Friday, December 09, 2005

Is investing / trading a zero-sum game? 3 comments



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The CW (conventional wisdom) is that the trading of futures and options is a zero-sum game, while that of equities is not. The reason is that the options-writer or futures-issuer is essentially taking a bullish or bearish position on the stock, which is by definition contrary to the position taken by the buyer of the option/future. On the other hand, the fact that the seller of the equity makes a profit through his sale (ie. sell price higher than initial buy-in price) does not exclude the buyer of this stock from making a profit himself later, so long as he can find another buyer willing to pay a yet higher price for the same stock.

This is not really an accurate classification. Firstly, the primary market is where such a zero-sum game operates. The primary market refers to the direct issuance of securities instruments by banks/companies/options writers ie. new instruments are created. This is opposed to the secondary market which is otherwise known as the trading market, where securities are traded on the open market. Of course, without the primary market (issuance), we cannot have the secondary market (trading), hence the terms. Hence the call options writer and the buyer of his options are operating on the primary market; if the market goes up, the former loses by an amount equal to what the latter gains; that's the zero-sum game in operation. On the other hand, for commodities futures freely traded on the open market ie. the secondary market, there is no difference from the stock market. Of course, a possible reason why derivatives markets are seen as zero-sum is due to the time expiry of the instrument where contracts must be settled: the structured warrants issuer, for example, will be tempted to intervene in the market to push down mother share prices prior to warrant expiry so that he can buy them in at lower prices to deliver to the warrant-holders at warrant expiry (doesn't apply if he already hedged by buying in the mother shares long ago). The time expiry feature is what gives derivatives markets their reputation of being zero-sum, in my view.

Secondly, to take a broader view, even trading can be considered a zero-sum game, if we consider opportunity costs. Essentially, in all trading, the seller and buyer are both taking a position on the stock, even though they might have self-professed reasons like profit-taking, portfolio adjustments or whatever. Take shares: the seller is taking a bearish position while the buyer is taking a bullish position. If the share price rises, the seller actually loses; the loss is the opportunity cost of not having stayed and reaped the financial gains from the post-sales share price rise. Of course, he doesn't actually lose money, and he might even have gained through the allocation of the sales-derived liquidity to other instruments. However, for this particular trade, every cent of price rise post-trade means the buyer gains (in real value), while the seller loses (in opportunity costs). Bringing opportunity costs into the equation is rather controversial since by itself it is a rather murky concept, but it helps to inculcate self-awareness in the investor. I always keep this in mind when I invest my money on the stock market, to remind myself that it's not an airy-fairy world out there where everybody can make money and cheer together as the market rises or groan in unison as it falls; rather, every trade is actually your position against your counterpart's position and every time you win, he loses.

 

 

3 Comments:

Anonymous Quest said...

"it is a rather murky concept"

this would the phrase i would use to describe your latest article. perhaps it is because i already have my own conclusion to the matter, or that i find it easy to refute the points to your argument.

1. the primary market is the zero-sum market and the secondary market is not - why is this so? in my view they are both the same where one holder of risk decides to trade risk for value to a holder of value. it is zero-sum in that the value of cash inflows = cash outflows. this is true for both primary and secondary markets.

2. opportunity cost - the seller of a security still loses money even after selling at a profit. how can this even make sense? it is true that if the value of the security increases after the sale, the seller has wasted a chance to make more money. it is his fault for limiting his risk at his selling price. the buyer of the said security is then rightly rewarded for his risk appetite.

i was terribly disappointed that dividends was not even mentioned in this article. the reason why the stock market is not zero-sum and the derivatives market is, is because of dividends. dividends is the market's way of injecting more funds back into the market, thus rendering the definition of zero-sum(inflows=outflows) indescribable to this market. the cash inflow to this system is more than its outflow due to dividends.

the derivatives market does not inject money back into its system. the players are merely transferring risk and value at each other's expense.

12/10/2005 8:12 AM  
Blogger DanielXX said...

Hi quest, my replies as follows:

1. I have to clarify that my first point about the primary and secondary market was talking more about the derivatives market; for equities, the primary market should not be considered a zero-sum game; when a company issues new shares, how the stock performs after placement is of no issue to them, only to the investor who took the placement --- not a zero-sum game.

2. Indeed I am taking it a step further by introducing opportunity costs. Sure, two successive buyers of a security can make money as long as the stock continues in a favourable price trend, but let's forget about seller's profits and instead concentrate on the situation post-transaction ie. don't think about historical gains, just think about the transaction per se. That's where the opportunity costs and zero-sum game set in.

12/10/2005 4:59 PM  
Anonymous PENNY STOCK INVESTMENTS said...

Oh yes trade your way to riches.

1/14/2014 10:50 AM  

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