Debunking the Option-Trading Myth of Zero Sum

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March 19, 2015
arm wrestling

There’s an urban myth in options trading that’s probably as old as the CBOE itself: It’s often said that options trading is a zero-sum game. In other words, if someone wins, someone else has to lose, right? Well, no.

It’s true that the stock or option or future or whatever will go up or down, and only one of us can be right. But that assumes that each of us doesn’t do something else on the side.

Let’s look at a few scenarios in a typical options trade on an underlying stock.

Myth Buster One

Say you buy a call, which means the market maker sells the call to you. If the stock goes up, you make money and the market maker loses money, right? Right. But there's more to it. When a market maker sells you that call, he or she might choose to hedge it immediately by purchasing the stock to hedge the short call.

Now, you’re still long the call, but the market maker is short the call and now long the stock. Let’s assume the stock goes up, and your call goes up in value as well. The market maker who’s short that call is losing money on it, but is making money on the long stock. It’s possible for the profit on the long stock to exceed the loss on the short call. In that case, you make money on your position, and the market maker makes money on her position, too.

In this case, you both can win.

Myth Buster Two

Let’s say the stock goes down. The market maker is short a call, and makes money on that because she keeps the premium received when she sold the call. But she’s long stock, too, and loses money on that—probably more than what she made on the short call. You own that long call, and you lose when the stock goes down.

In this case, you both lose. The difference is that the market maker started out with the opposite of the trade you had, but she changed it into something else.

A Caveat

So, the options market isn't really a zero-sum game when you look at two independent traders taking opposite sides of a trade. Each can hedge or adjust their position without the other trader doing anything. The beauty of trading options is that you can make investment decisions based on market news, volatility, time to expiration, underlying moves, and so on, and/or create different option strategies to hedge your initial trade or position at any point of time. If there's a hedge involved on the "loser" side of a trade, and the net result is a win, two traders can net out as winners, and the zero sum argument goes out the window.

However, if you look at all the traders and investors out there in aggregate, trading does become a zero-sum game. When the market maker buys the stock as a hedge against her short call, someone else is selling that stock to her. If the stock goes up, the person who sold the stock misses out on the profits.

So, the zero-sum theory works for the grand scheme of the markets, but not necessarily on the trader-versus-trader level.

Where does this leave you? Pick your trades carefully and make sure they make sense to you. Consider proper hedges with your options trades, and let the other folks worry about their own profit/loss ratios. You just have to worry about yours.

 

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