Most people consider options trading to be a zero sum game. When you make a trade, someone takes the other side and when one of you gains, the other loses an equal amount. From that definition it’s difficult to argue that the term ‘zero sum game’ does not apply to options, and to trading in general.
However, I do make that argument.
A Profit in Stocks
When a trader decides to sell a specific holding when it rises to $75 per share, the trader may make a mental stop, or enter a GTC (good ’til canceled) sell order with his/her broker. When the stock is sold, the trader is happy with the result. Sure the stock may move higher, and one can argue that our trader ‘lost’ money by selling and that the ‘buyer’ made money. With this point of view, trading is a zero sum game. I’ll concede that the buyer earned money, but not at the expense of the seller.
I prefer to look at it this way: Our trader earned the profit he hoped to earn, and when that happened, he/she willingly transferred ownership of the shares to another trader. Once the position is out of the account, the trader neither makes nor loses anything. Any change in the stock’s value affects only the new owner. There is no corresponding loss on the part of the trader who sold the shares. One trader made a graceful exit, accepted a profit, and now a different trader has a new investment.
Options are Different
Most of the world looks at options differently. But I don’t.
If I buy a call option and earn a profit by selling at a higher price, there is no reason to believe that the seller took a loss corresponding to my gain. The seller may have hedged the play and earned an even larger profit than I did.
The thought that options represent a zero sum game assumes that all trades are standalone plays and that if you profit, the other person must have lost. Just as our trader above decided that transferring ownership of the shares to another investor would be a good idea at $75/share, so too does the covered call writer.
When I sell a covered call, I am thrilled when the stock rallies far above the strike price. It means I will earn my desired profit. Better than that — if the big rally comes soon, I will be able to exit the trade with perhaps 90% of my cash objective. Why is that so good when the last 10% is sacrificed? Because of time. If there are still many weeks remaining before expiration day arrives, I can reinvest my money into another position and use the same cash to earn even more than that 10% left on the table.
It may be true that the person who bought my call scored a big win (if the trade was not hedged), but that’s not my loss. In fact, it was my additional gain (in the scenario presented).
Options were designed to transfer risk. In the covered call example, the seller accepted cash to help reach the target profit. By doing so, he/she willingly took cash to limit the profit potential of the trade. However, the point is that there was no potential profit to be sacrificed. The call seller would have sold stock at the strike price ($75) and earned less profit than the covered call writer, who collected $75 in addition to the option premium.
The option buyer took on limited risk. If the stock did not rise far enough or fast enough, that buyer would have earned a loss.
I don’t see anything resembling a zero sum game in hedged options transactions. I understand that others see it as black and white: If one gained, the other lost. But that’s an oversimplification.
Follow Mark Wolfinger on his ‘Options for Rookies’ blog: http://blog.mdwoptions.com