Ask HN: Why be an option/futures/day trader when it is zero-sum? | Hacker News Reader

Ask HN: Why be an option/futures/day trader when it is zero-sum?

27 pointshashtable67 comments

Many very intelligent people whom I admire, such as Nicholas Taleb, are speculators. But isn't it very irrational considering that it is provably zero-sum? I also would have moral qualms about doing it as well considering that I am not using my energies to produce wealth in any meaningful way.

Nicholas Taleb talks about jobs that "scale well". But isn't it more important to have jobs that are non-zero sum? If you have a job that is zero-sum, you have to keep working to stay ahead, whereas if you have a job that is less competitive you can relax. There will always be jobs available even for bad programmers because they at least create some wealth, whereas bad speculators would quickly lose their money and bad baseball players would starve in the streets.

I think it is as a rule irrational to enter a zero-sum game. When you enter the game, you are assuming that you are better than at least half of the other players. But everyone else is thinking the same thing. Clearly someone has to be wrong, and is going to be sorry. Is there any reason to believe that it is not you?

What do you think about this? I have been thinking a bit about getting into option trading, if you have any experience with it, please share.

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The irrationality you are referring to is called the self-serving bias (SSB). I wrote a thesis on overconfidence for my master in behavioral economics, and the two are related. SSB is a well-documented bias. For instance, 90% of American drivers think they are in the top 50%. It's hard for people to fully appreciate this fact. Allow me to illustrate. Do you still consider yourself, even after reading this statistic, to be in the bottom 50% of drivers? If so, then you're a minority, my friend ;-) (10%, to be exact)

90% (actually, about 98%) of American drivers are above average, owing to a statistical quirk. There are 6 million car accidents in the U.S. each year, out of roughly 240 million vehicles. At a minimum, that means that 97.5% of drivers get in no accidents that year. They join the big bulge of people who are "average", having perfect driving records or only an accident a decade or so.

Accident frequency is a power law distribution - a large percentage of crashes are caused by a small number of drivers who habitually violate traffic laws, drive drunk, or otherwise engage in risky behavior. One of the distinctive features of power law distributions is that there's this long tail of people with very small values, and then a few people who make up most of the curve. So (made up numbers) you might have 60% of the population who has never gotten in an accident, then 35% who has gotten in one, then a tiny fraction of 1% who's been in a dozen. Over an 80 year lifetime, that 6 million accidents/year results in 480 million accidents, or 2/person, so with the hypothetical percentages above, 95% of people are above the mean and 60% are above the median.

Just goes to show that you can't assume everything is a Gaussian. ;-)

A similar phenomenom occurs in many, many other fields. The average (median) wage-earner actually makes below average (mean) wages, because the existence of Bill Gates and Carl Icahn skews the distribution upwards. The median sale price for a startup is $0, because over half of them fail. The average test scores in Palo Alto or Weston, MA or Hunter College High School really are above average, because those places already preselect for bright kids. It's quite possible for Lake Wobegone to exist: you just need to compare your kids with someone else's average.

And none of this invalidates SSB, but you picked a bad example to illustrate it. When 90% of drivers think they're in the top 50%, they're right.

Sure, but that only works because you've chosen a discrete measure of how "good" a driver is. If you defined a "good" driver by some other measure (say, a function of risky behavior and fuel consumption), then 50% of drivers would be above the median and 50% would be below, by definition.

All 3 of you are right.

Lies, damn lies and statistics :-)

It's all in how you phrase the question, isn't it? Your analysis is right if we're talking about how a person's score on a driving test stacks up against the average score, gp's is right if we're talking about how people rank themselves among the population of all drivers (i.e., if 9/10 drivers think they're in the top five, then there are at least 4 delusional people).

I think nostrademons is essentially saying that the top nine drivers are indistinguishable from each other, as none of them have been in an accident. They are all "the best". Depending on how pessimistic you are, there are either no people in the top five, or nine people in the top five.

