When it's not the purchase-a-thing model it's otherwise-disinterested third parties making large bets on possible future outcomes. It has more in common with a bookie's ledger than a warehouse of goods.
Why this is often harmful and dangerous is that the financial viability of businesses and individuals are often backing these bets. A person or company expecting financing to be predictable and stable may suddenly find it not so because their lender is desperate to cover their gambling losses.
I still don't understand why these kinds of derivatives are not banned. They're, as you described, basically betting.
Except for a handful of folks, everybody loses money on them. The ones that do make money are rigging the game (à la casinos) or are just lucky. Some of the lucky ones have been lucky for decades, some even went bankrupt after being lucky for so long.
> I still don't understand why these kinds of derivatives are not banned. They're, as you described, basically betting.
Imagine I run a chain of hotels in beach resorts. When tourism is up, I make a ton of money; when tourism is down, I lose a ton of money. I'd like to flatten this so I can make a steadier, safer stream of money, budget more sensibly, and not be at risk of going under if 2-3 bad years come in a row.
What can I do? Well, maybe I look around and notice that a big spike in jet fuel prices drives ticket prices up, and when ticket prices go up people stay home and I lose money, whereas cheap jet fuel means high occupancy rates. So I might hedge by buying put options (and/or selling call options) on jet fuel. When fuel prices go up, I can offset my low revenues with cash from selling my now-valuable put options (or the cash I received earlier from selling now worthless call options). And when fuel prices go down, I can use some portion of my higher revenues to pay for the cost of the worthless puts I purchased (or to settle the now valuable calls I sold).
This sort of thing is common and healthy, not just among end users, but even more so among intermediaries working to remove and reduce the amount of risk inherent in the system.
Why are they not banned? Why would they be banned?
> Except for a handful of folks, everybody loses money on them.
That's not really how this works. Or indeed, could work.
This just seems like a complicated way to go about budgeting correctly. Save money when you have excess from increased revenues, and use that to cover yourself when revenues decrease. I don't understand what is gained by bringing puts into the equation, if they are just as cyclical as your revenues. And it seems to me that you'd need a decent understanding of what your budget should be in order to decide how much to spend on puts in the first place. What am I missing?
Saving money requires keeping cash (sometimes a lot of it) in the bank that could otherwise be put to productive use. Options contracts allow offloading of risk without keeping this excess cash sitting there doing nothing.
Call me crazy but I thought the idea is that banks would use deposits to fund loans and kick some of the profit back to the account holder in the form of reasonable interest rates.
That seems capital efficient to me, but it's apparently a quaint relic of the past now that eternal 0% interest rates are the norm.
I'm reminded of the scene from It's a Wonderful Life where George Bailey explains to all his account holders why they can't all withdraw their money at once, because it's being put to productive use by their fellow townspeople: https://youtu.be/iPkJH6BT7dM?t=49
Banks don't use deposits to make loans though, that's a widespread misconception which is perpetuated by concepts such as 'fractional reserve banking'. In the modern economy bank lending is simply adding a number to someone's account and adding an equal number to the bank's loan sheet.
The banks still do this; they leverage deposits to back the loans they provide.
However, they have little to no impetus to provide a reasonable interest rate on savings accounts; they'd much rather pay the absolute possible minimum the market (and regulation) will allow, and pocket the rest as profit.
Maybe I'm misunderstanding you, but don't options contracts introduce risk? I've never run a business -- what risk are you incurring by having the cash sitting in a bank? If the play is instead to take a (perhaps small) risk in order to increase your amount of money or keep up with inflation, I understand that. But then I still don't see why options are necessary. There's lots of ways to do that.
The original post described options as a way to make your stream of money both "safer" and "steadier". I'm struggling to understand how introducing options can be safer and steadier than keeping money in a bank and creating an intelligent budget.
But you're not offloading risk -- you're increasing risk. What if jet fuel rises for some reason other than increased usage? What if usage is increased, but, people simply aren't visiting your region?
Simply doing something with the money is not necessarily better than doing nothing with it. None of the above is productive use -- it's simply betting. Jet fuel producers don't care about your commodity-indexed fund call option.
Who says we shouldn't? In Romania, where I'm from, there is sports betting everywhere and a lot of people are addicted to it.
I think sports betting in general is on the rise, at least in Europe, and I can't imagine it having positive financial or psychological effects for the average person.
The argument in favor of allowing shorts is that they provide a strong monetary incentive for private investors to investigate and expose financially fraudulent companies.
I don't have a good general answer; it's complex. But some specific things relevant to this story:
Market makers are allowed and expected to run naked shorts in order to ensure liquidity. We want a system where you can just buy or sell an item "into the market", and then everything will get sorted out eventually. We optimise for the case where shares can be found because it's overwhelmingly common.
Stock borrowing is routine and transparent. People often have no idea if their stock has been lent out or if they own a borrowed stock; the reason for this is because the system has been designed so it doesn't matter. Shorting is common and accepted.
The volume of transactions is enormous, and the system began to freeze up under the weight of its own paperwork in the 60s and 70s. To work around this, a policy of stock immobilization was implemented to ensure that stocks don't need to physically change hands. As a result, almost all stocks in the US are actually owned by a small, obscure partnership called Cede & Co. As the excellent writer Matt Levine wrote a while back:
> Nobody owns stock. What you own is an entitlement to stock held for you by your broker. But your broker doesn't own the stock either. What your broker owns is an entitlement to stock held for it by Cede & Co., which is a nominee of the Depository Trust Company, which is a company that is in the business of owning everyone's stock for them. This system sounds convoluted but actually makes it easy to keep track of things: If I sell stock to you, I don't have to courier over a paper share certificate, or call up the company and have it change its shareholder register. Our brokers just change some electronic entries at their DTC accounts and everything is cool.
Dematerialization has been extremely helpful, but at scale, it moves us even further away from a system that deals with concrete items. Hence, eg, Levine's hilarious story "Banks Forgot Who Was Supposed to Own Dell Shares", from which my earlier excert comes from: https://www.bloomberg.com/opinion/articles/2015-07-14/banks-...
And so forth, and so on. The system, at every level, is not one where it makes any real sense to say "the company has issued five hundred thousand shares, I own twenty of them, I keep them in a drawer in my office, look, here are the serial numbers". It's more probabilistic than that, very much by design.
"Probabilistic" markets will be (and to some extent already are) re-invented on-top of the blockchain.
Current generation cryptocurrency blockchains are more similar to the post-trade settlement system, where everyone figures out who owns what after-the-fact.
Maybe smart contracts will change that, but performance will need to get a lot faster and I'm not sure how feasible it is to implement a full exchange on top of (for example) Ethereum. Would love to see it though!
