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Options and many other derivatives are not merely a casino game. Their unique role as financial instruments is to allow the transfer of risk from those who have

Options and many other derivatives are not merely a casino game. Their unique role as financial instruments is to allow the transfer of risk from those who have risk and don't want it (hedgers) to those who don't have any risk and do want it (speculators). This is different from gambling because gambling by definition involves the creation of entirely new risk for the purpose of wagering; derivatives transfer pre-existing risk that will continue to exist anyway even if the derivative didn't exist. This is identical to the more familiar role of an insurance company in everyday life. For example, suppose someone has a long term stock portfolio -- a classic fundamentals investor with a decades-long time horizon, the farthest thing from a casino style gambler you can find in the stock market. Maybe it's a pension fund or an institutional endowment. They very much do not want to take highly risky short term bets. They are only interested in safe, slow, long term returns. But markets can only provide that in aggregate. In the short term, markets are very unstable, and individual stocks go to 0 if the company folds. The long-term investor thus constructs a portfolio of many small investments rather than a few big ones. The portfolio manager has reason to believe that XYZ, one of the portfolio companies, is about to go bankrupt. This is not certain, but the stock has already begun to drop. If the stock drops to 0, the portfolio stands to lose a lot of money (despite continuing to exist overall because of diversification.) The portfolio manager can buy put options to hedge XYZ. These give the holder the right to sell XYZ stock at a certain price, regardless of its current market price. In this case, they function as a form of insurance. If the rumors are false, XYZ stock will bounce back up and the put expires worthless. If the rumors are true, XYZ drops to 0, but the portfolio manager can still sell his XYZ stock to the speculator who sold him the put option at a pre-determined price. This is no different from buying fire or flood insurance on your house -- if the value of your house goes to 0 through disaster, you can in essence sell that worthless house to the insurance company for a predetermined price and buy another house. Options are the stock market version of that. If you tax them more heavily, that will make them more expensive to use, which will discourage people from using them and arguably increase instability while decreasing growth in the stock market as everyone will be forced to carry the full value of any losses themselves, with less possibility for insurance.

amelius 12y ago
That's a great explanation, thanks! However, I still don't see the necessity of these instruments. For example, wouldn't it be more natural for a pension fund to just spread the risks by buying different stocks? Also, I'm not convinced that derivatives would decrease instability. Like I said, I would guess they do the opposite. Perhaps there is some theory that can show this (something akin to e.g. the fact that passive systems are always stable, for some definition of "passive"). Or perhaps there exist empirical simulation-models that can shed a light on this?
- vasilipupkin 12y ago
  Imagine you have a very diversified portfolio of stocks. You are concerned with a very real possibility of a big market drop. Sure, you could start selling off stocks from your portfolio, incurring various transaction fees, capital gains taxes, plus you know have to reoptimize your portfolio on the fly because since you sold off some stocks, it's now probably out of balance. Or, you could just buy puts on S&P 500 and you don't have to deal with any of those issues. It's much more convenient and efficient to do that. It's really the same thing as going to a supermarket and seeing a wide variety of products instead of just bread, meat and apples. Is it a must have? no. Is it useful, though? yes
- forthefuture 12y ago
  I think the real answer is that things don't need to be necessary to exist. Options are just another way to structure investment. They exist because someone decided to create them, and they continue to exist because humans don't like losing things they already have.
  - pjlegato 12y ago
    Well, for that matter, stocks don't need to exist, either. We could go back to the medieval way of requiring all business enterprises to be fully funded by the founders personally. The problem is that greatly restricts the scope of what kinds of businesses can exist, since most interesting things for a business to do require a lot more capital than most people have or can raise. There are many examples of failed derivatives instruments -- that is, derivatives instruments that once existed and no longer exist today because of lack of interest in using them. They performed an insufficiently useful economic role, so nobody traded them. Today, for example, there is an ongoing effort to list real estate futures, but there is little marketplace interest and they will probably be delisted within the next few years. The derivatives that survived survive not from mere inertia, but because people (not some abstract "system," but real people) find them economically beneficial in some way.

amelius 12y ago

That's a great explanation, thanks! However, I still don't see the necessity of these instruments. For example, wouldn't it be more natural for a pension fund to just spread the risks by buying different stocks? Also, I'm not convinced that derivatives would decrease instability. Like I said, I would guess they do the opposite. Perhaps there is some theory that can show this (something akin to e.g. the fact that passive systems are always stable, for some definition of "passive"). Or perhaps there exist empirical simulation-models that can shed a light on this?

vasilipupkin 12y ago
Imagine you have a very diversified portfolio of stocks. You are concerned with a very real possibility of a big market drop. Sure, you could start selling off stocks from your portfolio, incurring various transaction fees, capital gains taxes, plus you know have to reoptimize your portfolio on the fly because since you sold off some stocks, it's now probably out of balance. Or, you could just buy puts on S&P 500 and you don't have to deal with any of those issues. It's much more convenient and efficient to do that. It's really the same thing as going to a supermarket and seeing a wide variety of products instead of just bread, meat and apples. Is it a must have? no. Is it useful, though? yes
forthefuture 12y ago
I think the real answer is that things don't need to be necessary to exist. Options are just another way to structure investment. They exist because someone decided to create them, and they continue to exist because humans don't like losing things they already have.
- pjlegato 12y ago
  Well, for that matter, stocks don't need to exist, either. We could go back to the medieval way of requiring all business enterprises to be fully funded by the founders personally. The problem is that greatly restricts the scope of what kinds of businesses can exist, since most interesting things for a business to do require a lot more capital than most people have or can raise. There are many examples of failed derivatives instruments -- that is, derivatives instruments that once existed and no longer exist today because of lack of interest in using them. They performed an insufficiently useful economic role, so nobody traded them. Today, for example, there is an ongoing effort to list real estate futures, but there is little marketplace interest and they will probably be delisted within the next few years. The derivatives that survived survive not from mere inertia, but because people (not some abstract "system," but real people) find them economically beneficial in some way.