore conclude that non zero sum trades are a meaningful portion of the overall economics of these options markets and that in aggregate the options markets will not be zero sum because aggregate trading books are not perfectly balanced between longs and shorts a large majority of time (perfectly balanced between net long and short stock would be unusual for a single underlying ticker, let alone over all tickers).