Never Fall for the Schtick

| March 31, 2023

A friend of mine had a saying that I always detested for its cruelty. Whenever we had a market reversal, he would tell me that “money always returns to its rightful owners.” Unfortunately, there is an element of truth to his cynical expression. No, unless someone has been robbed or misplaced his or her wallet, there is no such thing as returning money to its “rightful” owner. There are, however, gullible people waiting to be taken. If the schtick is good enough, people will jostle to the head of the line to be the first one fleeced.

A popular schtick is to offer something for nothing while claiming noble and altruistic intentions. Companies offer commission-free trades or tout applications that claim to “democratize” the markets. Once the gullible open accounts, they are encouraged to trade often. The transactions are free after all. Inexperienced investors are soon encouraged to borrow money and purchase risky investments. Firms make a lot of money from lending money against securities, far more than banks make lending against homes. Moreover, the firms take on very little risk since they can demand more cash or sell investors out should the market go against them. Heads we win, tails you lose should be the motto.

Firms also steer novices into securities that have the highest bid-ask spreads. This is the difference between the buy and sell prices for a security. This is why “democracy” firms enticed so many investors into options, which typically have spreads that are double those of stocks. I have previously explained how these contracts to buy or sell work and shall not go into it again here. The important point is that investors have lost billions of dollars in options over the last several years, while firms have raked in similar billions. I guess that this is a kind of democracy.

I did not know the extent of this transfer from the gullible to the crafty, but thanks to an article in The Economist and a study by The Journal of Finance I do now. The authors “estimate that between November 2019 and June 2021, retail investors collectively lost $2.1bn on options.” How much did the retail firms make from options investors? In 2022 alone these “retail brokers made $2bn from options trading.” I believe that they may have also created another systemic risk to the economy by boosting options trading to “a record notional value of $1trn.” *

Which is why I think so often of my cynical friend. I am sure that the companies that have promoted this frenzy believe that they are only helping money “return to its rightful owners.”

* The Economist, ´╗┐Online/Graphic Detail/No Good Options, March 7, 2023. Accessed on 03.29.2023.