I know I'm in the bottom 50% of drivers: I only have a G1 license (i.e, Ontario's "learner's permit"). ;-)

Speaking as a trader at a major Wall Street firm... if you want a job that will allow you to relax, or if you aren't interested in "working to stay ahead," it's best to stay away from trading. Seriously. The hours aren't quite as bad as the investment banking/corporate finance guys, but I work 13+ hours a day, and my hours are not atypical for a junior guy. If you aren't going to work as hard as the competition, you'd better find some way to be smarter than them.

If you are interested in getting into option trading, make sure you understand it cold. Know what delta, gamma, vega, and theta are. Understand the relationship between these parameters and the price of an option: be able to explain it intuitively, and be able to derive the relationship from an option pricing formula. Understand implied volatility and the connection between vol and option prices. Build a simple Black-Scholes pricer to allow you to compute your own implied vol. Know why the vol surface has the shape it does. Make sure you realize that volatility is directional: vol goes up when markets go down. If you are playing index options vs. single-name options, make sure you understand your correlation risk. The list goes on and on.

Options are interesting, though, because they allow you to trade volatility. Vol is a more complicated thing than simple price movement, so if you understand it well you could have an edge over your competition.

Finally... I think trading is a good job choice for young, ambitious, and numerically minded people. Seems like there are a lot of readers like that here... maybe I'll write a more detailed article about this sort of thing later.

Please do so. That would be interesting.

First, options and futures involve a sub-zero game. Money leaks out via commissions.

Second, there are two types of players in this game. The first group is the speculators. They play the game for profit from the game. The second group is risk managers. They play the game for risk reduction. Speculators serve the risk managers. The speculator's strategy is starkly different than the risk manager's strategy. The speculator can profit by optimizing his strategy.

EDIT: The assumptions made by Black, Scholes, and Merton are highly idealized. There is much research to still be done in the area of behavioral finance and the game theoretic approach to derivatives pricing.

I've thought about conducting graduate research in this area because the mathematics are truly fascinating in this branch of finance/economics. When you start exploring this area from a game theory approach, you can start to understand why John Nash won the Nobel.

My understanding is the "speculators" create liquidity for the risk managers, thereby assuming their risk.

Why does the money leaking via commissions necessarily make the game sub-zero sum? Is it because we aren't looking at the big picture where everyone wins?

It seems like the risk managers must have a positive incentive to sell their risk on the marketplace instead of assuming it themselves. I.e. hedging another investment like someone else said already.

Liquidity is one type of risk. There exist also interest rate risk, price risk, etc.

Commissions are an expense that both sides pay to play the game. Money is not transferred from one player to another, it is transferred to outside the game.

It is true that there is a positive incentive to sell risk from the risk-manager's view. That is the whole reason the markets were initially established, both derivatives and the underlying of the derivative.

I was thinking about how to better answer your question concerning the sub-zero game statement I made. Let's remove ourselves from finance for a minute into something that is more traditional in the game theory studies--namely poker.

If the game is played where the players arrange transfers face to face such as in a home poker game, then the game is zero-sum. Your losses are my gains. No money is created. No money is destroyed. It stays inside the game. The minute we go to a casino to play the same game, the game becomes sub-zero due to the rake. You lose X to me and Y to the rake. I gain your X and lose Y to the rake.

Your cash flows: -X - Y. My cash flows: X - Y. In a zero-sum game your cash flows are the negative of my cash flows. This implies -(-X - Y) = X + Y. This is a contradiction. Therefore, the game is not zero-sum.

I was thinking that, because the market created value, it couldn't be zero or negative sum. Now I realize that it's negative sum within the scope of the market itself, even though it may create value in a grander scheme of things.

To truly understand the implications of game theory applied to the financial markets, you should look up the concept of Pareto improvements and Pareto optimums.

Good call. My roommate and I are about to start an econ discussion site. Shoot me an email if you're interested in helping us get conversation started or just have any suggestions for us.

Email?

See profile, forgot that it doesn't show.

It's still zero sum. Just one of the winners is the guy charging the commission. Every dollar in commission is a dollar someone else has to lose.

No, the broker is an externality--his strategy is fixed before the game even starts.

