Quote from roberk:
Could you explain this pithy paragraph.
Thanks for the additional comments. Would like to hear what maverick74 has to say..?
I'm not sure what part of this thread I am suppose to respond to. As for the zero sum part, this is obviously not correct for the reasons risk arb pointed out. I could buy a straddle from risk arb and we both could trade the gamma, I from the long side and he from the short side. If I am a better underlying trader then he is I might make more money then him on this trade even if I was wrong on the straddle purchase and vice versa. The option gains and losses are never absolute. Most traders that trade large option positions trade the gamma in some form. And even in that case, you have to keep in mind that a trader may have on a portfolio of positions in which some positions lose money in the same group in which others make money. So while Trade A lost money, it lost money at the expense of Trade B making money.
Another angle I would like to throw out there. Insurance companies, when you buy health insurance or car insurance, do you consider this a zero sum game? Obviously if you never have to use it, you might see it as the insurance company winning and you losing the premiums, but did you really lose? Your goal here was to lose was it not? Surely, you don't buy health insurance in the hopes of getting cancer, or buy car insurance with the hopes of driving your car into a brick wall. So in this example, you actually pay the premiums and hope to lose.
Well the same can be said of options. Say a large hedge fund owns a million shares of stock XYZ at $100 a share. The stock is reporting earnings next week. The stock has had a huge runnup going into earnings and the hedge fund is scared that if the company disappoints the stock could fall maybe 10 or 20 pts. So the hedge fund buys insurance, in this case, maybe some slightly out of the money puts.
Now think about this. In this case, the hedge fund actually wants to lose money on the puts. Then why would they buy them you might ask? Because, in this case, the cost of being wrong is too great. So they buy the puts in the hopes that the company announces good results and the stock goes higher. The puts then expire worthless and the hedge fund could not be happier. They wanted to lose!
This is sometimes a hard concept for people to grasp because it goes against our intuitive nature. Why would anyone want to lose? For the same reason that none of want to get cancer or get into a car accident. Because of this paradigm, options have a special innate value that the underlying does not have. That is, no one buys or sells the underlying in the hopes of losing. If someone buys stock, they expect the stock to go higher, they are not buying it for defensive reasons. Even with arbitrage, the trader is hoping to make gains on both sides.
So what the underlying trader has to live with, is the fact that every time he buys a stock or future, there is another guy on the other side of that trade that thinks exactly the opposite of him. With options, this is not always the case, therein lies the edge. Anytime you can take money from someone that actually wants to lose it and give it to you, well, you probably should provided that you understand the risks that you are taking.
For these reasons, I think trading options is much more profitable then trading the underlying. There are built in profits for you to take. Here is another way I look at it. With options buying and selling in terms of laying off risk, I always look at it from the standpoint that someone wants to sleep better then me. If I am willing to accept his risk for him, I can make money at the expense of not sleeping as well. He has shifted his risk to me and I was willing to accept it. In this situation, the cost of me being wrong may not be as destructive as the cost of him being wrong. Here, both parties win.
That's my two cents.
