Options zero sum game

For my first guest post on SteadyOptions, I poured through many potential topics before coming up with this article. It was exciting, as the community is active and advanced — we could cover anything. Ultimately, instead of a typical educational post, how about we tackle a slightly different topic? Therefore, I get quite animated when I hear criticisms against options trading. Is options trading really a zero-sum game?

A zero-sum game is one where there needs to be a loser for every winner. This interplay between winning and losing creates a net value of zero, a world where your chance to win is all or none.

If you bet on Team A and they win the game, you win. However, if you win, the counterparty who chose Team B loses. If we apply our general understanding of what the meaning of a zero-sum game is, then would traditional stock trading buying and selling fit the description? With stock trading, as in any type of trading, there is a buyer and seller and with each dollar the stock moves one profits while the other takes real losses shorts or opportunity losses sellers.

However, conventional wisdom would say no, stock trading is not zero-sum. When buying or selling stocks, you create value. You create value for yourself in terms of a potential for unlimited gains, additional income in the form of dividend, and capital growth over time.

This type of value also creates a larger benefit for the community in the form of products and services, jobs, a taxable entity, corporate partner for social and charitable causes, etc. Stock trading is far from a zero-sum game. It is, in many respects, a value proposition that provides individual micro and societal macro benefits.

So, zero-sum is winning and losing in absolute states, if you continued to buy into the argument laid out so far. Why must others peg them a zero-sum game of winners matched with losers? Insurance as we know provides assurance and piece of mind against the potential for loss based on pure risks. Pure risks are those that are unforeseen, accidental in nature, and not based on winning or losing.

You buy auto insurance to protect against the financial loss associated with owning and operating an automobile, including financial loss for physical damage caused by you or to you by others, as well as bodily injury that may occur as the result of an accident that caused an injury to you or another person. You pay a premium, which is the exchange of value between you and the insurance company commensurate to the risk of the provided insurance.

Under this scenario there are no winners or losers. In fact, the expectation is that the insurance company remains solvent and profitable in order to protect you against financial loss. Even if you never experience an accident or other insurable loss to your vehicle, the premium you paid is the price for the peace of mind you receive.

That feels like you received something of value protection in exchange for something of value premiums paid. Options operate in the exact same manner.

You pay or receive a premium in exchange for the ability to either lock in a price for stock you own or are looking to purchase, or to protect the value of the stock or your portfolio in the event the market moves contrary to how you believe.

We will further develop this notion of options as an insurance tool by looking at the history of options. The origin of both options and futures begins with speculators taking bets on various harvests more than two thousand years ago in both Greece and Japan. However, the matching of buyers and sellers was a laborious manual process and struggled with manipulation. This, basically illegal activity, of course, does not bode well for the argument that options are more than zero-sum, but bear with me.

The activity of these bucket shops attracted regulatory authorities and, finally, some control over OTC options markets came down from the SEC. The exchange opened with call contracts only.

The put contract came 4 years later. The new exchange, run by those with extensive futures experience, meant options could be used not only as a speculation tool but as a risk transfer tool. With a strong exchange and renewed market confidence in a fungible financial product, finance saw the rise of options as not only a trading vehicle but also as a risk transfer tool.

Yes, the same consideration which is necessary for insurance policies to be legally binding contracts. Options operate in a similar manner. You pay or receive a premium based on a desire to protect value, peg profitability at a certain level, or increase income based on the current or future market sentiment. The concept of a zero-sum game is important because people use it in a wide variety of industries, such as economics, finance and experimental economics.

When people apply zero-sum game to these industries with equations and mathematical formulas, they can predict the outcome of a transaction. Experimental economics considers many factors like losses, gains, individual behavior and optimality to test economic theories and get real world insight. Even though a zero-sum game involves two distinct parties, the result of a zero-sum game could impact millions of people, depending on the sizes of the parties involved.

Related: Understanding Economics: Definition and Application. While the zero-sum game is most often a theory used in economics, there are additional instances where a zero-sum game may apply. Keep in mind that zero-sum game assumes perfect information and perfect competition, where both parties make an informed decision and have all the relevant information. Here are some examples of zero-sum game to help you better understand when and where it happens and how it works:.

Poker games or other forms of gambling are examples of how zero-sum game works. At the beginning of a poker game, the pot determines the initial amount of money for which everyone is playing. As the game progresses, some players win money while other players lose money. The combined sum amounts of wins is equal to the combined sum amount of losses. At the end of the game, the starting sum amount of money is still the same, it has just moved to different players for a different distribution.

Other games, like tennis or chess are also good examples of zero-sum game since there is one clear winner and one loser. One player has a gain and the other has a loss. Related: What Is Behavioral Economics? Definitive Guide To Behavioral Economics. Most trades, or transactions, are not zero-sum games because they don't have a clear winner or loser, but they are similar to examples of the practice. When two participants agree to make a trade, they both understand that the services or products they are receiving may be more or less monetarily valuable than the services or products they are giving in exchange, after any transaction or trade costs.

Poker and gambling are popular examples of zero-sum games since the sum of the amounts won by some players equals the combined losses of the others.

Games like chess and tennis, where there is one winner and one loser, are also zero-sum games. The game of matching pennies is often cited as an example of a zero-sum game, according to game theory. The game involves two players, A and B, simultaneously placing a penny on the table.

The payoff depends on whether the pennies match or not. As can be seen, the combined playoff for A and B in all four cells is zero. Zero-sum games are the opposite of win-win situations—such as a trade agreement that significantly increases trade between two nations—or lose-lose situations, like war, for instance. In real life, however, things are not always so obvious, and gains and losses are often difficult to quantify.

In the stock market, trading is often thought of as a zero-sum game. However, because trades are made on the basis of future expectations, and traders have different preferences for risk, a trade can be mutually beneficial. Investing longer term is a positive-sum situation because capital flows facilitation production, and jobs that then provide production, and jobs that then provide savings, and income that then provides investment to continue the cycle.

Game theory is a complex theoretical study in economics. Game theory is the study of the decision-making process between two or more intelligent and rational parties. Game theory can be used in a wide array of economic fields, including experimental economics , which uses experiments in a controlled setting to test economic theories with more real-world insight. When applied to economics, game theory uses mathematical formulas and equations to predict outcomes in a transaction, taking into account many different factors, including gains, losses, optimality, and individual behaviors.

When applied specifically to economics, there are multiple factors to consider when understanding a zero-sum game. Zero-sum game assumes a version of perfect competition and perfect information; both opponents in the model have all the relevant information to make an informed decision. Taking a step back, most transactions or trades are inherently non-zero-sum games because when two parties agree to trade they do so with the understanding that the goods or services they are receiving are more valuable than the goods or services they are trading for it, after transaction costs.

This is called positive-sum, and most transactions fall under this category. Options and futures trading is the closest practical example to a zero-sum game scenario because the contracts are agreements between two parties, and, if one person loses, then the other party gains.

While this is a very simplified explanation of options and futures, generally, if the price of that commodity or underlying asset rises usually against market expectations within a set time frame, an investor can close the futures contract at a profit. Thus, if an investor makes money from that bet, there will be a corresponding loss, and the net result is a transfer of wealth from one investor to another.

Behavioral Economics. Investing Essentials.