I have a Series 3 (futures/forex) license and worked in that industry for about 6 months. It was like the bad parts of Boiler Room. I left when I realized the shop I was working for had no problem ripping off retail clients and allowing them to speculate with money they didn't have; clients had to sell their homes to cover their obligations.

Bona fide hedging is a lucrative business for the companies involved, whether that's hedging against currency or commodity price fluctuations. It's also more "buy side" than "sell side" - you're dealing with companies rather than 'raising money' from new clients who get blown out over the course of 3 months.

I know a few successful options traders. It's highly lucrative (high 6 figs base after a few years), you just need the pedigree and the intellect to pull it off. If you're in a position to do that, though, you might try to get an analyst job, get on a path to assistant portfolio management, portfolio management, keep a good track record and start a hedge fund. That's all buy side and would allow for some flexibility in the strategies you implement.

Was the acting as bad?

Don't some people, especially big organizations buy options/futures as hedges for another investment?... so it might not be a true zero sum game in the sense that some of the players aren't really playing to win.. they are just putting money in for insurance

Correct. There is a big difference in leveraging options when you own tons of stock in a company vs. using options as a high class lotto ticket.

Example: Mark Cuban used options to guarantee he would be set for life no matter what happened to Yahoo's stock after they bought Broadcast.com for $5 billion (in stock mostly).

> Mark Cuban used options to guarantee he would be set for life no matter what happened to Yahoo's stock

Care to explain further, or point me to where I can read more?

Edit: I think the "equity collar" article linked below sorted me out.

http://www.fastcompany.com/magazine/63/fasttalk.html

"The basic worry that comes with having lots of money is no different from what worries everyone else. Whether you've got $100 or $100 million, you don't want to lose it. After we sold Broadcast.com, I hedged my stock with synthetic indexes, in case the market cratered in the six months before I could hedge my actual Yahoo shares. It cost me $20 million, but I protected what I had. Todd Wagner and I had a credo: "Pigs get fat; hogs get slaughtered.""

Yup, This is called an Equity Collar. One should consider getting this insurance even as an individual investor... to protect your investments against worst case scenarios.

Where can one learn more about an Equity Collar?

Check this out: http://www.cboe.com/Strategies/EquityOptions/EquityCollars/p...

The other thing worth noting is that a well functioning capital market is not zero-sum, it puts the capital in the most profitable growth opportunities. So speculators may be incorporating information into prices that has value. Of course they may be incorporating disinformation as well; hence the importance of regulation against cornering the market or pump-and-dump schemes.

Aren't options zero sum? I don't think anyone would suggest the entire stock market is. But every penny you make from an option is a penny someone else loses, unless I'm missing something.

Right, sorry options are zero sum in a money sense, but not in a utility sense. If I write a covered call on shares that I own and a speculator buys it, we both might end up with returns distributions that are preferable to what we had before and so expected utility of wealth is increased though wealth itself perhaps isn't.

Also you have to remember that when options mature in the money they will be exercised resulting in transactions in the actual stock market which is more obviously not zero sum.

So suppose I think Yahoo is under-priced at the moment. I could 1. Purchase a share of Yahoo on the open market, exerting buy pressure on the stock driving up the price

2. Purchase a call on Yahoo; Yahoo's price appreciates some if I'm right putting my call option in the money. If the option writer was naked, they have to go to the open market to purchase a share for me to buy, resulting in buy pressure on the stock driving up the price.

Obviously the link in #2 is not as direct, but potentially prices in the actual stock market can move to incorporate information in the purchases and sales of option contracts as they are exercised. And one step further removed a long equities trader might use the size of the outstanding call and put options market on a stock to forecast price changes.

"When you enter the game, you are assuming that you are better than at least half of the other players."

I think the difference is - at what point does that assumption become atleast somewhat provable. Shaquille O'Neal was probably an athletic 6'10" 280 lbs in high school. Just because the game of basketball itself is zero sum, does that make it irrational to think that he would become a decent professional basketball player?

