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So, can someone explain rationally how options/derivatives are actually useful to the economy, rather than a market manipulation and gambling mechanism? In the

So, can someone explain rationally how options/derivatives are actually useful to the economy, rather than a market manipulation and gambling mechanism? In the traditional, elementary school understanding of stock, people buy into a company because they want part ownership, and the stock goes up as the company does well and has solid financial strength. Derivatives seem to be an unnecessary accelerator.

shmoogy 6y ago
If you use them like WSB they are an unnecessary accelerator, they're intended for being used as a hedge (and probably other things more savvy investors know more about).
jacksnipe 6y ago
I'm generally sympathetic to the idea that financial derivatives are a great evil, and a huge part of what feels "broken" about the current system. However, consider futures, which are very similar to options. Futures were, as I understand it, popularized in Chicago as a way for farmers to be able to get money for their crop right now, at a fixed price. In this way, they could pass the risk -- and a little bit of the profit -- off to people with more capital, who were better able to weather all possible outcomes.
- croon 6y ago
  And in practice, how would that be different from incorporating and selling stocks to those investors, thus raising money now, and then growing in value as the crops are reaped?
  - deleted 6y ago
    [deleted]
- xmprt 6y ago
  Even futures markets aren't protected from this manipulation. The Onion Futures Act has an interesting story.
- smabie 6y ago
  I wouldn't call futures as very similar to options. The mathematical profiles of the two are very different, though a far ITM option is basically a future
p_l 6y ago
The most traditional version of the stock market is that a company issued shares in order to gain cash for investment, with shareholders essentially fronting the risk for a portion of the pie. If it things went well, there would be dividends, then you addition of trading shares to someone other than the originating company. Can't say much on derivatives and others, at least futures made sense as way of fronting money for agriculture :/
jdjfktkrnj 6y ago
A nice mind-blowing true exemple I've read is you buy gas futures (cheap), you sell electricity futures (expensive) and you use the profit to build a power plant which turns gas into electricity.
cbozeman 6y ago
They're not useful. They're a means of wealth extraction disguised under whatever load of bullshit someone wants you to believe. I'll even prove it to you. Ask someone with skin in the Wall Street game to explain this stuff to you, not mathematically, but in layperson's terms, so simple that a young child could understand it. They either won't be able to do it, or they won't do it. You'll get one of two answers, "It's really complex." or "It can't be simplified." When you hear this kind of shit, you're can safely deduce one of two things: 1. The person in question doesn't have a deep understanding of the phenomenon or principle they're trying to explain. 2. The person in question isn't interested in explaining it because it directly affects them. Ask a Ph.D.-holding, teaching nuclear physicist to explain how a star works. They'll be able to break it down for a 5 year old, a 15 year old, and a 24 year old graduate student, at various levels of complexity. Ask a Ph.D-holding investment banker or hedge fund manager how all this works. They don't want you to know, because it isn't creating value. Not the kind of value an Amazon or a Tesla creates. It creates value for them and for the large investors they represent. Not for you the layperson.
- dataminer 6y ago
  Aren't options like insurance? insurance can be explained rather easily. People buy insurance in their home, to protect their investment in an unlikely event that it gets destroyed. Similarly people can buy insurance to protect their investments in financial instruments.
- corey_moncure 6y ago
  Tell your 5 year old you're going to give him 10 cookies, but he has a choice. Either he can have the 10 cookies right now, or he can pick up his room, and then he has the option of getting 10 cookies from you any time of the day or night during the next month, whenever he wants, no questions asked, no matter how busy daddy is. Or he can sell the option to any one of his friends or family, to guarantee they get 10 cookies in exchange for those pokemon cards he's had his eye on. That's an options contract.
  - cbozeman 6y ago
    LOL, now take your analogy all the way. "If you don't clean your room in one week, Daddy is going to take away all your cookies, plus you'll owe Daddy 10 cookies."
alfl 6y ago
Let's say you want to invest your corporate treasury in equities (you've raised several years of burn and don't need it all now). If you lose the treasury you're out of business. You decide you can accept X% risk. You estimate portfolio risk is Y%. You can enter options positions for the portfolio components to force Y to X.
mLuby 6y ago
Derivatives provide useful abstractions over primitive financial data types. Instead of saying "give me the {id: int, name: string, birthday: date}" we can just say "give me the User" and that's helpful. But as in software, it's possible to build towers of abstraction high enough so as to lose sight of the fundamental data upon which they rest, and then differences between the abstraction and implementation open the door for bugs (i.e. financial crises). Options are similar to a down payment, or trip cancellation insurance. It gives you the ability to buy something (or not buy it) in the future, but for that privilege you must pay something right now. Options provide leverage (using more money than you presently have), like a credit card or mortgage. Just as most people can't bring piles of cash to buy a car or house outright, options give you the ability to buy the thing but also the chance to walk away. Key caveat: there situations where options that have unlimited risk; these can easily be avoided, but that's where options get their bad reputation. You're right that both can serve to accelerate growth, and that's a good thing for individuals, companies, and nations. But if things go wrong, crashes at high speeds are much more dangerous than those at low speeds.
ineptech 6y ago
If you put $X in to AAPL, you can hedge against catastrophe by putting $X/10 in to an option to sell AAPL, which will limit your losses if the stock drops to 0 tomorrow. So in theory, they can be used sensibly. But in practice I think it's not the existence of the derivatives market, it's the size. Our economy is like a town with 1 farmer and 9 investors who spend all day wagering with each other on whether the farmer will have a good crop.
- saddlerustle 6y ago
  > Our economy is like a town with 1 farmer and 9 investors who spend all day wagering with each other on whether the farmer will have a good crop. Objectively, that's not true. The finance industry is under 10% of GDP and under 5% of jobs.
  - unFou 6y ago
    Interestingly enough, a quick google search shows US farms contribute 136 billion, or about 0.6% of GDP. So, more like 1 farmer to 19 investors?
  - ineptech 6y ago
    Measured how? I would argue that some of the finance industry contributes to GDP (e.g. derivatives that facilitate some kind of real capital investment that wouldn't have happened without them), but John Q. Billionaire shorting a stock because he thinks it will go down does not.
Youden 6y ago
So many ways: - If you own a stock and want to reduce the downside risk, you can buy a put option to ensure you'll always be able to sell your stock for a reasonable price, even if there's a financial crash. - If you have the ability to produce some product (e.g. grain) but need some extra money (e.g. to buy seed or fix a tractor) or just want to lock in a sale price for your product, you can sell a futures contract. - If you want need some product at some point in the future (e.g. fuel for your jets) and want to lock in the price, you can buy a futures contract. Fundamentally, derivatives allow you to trade risk. You can pay somebody to absorb some risk for you or you can accept some risk in exchange for money.
mdnahas 6y ago
Options are valuable because they are how Wall St. deals with probabilities. We don't actually know what a company is worth. You can imagine estimating the worth (a.k.a., "net present value") of a company based on its future dividends (or stock buybacks). But any formula will contain a lot of probabilities of when each dividend will occur, the amount, and the discount factor (that is, how much future money is worth today). So what you get is actually a distribution of how much a company is worth. The stock market doesn't deal with distributions directly. It uses options. A call option is the ability to buy a stock at a given price called the "strike price". So, from the prices for two call options, you can infer the probability that the stock's worth is between their strike prices.
- smabie 6y ago
  This isn't really true. An options value is derived from a variety of inputs that have nothing to do with the price of the stock, namely, forecasted volatility and interest rates. No real option market maker is using anything except the current price of the stock to price their options. This isn't strictly true, but what I'm saying is that people don't determine the fair value of a stock through looking at option prices. If you want to learn more, check out black Scholes pricing model and option Greeks.

