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Comment by amelius | Hacker News Reader

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?

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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.

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.

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