My favorite part of Taleb's book is when he describes the investing world as if all player's had a random 50/50 shot of making money each year. There are millions of investors, by random chance thousands will do really well, a handful will do really, really well over the course of decades. How do you know Warren Buffet is not part of that handful that is successful purely by chance? It's been awhile since I've read the book, but I remember his philosophy being something like if you have a logical investing/hypothesis that gets proven results, then maybe we can say it's not by chance.

So to answer your question, if you think you have an objective theory/algorithm/etc for option trading and have done blind historical tests or have successfully paper traded for a year+, then you might be on to something. If you think you are just smarter than everybody else, or maybe had a couple successful stock trades, it's probably not a good idea.

Competitive sports are also zero-sum games. Traders are banking "jocks." They are traders because it is a zero sum game, and they think they have what it takes to win.

As a person that has been on both the positive and the negative side of the sum, I can tell you that most people don't really think about this when they get into the speculation.

1) Serious quant trader types are rarely good at anything other than mathematics. Even if they are, if they are getting $500k+/yr it would be hard to start as an entry-level engineer for $60k. So most people don't really have an option once they get started in trading.

2) It's addictive. The top hedge fund manager in the US is paid to the tune of $1.7 BILLION per year. On January 2nd the next year, he's back in the office. Once you get in the quickpaced environment of trading everything else looks very boring.

3) It's usually a collective game, so your particular performance is not as important as the performance of the firm. You could do excellent, but somebody else could tank the whole bank. Similarly, you could have a bad year, but if the company is doing OK you'll still get a decent bonus.

After all, the same applies for startups. If you don't assume that you are better than most people at what you do, there's hardly a point in doing it.

Short answer: No, don't do it.

Long answer: For anyone interested in this stuff I highly recommend the book Trading & Exchanges by Larry Harris. The book is about market microstructure, and the knowledge applies to any market whether it's equities or options or online gambling like intrade.com. It's a textbook, so not riveting reading, but great information.

As other posters have pointed out, it depends on how you define zero-sum. Trading is zero-sum, when you compare it against market returns. However, as a trader you are providing services such as immediacy and liquidity. My AAPL stock is more valuable to me as an investor, since there is an active market, and people are willing to sell it to me and buy it from me on short notice, even though I am losing some money to them through the bid-ask spread and execution costs. The other comments about options being useful for spreading out risk are true as well.

As far as the rationality goes, it's rational if you're an expert, you have better information than the market, if reading the above textbook kept you up late at night, etc. Your intuition about the odds are correct, though, so keep your pessimism handy.

So why is my short answer 'no'? Well if you don't have the patience to read the whole post then you definitely shouldn't do it, since learning all the math behind it is going to be way more boring. You've read Taleb which is a good sign. Now that you're at the end the answer is 'maybe', but your wording concerns me: what do you mean by "getting into" options trading? If you're going to get some intensive training and learn from professionals working at reputable investment firms, then great. If you're going to read a few articles off the internet and then dive in, then that is definitely not a good idea. Trading is all about having an edge against the person you're trading with, so a few articles don't improve your odds much.

I'm just a undergrad college student. I read a few articles online and decided to try the options trading simulation at cboe.com

I think it has to do with the "superstar" phenomenon that Taleb discusses in Fooled by Randomness & The Black Swan. Being a dentist, you are not likely to see a multi-million dollar salary - yet you can definitely live comfortably.

What I believe Taleb's philosophy _was_ (he now remarks in bold text: "Finance is for philistines!" on http://fooledbyrandomness.com/ ) that by exploiting the random nature of markets he could "swing for the fences" by placing many small extremely risky bets that if they paid off -- even infrequently -- would guarantee him a lot of money.

From the little that I know/think I know: Options are a good way to leverage small amounts of capital into potentially large gains. If the price of the underlying security doesn't behave as you expected you can let your option contract expire worthless - meaning you have a defined risk which is what appealed to Taleb. Even in the worst case he knew how much was at stake.

That changes when you start to write options i.e. be the counter-party which does not have the right to buy/sell but the obligation.

In theory, a good speculator allocates money more efficiently. In 2004 this might have meant shorting Bear Stearns and buying stock in Google. Google could then sell stock to raise money, or take out a loan with its own stock as collateral, to pursue projects with the money. In theory, a good trader lends money to the companies that deserve those resources the most. So, as far as I can tell, it isn't a zero-sum game.

