Comment by runeks | Hacker News Reader

Comment by runeks | Hacker News Reader

'It also feels pretty far from the theoretical purpose of options trading. Options are meant to provide insurance (a “hedge”) against potential losses in a stock position. Market makers like my friend create the environment in which to buy the insurance. This bot instead treats that market like a roulette wheel—except it knows exactly where the ball will land. “If someone else has what we call the ‘future script,’ ” says my friend, referring to the crystal ball of the algorithm bot, “it really feels like they’re just robbing you."'

Robbing who? This is about as far from robbing as I can think of.

1. Someone offers to sell a bunch of options, because he thinks he'll make more money from this than if he didn't sell those options.

2. Someone buys these options because he think he'll make more money than if the didn't buy them.

3. Time reveals the guy who bought the options was right, and he makes money.

This is simple speculation, and has nothing to do with robbing.

It's only "robbing" when you're losing money instead of making money - which a lot of these crazy made up systems (options, etc) can't help but do most of the time. They're just complaining about evolution :)

Anybody that thinks the primary purpose of the options market is "insurance" is ignoring their history. Among other things, calls were introduced 4 years before puts. They are derivatives. They serve many purposes.

What purposes exactly?

If you'd ask me those derivative products are a convenient alternative to casino style gambling and mostly add instability to the market.

I would love to hear an informed opinion, though. What do these products solve, why are they essential? Also, what would happen if we would tax them more heavily, perhaps incrementally over a period of time?

Options and many other derivatives are not merely a casino game. Their unique role as financial instruments is to allow the transfer of risk from those who have risk and don't want it (hedgers) to those who don't have any risk and do want it (speculators). This is different from gambling because gambling by definition involves the creation of entirely new risk for the purpose of wagering; derivatives transfer pre-existing risk that will continue to exist anyway even if the derivative didn't exist. This is identical to the more familiar role of an insurance company in everyday life.

For example, suppose someone has a long term stock portfolio -- a classic fundamentals investor with a decades-long time horizon, the farthest thing from a casino style gambler you can find in the stock market. Maybe it's a pension fund or an institutional endowment. They very much do not want to take highly risky short term bets. They are only interested in safe, slow, long term returns.

But markets can only provide that in aggregate. In the short term, markets are very unstable, and individual stocks go to 0 if the company folds. The long-term investor thus constructs a portfolio of many small investments rather than a few big ones.

The portfolio manager has reason to believe that XYZ, one of the portfolio companies, is about to go bankrupt. This is not certain, but the stock has already begun to drop. If the stock drops to 0, the portfolio stands to lose a lot of money (despite continuing to exist overall because of diversification.)

The portfolio manager can buy put options to hedge XYZ. These give the holder the right to sell XYZ stock at a certain price, regardless of its current market price.

In this case, they function as a form of insurance. If the rumors are false, XYZ stock will bounce back up and the put expires worthless. If the rumors are true, XYZ drops to 0, but the portfolio manager can still sell his XYZ stock to the speculator who sold him the put option at a pre-determined price.

This is no different from buying fire or flood insurance on your house -- if the value of your house goes to 0 through disaster, you can in essence sell that worthless house to the insurance company for a predetermined price and buy another house. Options are the stock market version of that.

If you tax them more heavily, that will make them more expensive to use, which will discourage people from using them and arguably increase instability while decreasing growth in the stock market as everyone will be forced to carry the full value of any losses themselves, with less possibility for insurance.

That's a great explanation, thanks!

However, I still don't see the necessity of these instruments.

For example, wouldn't it be more natural for a pension fund to just spread the risks by buying different stocks?

Also, I'm not convinced that derivatives would decrease instability. Like I said, I would guess they do the opposite.

Perhaps there is some theory that can show this (something akin to e.g. the fact that passive systems are always stable, for some definition of "passive"). Or perhaps there exist empirical simulation-models that can shed a light on this?

Imagine you have a very diversified portfolio of stocks. You are concerned with a very real possibility of a big market drop. Sure, you could start selling off stocks from your portfolio, incurring various transaction fees, capital gains taxes, plus you know have to reoptimize your portfolio on the fly because since you sold off some stocks, it's now probably out of balance. Or, you could just buy puts on S&P 500 and you don't have to deal with any of those issues. It's much more convenient and efficient to do that. It's really the same thing as going to a supermarket and seeing a wide variety of products instead of just bread, meat and apples. Is it a must have? no. Is it useful, though? yes

I think the real answer is that things don't need to be necessary to exist. Options are just another way to structure investment. They exist because someone decided to create them, and they continue to exist because humans don't like losing things they already have.

Well, for that matter, stocks don't need to exist, either. We could go back to the medieval way of requiring all business enterprises to be fully funded by the founders personally. The problem is that greatly restricts the scope of what kinds of businesses can exist, since most interesting things for a business to do require a lot more capital than most people have or can raise.

There are many examples of failed derivatives instruments -- that is, derivatives instruments that once existed and no longer exist today because of lack of interest in using them. They performed an insufficiently useful economic role, so nobody traded them. Today, for example, there is an ongoing effort to list real estate futures, but there is little marketplace interest and they will probably be delisted within the next few years.

The derivatives that survived survive not from mere inertia, but because people (not some abstract "system," but real people) find them economically beneficial in some way.

Options are sometimes more liquid than the underlying stocks, allowing you to hedge when you wouldn't be able to directly. Consider a case where you want to short a particular stock. Shorting a stock requires borrowing it first, but some stocks may simply not have many people willing to lend. Often you can still get puts on hard-to-borrow instruments to hedge your position. There will be a premium for that insurance, but it may be worth it depending on your position.

Options also allow you to bet on more specific stock movements. Maybe there's a merger rumor and you think the stock will either go up (merger goes through) or down (merger fails). You couldn't make that bet with a static position on the underlying, but you could buy a put and a call (straddle).

> However, I still don't see the necessity of these instruments. > For example, wouldn't it be more natural for a pension fund to just spread the risks by buying different stocks?

That's like saying, "Wouldn't it be more natural for a homeowner to just spread the risk of fire by buying multiple houses?"

Yes, in theory you could buy 2 houses and just move into the 2nd house if the first one burns down... but it's much more cost efficient to buy one house and get insurance on it. You'd have to buy 2 inferior houses instead of putting all of your money into 1 nicer house and paying a small amount for insurance.

There are lots of theories and studies on the topic of stability, though it is very hard to draw firm conclusions as the economic and financial conditions at any given moment are unique, making repeatable experiments difficult or impossible.

Another complicating factor is that you can make lots of money by discovering a way to make market systems more stable that nobody else knows about, so much of the research on the topic is secret.

One purpose: leverage

I can see why it could be viewed as robbing. The person selling options assumes there is no information asymmetry. The bots that do this aren't betting, they have new information that shows that the current options price doesn't reflect yet.

I wouldn't say this is necessarily a bad thing myself just pointing out this is definitely not the spirit of what options are for.

But the information is public -- anyone can read the tweet as soon as it comes out, a computer just happens to do it a lot faster and better than a human.

Exactly and since bots are allowed to buy options, the seller shouldn't assume that only humans would be buying their options.

That's why I'm not saying it's "wrong" but it also is no longer making a bet on randomness.

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