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.
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?
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.
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?
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 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).
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.