If the entire stock market does its job like this, money gets to googles more easily than it gets to pets.com. The economy uses capital more efficiently, and grows more than it would otherwise.

Of course, that's all in theory. In practice, being an investment banker is rough.

This is exactly right. By making money day trading in the market, you are creating very needed services - adding efficiency and liquidity. Without these things, the markets wouldn't exist.

Options trading is not zero sum because the utility of money is not linear. When a rich person gives money to a poor person, the net gain is positive because the poor person can use the money to satisfy more basic needs that the rich person has already satisfied, and thus would otherwise have spent the money on something with a smaller return.

As brentr already pointed out, some people trade options for risky gains (such as selling an uncovered call), and some people trade them to offset risk (such as buying an underwater put). Acting in the latter category is like buying insurance: even though your expected return on money is negative, your expected return on utility might still be positive. Acting in the former category is like selling insurance: you run the risk of taking a big hit, but your expected return is still positive.

It's not uniformly irrational or unprofitable to enter a zero sum game. I made a great living for over 5 years playing a zero sum game, and know lots of people who have done it for far longer. Not options trading though. That one in particular I can't speak to.

It's often not that hard to prove within a reasonable certainty that you are a winner (or at least were one), depending on the variance. I haven't looked into the coefficient of variation of options trading though. I might one day.

Also, whether or not something is competitive has nothing to do with whether or not it is a zero sum game. It is generally just a factor of how much money can be made. The software industry is not zero sum, but is highly competitive. Low stakes poker tables are zero sum, but are not competitive at all.

But wouldn't the lose leave the game, leaving the previous winners to battle amongst themselves?

Nope. Any game involving variance allows one to chalk up bad results to bad luck for a very long period of time. And new losers join every day.

I'll save someone the task of googling Nicholas Taleb. I think this link has been here before, but even so, it's a good one:

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

It isn't zero sum, any more than manufacturing is zero sum because all you did was expend energy rearranging the same old atoms.

Trading well requires you to synthesize information that other people will act on. If oil is too cheap, you buy oil, this raises the price and alleviates the problem. The fact that this causes some people to lose money is material, but it just means that trading is a way to redistribute wealth from people who are usually wrong to people who are usually right. I do not see how anyone could believe that this isn't socially useful.

That doesn't make sense. Manufacturing is not zero sum because you're taking things people don't want (raw materials) and turning them into things they do. It's a zero sum game at the atomic level, but not at the wealth level.

Options trading is zero sum because every dollar made by one options trader is lost to another (or to a commission). There's no net wealth generation.

Of course it makes sense. Trading options takes something people don't want (a particular exposure to a particular set of cash flows) and turns it into something they do want (a different kind of exposure to a different set of cash flows). If people they were indifferent to sets of cash flows, markets wouldn't work.

Here is one incredibly obvious way that you're wrong: if you ran an airline, you might be worried that a sudden spike in fuel prices would bankrupt you. They could use futures to speculate that prices would go up, so they'd be indifferent to price changes -- an increase of $X in fuel costs would give them an increase of $X in futures profits. Suddenly, they are a more stable company -- people are more willing to work for them, banks are willing to lend them more money, passengers are more likely to participate in frequent flier programs, airports would be more likely to consider them for long-term spots, etc. Somehow, everyone on that side of the transaction benefits. And lo! The speculator on the other side, betting that prices will go down, is able to do so directly, rather than by indirect means such as buying stock in an unhedged airline and exposing himself to the vagaries of that industry. Even if he loses money in the end, he has what he wants when he makes the trade. However, I needn't restrict myself even to people making business decisions through the futures markets: even a compulsive gambler trading pork bellies is not a compulsive gambler getting drunk at casinos or playing illicit card games. In short, it's a very sanitary sort of gambling (this was not always the case -- in the 1920's, traders at the then-outdoor American Stock Exchange drank constantly to keep warm. This explains a lot).

