Your Trades and People who Take the Other Side of the Trade

SS writes: Mark,

is always going to be counter-party to each contract one buys or sells.

1) Yes there is always a counter-party.  If you buy, someone must sell it to you.

Let’s assume a scenario, based on earnings, in which 'everyone' agrees it's likely that the share price will move higher.

Clearly, any active trader (a large hedge fund for
instance) is not likely to take a short view based on this news,
and let’s say the open interest on the available put contracts confirms
this. Sure enough, the stock goes through the roof. Yet, somehow,
individual traders who were long were able to take on somebody as counter-parties for their positions.

I disagree.  It's not 'clear' to me that 'any active trader' will not take a short position. Why would you believe that's true?

Just because the majority anticipate good news and a boost in the
stock's price, that does not mean it will happen.  There are plenty of
contrarian traders who do exactly as you suggest they won't:  Some will go short in anticipation that whatever the news, the market will react as if the news is disappointing.

But most hedge funds (to use your example) prefer not
to take market risk.  The earn their profits by remaining neutral to as
many risk factors (the Greeks) as possible – and that certainly
includes not being exposed to delta or gamma risk when earnings news is
about to be announced.

3) The open interest on the short put confirms NOTHING.  Anyone can
hold a short position by selling naked calls or call spreads.  In addition, a synthetic
put position can be created by buying calls and simultaneously shorting
stock.  The open interest of the puts is meaningless.  Too many people mistakenly assume that a huge call open interest signifies that the call buyers are bullish.  In order to hide his/her intentions, the call buyer may be creating synthetic puts by selling 100 shares of stock for each call purchased. 

Don't forget that 'neutral' traders can buy calls and by selling 50 shares of stock for each call purchased, creating a synthetic long straddle position.  The bottom line:  Unless you know how the calls were hedged, you have no idea if the call (or put) buyer is bullish.  Don't assume anything.

The only way I can understand
the individual profiting is if they extracted their profits from the
very long-term view of other traders– such as hedge funds– who
purchased put options with the expectation that their positions would
be worth more after a significant period of time…

this correct? If so, it wouldn’t necessarily be true that the counter-party to your trades is intentionally taking the opposite side
of your view at the moment you purchased your
contracts. It may just be that you were able to profit in that short
window of opportunity because their position was worth less at the
moment you bought them.

4) Investors who bought calls – and who are making a lot of money in your scenario – bought those calls from someone else – the counter-party. But, they do not 'extract' their profits from anyone.  As soon as the trade is made, the counter-party is separated from the customer with whom the trade was made.

You are implying that the counter-party loses as much as the call buyer gains.  Why?  Just because you, the buyer, choose to hold the options 'naked long' and make no attempt to hedge the position, that doesn't mean that your counter-party has done the same.

If that counter-party is a 'hedge fund' or any large, active trader, there is virtually zero chance that the trade was not hedged as quickly as possible.  You, the public investor, may be willing to gamble that the news will be good and purchase options based on that hope.  But I assure you that no professional trader does the same.  They hedge any and all risk.  They earn their profits by selling options to you – at a price that's higher than they are worth.  They don't care if you make a fortune on the trade.  Their task – and they are very efficient -  is to buy other options and/or stock to construct a position with almost no risk.  They lock in an 'edge' by selling overpriced options to you, and hedge by buying options that are nearer to fair value.

On this trade, you 'win' because you make a lot of money.  But the counter-party also profits.  This is not creating money out of nothing.  Some people sold options, closing a position to lock in a profit (or loss).  Others sold stock at a price they were willing to accept, and the buyers of that stock made money.  Those who chose to sell naked calls or call spreads, lost money.  But that has nothing to do with you and your counter-party.   This is not magic and money does not appear out of nowhere.  But it does not necessarily mean that others lost an amount equal to the gains.  Others may have simply sold early and someone else made money the early sellers could have earned.

None of this has any long-term implications.  You buy calls, they sell calls.  Then they eliminate risk.  Then the people who sell options to your counter-party, hedge their trades with yet another counter-party.  Someone winds up with risk – but only if that trader elects not to hedge.

This is not an 'I win; you lose' situation.  I don't know what you are trying to say in the last paragraph.


6 Responses to Your Trades and People who Take the Other Side of the Trade

  1. 07/11/2009 at 9:53 AM #

    Nice Post Mark,
    Great Insight on why options are not necessarily a zero sum game.

  2. Manshu 07/11/2009 at 4:13 PM #

    When GM was about to declare bankruptcy people were why the stock isn’t hitting zero and why are there still buyers for the stock?
    Turns out that there were Index funds who had to hold GM, because it was part of a certain index.
    Other traders were covering their shorts and so there was still demand.
    There can be any number of reasons for someone to want to buy or sell a stock, when the majority doesn’t.

  3. Blue cat 07/11/2009 at 6:31 PM #

    Hi Mark,
    When you were a pit trader, I imagine that most trades were done by traders making individual decisions about each trade. It’s my sense that these days most trades at that level are done by computers. Is that right? Do you know what percentage of trades are done automatically? When I place an order, is it most likely that the counter-party will be a computer representing a large hedge fund or market maker?

  4. Mark Wolfinger 07/12/2009 at 9:28 AM #

    I’m not sure why so many believe it is a zero sum game. Sometimes everyone can win.

  5. Mark Wolfinger 07/12/2009 at 9:30 AM #

    Yes, any number of reasons, but I was surprised that the stock traded so high. I would have expected a couple of pennies per share.
    What I do know is that if I believe a stock is worth zero and others are paying $1 pr share, I’m not going to bet the others are wrong. I just watch from the sidelines.

  6. Mark Wolfinger 07/12/2009 at 9:37 AM #

    Yes, years ago, it was pretty much all independent traders, acting on their own.
    I don’t know the numbers, but the majority of trades are done electronically. My guess (and it is a guess) is that brokers only come to the trading pit when they have a large order and want to negotiate a price. I also believe that such orders have already been ‘shopped upstairs’ and the broker has both a buyer and seller and wants to cross the orders (That means the broker executes both the buy and sell).
    Maket makers can take part of the trade, so individual decisions are still being made. But – the big difference today – is that once the market makers takes a position, he forgts about it. His/her partners, who are off the floor and who have the computer power, find ways to hedge that trade – and quickly. The floor trader’s job to get good prices for trades that are made, but the job of hedging and reducingg risk is taken out of the trader’s hands.
    Yes, your orders are likely to be filled by a computer representing market makers. And yes, trading firms also participate as off-the-floor market makers.