shmoogy 6y ago

If you use them like WSB they are an unnecessary accelerator, they're intended for being used as a hedge (and probably other things more savvy investors know more about).

jacksnipe 6y ago

I'm generally sympathetic to the idea that financial derivatives are a great evil, and a huge part of what feels "broken" about the current system. However, consider futures, which are very similar to options. Futures were, as I understand it, popularized in Chicago as a way for farmers to be able to get money for their crop right now, at a fixed price. In this way, they could pass the risk -- and a little bit of the profit -- off to people with more capital, who were better able to weather all possible outcomes.

croon 6y ago
And in practice, how would that be different from incorporating and selling stocks to those investors, thus raising money now, and then growing in value as the crops are reaped?
- deleted 6y ago
  [deleted]
xmprt 6y ago
Even futures markets aren't protected from this manipulation. The Onion Futures Act has an interesting story.
smabie 6y ago
I wouldn't call futures as very similar to options. The mathematical profiles of the two are very different, though a far ITM option is basically a future

p_l 6y ago

The most traditional version of the stock market is that a company issued shares in order to gain cash for investment, with shareholders essentially fronting the risk for a portion of the pie. If it things went well, there would be dividends, then you addition of trading shares to someone other than the originating company. Can't say much on derivatives and others, at least futures made sense as way of fronting money for agriculture :/

jdjfktkrnj 6y ago

A nice mind-blowing true exemple I've read is you buy gas futures (cheap), you sell electricity futures (expensive) and you use the profit to build a power plant which turns gas into electricity.

cbozeman 6y ago

They're not useful. They're a means of wealth extraction disguised under whatever load of bullshit someone wants you to believe. I'll even prove it to you. Ask someone with skin in the Wall Street game to explain this stuff to you, not mathematically, but in layperson's terms, so simple that a young child could understand it. They either won't be able to do it, or they won't do it. You'll get one of two answers, "It's really complex." or "It can't be simplified." When you hear this kind of shit, you're can safely deduce one of two things: 1. The person in question doesn't have a deep understanding of the phenomenon or principle they're trying to explain. 2. The person in question isn't interested in explaining it because it directly affects them. Ask a Ph.D.-holding, teaching nuclear physicist to explain how a star works. They'll be able to break it down for a 5 year old, a 15 year old, and a 24 year old graduate student, at various levels of complexity. Ask a Ph.D-holding investment banker or hedge fund manager how all this works. They don't want you to know, because it isn't creating value. Not the kind of value an Amazon or a Tesla creates. It creates value for them and for the large investors they represent. Not for you the layperson.

