Options: A Zero Sum Game?

Originally published at Investor Place

Most people consider options to be a zero sum game. When you make a trade, someone takes the other side and when one of you gains, the other loses an equal amount. From that definition of ‘zero sum’ then it’s difficult to claim that options are not a zero sum game.

However, I do make that claim.

Assume that a trader decides to sell shares of a stock that he/she – if the price rises to $75 per share. The trader may make a mental stop, or enter a GTC (good ’til canceled) order with the broker. When the stock is sold, the trader is happy with the result. Sure the stock may move higher, and one can argue that our trader ‘lost’ money by selling and that the ‘buyer’ made money. With this point of view, trading is a zero sum game.

I prefer to look at it this way: Our trader earned the profit he/she hoped to earn, and when that happened, ownership of the shares was willingly transferred to another trader. Once the position is out of the account, the trader neither makes nor loses anything. Any change in value for the stock belongs to its new owner. There is no gain and loss to add together to reach that zero sum. One trader made a play, accepted a profit, and now a new trader has an investment.

Options are different

Most of the world looks at options differently. But I don’t.

If I buy a call option and earn a profit by selling at a higher price, there is no reason to believe that the seller took a loss corresponding to my gain. The seller may have hedged the play and may have earned even more than I did.

The thought that options represent a zero sum game assumes that all trades are standalone plays and that if you profit, the other person most have lost. Just as our trader above decided that transferring ownership of the shares to another investor would be a good idea at $75/share, so too does the covered call writer.

When I sell a covered call, I am thrilled when the stock rallies far above the strike price. It means I earn my desired profit. Better than that – if the big rally comes soon, I will be able to exit the trade with perhaps 90% of my desired profit, and do it quickly. Why is that ‘good’ when the last 10% is sacrificed? When anyone uses an ‘income-producing strategy,’ time is money. To exit one trade and gain the ability to reinvest the same funds into a new position – without having to wait as long as anticipated – is a bonus. When there are several weeks remaining before expiration day arrives, I can reinvest the same cash to earn additional profits with over the same period of time. That’s even better than earning 100% of the original profit target by waiting until expiration.

It may be true that the person who bought my call option scored a big win (if the trade was not hedged), but that’s not my loss. In fact, it was my additional gain (as described above).

Options were designed to transfer risk. In the covered call example, the seller accepted cash to help achieve a specific investment goal. By doing so, he/she willingly accepted the option premium in exchange limiting profits for the trade. The main point to be made is that there was no potential profit sacrificed. The call seller would have sold stock at the strike price and earned less than the covered call writer.

The option buyer accepted limited risk. If the stock did not rise far enough or fast enough, that buyer would have lost money.

I don’t see anything resembling a zero sum game in hedged options transactions. I understand that others see it as black and white: If one person gained, the other lost. But that’s oversimplification.

Bonus Video: Options for Rookies Premium

940
Comments are closed.