From Theory to Practice

A Pair of Zero Sum Games

| Mar 23, 2016
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    From Theory to Practice

    A Pair of Zero Sum Games

    Mar 23, 2016

    We always hear that options are a “zero sum game”, when it comes to trading. Interestingly, this phrase has taken on two entirely different meanings over the years, one of which is absolutely true, while the other is completely false. Therefore, we examine these two interpretations.

    The textbook definition of a zero sum game, in regards to options trading, refers to the relationship between the long side of a contract and the short side of a contract. Essentially, for a given contract in a given underlying, there will be a winner and a loser. Whatever one side gains the other side will lose, and vice versa. This is the true form of what it means to be a zero sum game, and it is unequivocally true.

    However, there is this second interpretation of the phrase that misses the mark. Often times, people will refer to trading in general as a zero sum game proposition. The spirit of this criticism is that the bulls will fight with the bears, over and over and over again, but in the end, it will all be for naught. The efficiency in the market place and the market randomness will dictate that there will be no clear winner, and the results will all net out to zero.

    The problem with that line of thinking is that it ignores everything we know to be true about option prices, overstated expected moves, and exaggerated volatility. What actually happens is that erroneously high levels of volatility create erroneously high option prices, which leads to premium sellers getting paid more than they “should” on contracts in underlyings that don’t move as much as they “should”. Thus, over time, premium selling continues to defy the odds.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

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