Saturday, May 28, 2011

Gambling Or Investing?

"The stock market is just a big casino." I hear this analogy all the time. I hear this most-of-all from relatives who worry that I am just gambling away my money. These same relatives have their money in savings accounts earning .1% interest. So it is important to explore and understand the difference between gambling and investing.

A gambler is someone who risks money thinking he can beat the odds stacked against him. Consider roulette. There is no payout on a roulette table that is better than the odds. In other words, the probability of winning multiplied by the pay-out is always less than the probability of losing the bet. Consider betting red in roulette. On a one dollar bet there is a 18/38 chance that you win a payout of one dollar but there is a 20/38 chance of losing a dollar. This means that over a large number of bets you would expect to lose an average of about a nickel (2/38) per dollar bet.

However, consider the counterparty to these risks: the casino. Is the casino gambling!? I should say not. They have a business model that produces a mathematical 5% return on risk. The casino is actually investing not gambling. To be sure, the house is engaging in a risky operation, the players might conceivably hit a winning streak, but over time this is a solid business model.

Simplistically, in the stock market, anybody can be the house because anybody can buy stocks of publicly traded casinos (LVS and WYNN, for example.)  In a more general sense, options give us smallDogInvestors, the ability to play the role of the house in a wide variety of strategies.

One edge we have is time. When we sell option premium we put time on our side. Time decay of option premium is a mathematical certainty in much the same way that the casino has a mathematical edge over roulette players. Time and tide wait for no man. By actively playing the seller of option premium, a smallDogInvestor can beat the market. To be sure, bigDog plays this game too, but his problem of moving the market is compounded by a factor of 100 when he does, since each contract represents 100 shares of the underlying equity.

Moreover, the purported casino operators of this enterprise, the brokerage houses, have no vested interest in you losing the game. They collect their commissions and the bid-ask spread, whether or not you are profitable. If anything, they stand to benefit by you winning because you will come back to trade more if successful.

To my mind letting money sit in a savings account earning .1% while inflation is at .4%, that is really gambling. You have negative real rate of return that, while not as bad as the 5% expected rate of loss at the roulette table, is assuredly negative.

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