It is trivial to declare that some business is zero-sum or negative sum. Even retail is a series of zero-sum transactions: I had $5 and the restaurant had a burger, now I have $5 worth of burger and the restaurant has $5 worth of cash. Even, minus time and taxes. And yet, for the most part, our bias is to quite correctly assume that when people voluntarily hand over billions of dollars, some of them becoming poorer and some of them become quite richer in the process, they may be doing something rational. The fact that rich countries develop stock exchanges, and that the development of stock exchanges correlates with future wealth, is not a coincidence.

Anyway, every asset can be described as a set of options (I dare you to name something you can sell for cash that you can't theoretically analyze as an option). So by arguing against options, you're arguing against all commerce.

Has anyone else read "Nonzero" by Robert Wright? It's one of two nonfiction books that have noticeably improved my understanding of the world, with almost daily benefits. (The other is The Black Swan.)

Being a quant has a certain appeal, but nothing (to me) is as appealing as creating tools that people use to accomplish things.

Gambling on anticipating/creating the future is not an easy way to make money. However I agree that there is no wealth creation resulting from this (the increased liquidity of the market due to new kinds of derivatives may increase the efficiency of the market, but I think you are talking about "simple" trading.)

Zero-sum depends on your perspective. Speaking strictly in theory here: a successful speculator creates value in the same way a hunter creates value when he sharpens his spear. By taking decision making power (money) away from people who make wrong decisions he "sharpens" the market and makes it a more useful tool when other people use it to create value.

Of course I totally missed the point of the question. It strikes me as just a matter of personal temperament. I, personally, have no interest in jobs that involve going into battle againt other people every day. But if that sounds appealing to you then I think you should go for it, even if probability says you won't succeed. Passion > reason.

Wrt to the "why" of the market, without speculation, liquidity is far lower. Take a look at the Chicago Climate Exchange's (CCX) price fluctuations compared to a fall expiring wheat contract on the CME/CBOT - you can move the CCX with a small amount of money.

I am not sure that traders don't create value. Their job is to allocate money to the most useful company, I suppose?

Except the companies don't see any of the money once the IPO is finished.

Of course, the only reason the IPO can proceed is because people who buy shares know that they can sell them to other people later. So I suppose in that sense they help. However, once the market already exists, no extra value is created by an extra trader entering it.

As others have pointed out though, there genuinely is value created by the options trading market, since the existence of options allows risk to be spread.

Well, companies do sometimes make further public offerings.

Stock trading also provides a somewhat objective measure of the value of the company. For instance, if MS wants to buy Yahoo, how much should they offer? Without the stock market, it's tough to tell if they are lowballing or paying a premium.

You're spot on that the market is a means of both creating information and disseminating information. Information is key to game theory. That's where sigma algebras and filtrations start to creep into theory.

Trading long is positive sum.

For stocks, yes, but not for options/futures.

I am talking about stocks.

speculation done right consists of creating knowledge about what resources will be in what demand in the future, and then saving resources that are cheap now but will be expensive later. doing this raises the price a bit now (b/c you buy a bunch) and lowers it then (b/c supply is higher then). you make money smoothing out price fluctuations. this is a valuable service -- price fluctuations can really hurt people or companies that don't have spare money at the moment.

there is a limit on how much total money can be made doing this. the more people do it, the less price fluctuations are available to even out.

but anyway, there are good types of trading.

I'm guilty of not creating a distinction between speculation and investing. Technically, investing done right consists of creating knowledge about what resources will be in what demand in the future. A speculator plays a mere hunch. The distinction lies in the amount of information processed in the decision formulation. A good discussion of the dichotomy between a speculator and an investor can be found in Graham and Dodd's Security Analysis.

This is human nature. It happens everywhere, the most commonplace example is a lottery ticket: that is a negative sum game. Venture capital is also a negative sum game (EDIT: I'm actually not sure about this, the winnings of top VCs might outweigh the losses of the majority).

Risk hungry people will pay a premium for increased upside. For example, they will prefer a win 20-lose 30 game over a win 10-lose 0, because 20 > 10.

Venture capital is not an example of this phenomenon. VCs accept high risk/variance in order to achieve high expected value, and it is not a negative sum game.

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