dataminer 6y ago
Aren't options like insurance? insurance can be explained rather easily. People buy insurance in their home, to protect their investment in an unlikely event that it gets destroyed. Similarly people can buy insurance to protect their investments in financial instruments.
corey_moncure 6y ago
Tell your 5 year old you're going to give him 10 cookies, but he has a choice. Either he can have the 10 cookies right now, or he can pick up his room, and then he has the option of getting 10 cookies from you any time of the day or night during the next month, whenever he wants, no questions asked, no matter how busy daddy is. Or he can sell the option to any one of his friends or family, to guarantee they get 10 cookies in exchange for those pokemon cards he's had his eye on. That's an options contract.
- cbozeman 6y ago
  LOL, now take your analogy all the way. "If you don't clean your room in one week, Daddy is going to take away all your cookies, plus you'll owe Daddy 10 cookies."

alfl 6y ago

Let's say you want to invest your corporate treasury in equities (you've raised several years of burn and don't need it all now). If you lose the treasury you're out of business. You decide you can accept X% risk. You estimate portfolio risk is Y%. You can enter options positions for the portfolio components to force Y to X.

mLuby 6y ago

Derivatives provide useful abstractions over primitive financial data types. Instead of saying "give me the {id: int, name: string, birthday: date}" we can just say "give me the User" and that's helpful. But as in software, it's possible to build towers of abstraction high enough so as to lose sight of the fundamental data upon which they rest, and then differences between the abstraction and implementation open the door for bugs (i.e. financial crises). Options are similar to a down payment, or trip cancellation insurance. It gives you the ability to buy something (or not buy it) in the future, but for that privilege you must pay something right now. Options provide leverage (using more money than you presently have), like a credit card or mortgage. Just as most people can't bring piles of cash to buy a car or house outright, options give you the ability to buy the thing but also the chance to walk away. Key caveat: there situations where options that have unlimited risk; these can easily be avoided, but that's where options get their bad reputation. You're right that both can serve to accelerate growth, and that's a good thing for individuals, companies, and nations. But if things go wrong, crashes at high speeds are much more dangerous than those at low speeds.

ineptech 6y ago

If you put $X in to AAPL, you can hedge against catastrophe by putting $X/10 in to an option to sell AAPL, which will limit your losses if the stock drops to 0 tomorrow. So in theory, they can be used sensibly. But in practice I think it's not the existence of the derivatives market, it's the size. Our economy is like a town with 1 farmer and 9 investors who spend all day wagering with each other on whether the farmer will have a good crop.

saddlerustle 6y ago
> Our economy is like a town with 1 farmer and 9 investors who spend all day wagering with each other on whether the farmer will have a good crop. Objectively, that's not true. The finance industry is under 10% of GDP and under 5% of jobs.
- unFou 6y ago
  Interestingly enough, a quick google search shows US farms contribute 136 billion, or about 0.6% of GDP. So, more like 1 farmer to 19 investors?
- ineptech 6y ago
  Measured how? I would argue that some of the finance industry contributes to GDP (e.g. derivatives that facilitate some kind of real capital investment that wouldn't have happened without them), but John Q. Billionaire shorting a stock because he thinks it will go down does not.

Youden 6y ago

So many ways: - If you own a stock and want to reduce the downside risk, you can buy a put option to ensure you'll always be able to sell your stock for a reasonable price, even if there's a financial crash. - If you have the ability to produce some product (e.g. grain) but need some extra money (e.g. to buy seed or fix a tractor) or just want to lock in a sale price for your product, you can sell a futures contract. - If you want need some product at some point in the future (e.g. fuel for your jets) and want to lock in the price, you can buy a futures contract. Fundamentally, derivatives allow you to trade risk. You can pay somebody to absorb some risk for you or you can accept some risk in exchange for money.

mdnahas 6y ago

Options are valuable because they are how Wall St. deals with probabilities. We don't actually know what a company is worth. You can imagine estimating the worth (a.k.a., "net present value") of a company based on its future dividends (or stock buybacks). But any formula will contain a lot of probabilities of when each dividend will occur, the amount, and the discount factor (that is, how much future money is worth today). So what you get is actually a distribution of how much a company is worth. The stock market doesn't deal with distributions directly. It uses options. A call option is the ability to buy a stock at a given price called the "strike price". So, from the prices for two call options, you can infer the probability that the stock's worth is between their strike prices.

smabie 6y ago
This isn't really true. An options value is derived from a variety of inputs that have nothing to do with the price of the stock, namely, forecasted volatility and interest rates. No real option market maker is using anything except the current price of the stock to price their options. This isn't strictly true, but what I'm saying is that people don't determine the fair value of a stock through looking at option prices. If you want to learn more, check out black Scholes pricing model and option Greeks.