18 August 2009

Stocks Good, Options Bad

How many times have you heard someone pontificate on the subject of "stocks are good, options (or futures) are bad with the contention that:

  1. Options (futures) are a zero sum game, for you to win, someone has to lose. They do not create any net wealth.
  2. Stocks are a positive sum game. When you buy shares you are assisting the company to raise capital to build infrastructure, employ people and create value and wealth.

Anyone who's been around markets longer than 3 days will have heard this, or some variation of it It's a very persuasive argument used by many civic minded folk to avoid derivatives as they must be the spawn of Satan, stocks are virtuous. There is only one problem with this argument.

It's bullshit!

If one buys stock on the open market, not one dram, not one iota, not a jot of that capital goes to the company in question at all. While it's true that stock and bond markets are mechanisms for companies to raise capital, the vast majority of investors probably never contribute to this process at all. Or if so, it is a pittance.

Why? Companies only raise money through the issuance of NEW shares or bonds. Unless participating in an IPO or bond offering, the company will never see a cent of your money.

These are a miniscule proportion of transactions, with the overwhelming majority of transaction being the exchange of existing shares between specialists, marketmakers, institutions, traders and investors. The actual company whose shares we are trading is outside this loop, apart from you actually removing capital from the company if they pay you a dividend.

That means that for the most part, share trading is also a zero sum game (actually negative sum because of tranaction costs), capital profits come as opportunity cost for the seller.

The wealth creation bit is performed by the company itself, not the owner of shares purchased second hand on an exchange.

Ergo, the trading of options (or futures) or shares are equal in virtue, none have any moral advantage over the other.

1 comment:

Grinder said...

well said. It's an argument I've had many times over.