Not What You Have Been Taught: Why Capital Market is Not a “Zero Sum Game”

People often refer to capital markets as a “Zero-Sum Game”, meaning that one’s profit comes at the expense of another one’s loss. This has been the case for many years, and still is in some cases. However, with the rapid development of the derivatives market, this statement starts to show cracks.

Outside of the financial derivatives world, things are very simple: If Trader A bought shares from Trader B and the share price rose, then Trader A made profit equivalent to (market price – purchase price) x number of shares. This profit will be Trader B’s exact loss, even though he/she didn’t actually lose it, but rather had an alternative loss. Meaning that he/she could have profited more if he/she held it longer.

Now, this is where things get interesting…. Let’s assume that Trader A holds the shares, and sells a CALL option (usually known as a “Covered Call”) to Trader B with a strike price equivalent to the market price (At-The-Money strike). Trader A then receives premium for selling the option and Trader B owns the right to buy the shares at the strike price. If the share price rose, then Trader B will gain profit because he/she now owns the right to pay a low price for the share (and can sell it higher in the market). Trader A, on the other hand, locked the profit earlier by selling the option for the amount of share that he/she had (and was paid premium on top of that). As we can see in this example, both traders have actually made profit, which contradicts the assumption that capital market is a “Zero Sum Game”. This phenomena is called “Risk Transfer”, and is used by participants (investors and traders) to pick and choose the risk they want to be exposed to.

Generally speaking, the entire derivatives segment of financial markets was originally designed for the purpose of “Risk Transfer”. Derivatives have existed since 8000 B.C, obviously not in the form that we all know today, but the idea was the same. Farmers wanted to “lock” the price of their harvest before they harvested their crops, so that they will know the exact revenue they are due to receive, and they could plan their financials accordingly.

Nowadays, there are three types of market participants in the derivatives markets, each one has a different characteristics:

1. Hedgers – the original users of derivatives. Corporations and firms that wish to offset different exposures (currency exposures/commodity prices/interest rate exposure). Derivatives help the hedgers “smooth” their balance sheets, and help them avoid risks to their cash flows.

2. Banks (Market Makers) – The market-makers provide liquidity to the market, and enjoy the “spread” (bid/ask spread). They will occasionally use their flows to offset risk in their trading books.

3. Speculators – The speculators (day-traders, hedge funds, and investment firms) use the derivatives market to gain the highest leverage possible (as derivatives are leveraged instruments).

The different roles of the market participants cause the derivatives to bear opportunities for everyone. A trader can tailor a strategy to express a certain view and would yield profit, while at the same time another participant can take the exact opposite side of the trade and be profitable as well. It all depends on the nuances, and the specific risk that the investor is trying to exploit. Some investors will use options to express a view on the direction of the market (so they will buy options instead of trading the underlying asset). While other investors may look to express a view on the level of fear (volatility) in the market (either they think it is too low, so options will be cheap to buy, or they think it is too high, so options will be appealing to sell).

The derivatives world is an amazing opportunity for investors to express their views in a way that will both provide sufficient leverage (meaning that the investor doesn’t have to invest a significant amount to enjoy high profits), and could be tailored specifically for them and their views. Obviously, to fully understand the nuts-and-bolts of the market, one needs to devote time to study and practice. But once the basics are there, it is only a matter of time until it yields good returns.

A good starting point for those who wish to get familiar with derivatives is the book “Option, Futures, and Other Derivatives”, by John C. Hull, which is still considered the “bible” of the derivatives theory (and practice). This is going to provide the foundations for anyone who wants to understand the mechanism and the practical applications.

 

Good Luck.

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