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The Winner’s Curse


Chief Strategist at Interactive Brokers

Sometimes, a lesson goes unlearned. 

When our boys were growing up we used to vacation in Maine every summer.   We occasionally spent an evening at Scarborough Downs, a nearby harness racing track.  Neither my wife nor I are gamblers or horse aficionados, but it was a fun and inexpensive diversion when there was a little too much “together time”.  Our older son was a quick study, and realized that the point of the activity was not to watch the outcome of the races, but to bet on them.  After what seemed like incessant haranguing, we broke down and told him that we would let him pick a race.  We said nothing when he picked a long shot exacta, figuring that it would teach him a valuable lesson about how difficult it was to win at gambling.

Sure enough, the exacta came in.  It paid about $60 for a $2 bet.  Gamblers would normally be ecstatic at such a payoff, but my wife and I were chagrined.  The lesson had completely backfired!

I believe that the same sort of reinforcement is at work in the markets right now.  Many novice and newish investors came into the markets this year, emboldened by $1200 stimulus checks and moratoria on their student loan repayments.  Who could blame them?  The full weight of the US Congress and the Federal Reserves was behind an effort to wrest the economy and the markets out of a virus-induced tailspin.  Coincidentally, the advent of zero commissions and fractional shares made it cheaper and easier than ever for individuals to participate in the markets.  A basic economic rule is “if you want more of something, make it cheaper.”  The deck had never been so stacked in favor of investors, and many were smart enough to recognize it.

Winning emboldens gamblers and investors alike.  As they realized that some of the most speculative stocks were among the biggest winners, they joined the fray.  Those bets, er investments, paid off too.  Many of them came to learn that if stocks could pay off big, options could pay off even bigger.  Many of the new investors were actually frustrated sports gamblers who came to the markets when there were no games on which to bet.  They realized that options can have a similar payoff structure to a sports bet.  Much like a money-line sports or racing bet, where a gambler lays out an amount of cash hoping for a wind that will return his initial bet and then some, an options buyer lays out an initial premium and a successful purchase can pay off several times. 

Options professionals concern themselves with the level of volatility and other factors (“the Greeks”) that influences the prices of derivatives.  Options speculators concern themselves primarily with only one of the variables – delta, the change in the value of an option that comes from a change in the underlying stock.  Quite frankly, that is another bet that has generally been paying off well in a rising market.  If stocks go up wildly, so too do their call options. 

It is no coincidence then, that we are seeing record demand for call options.  Volumes and open interest are at all-time highs, with much of that volume concentrated in calls expiring within a week or less.  (Weekly options were another innovation that broadened investors’ access to tradeable products.)  The timing and payoff structure are indeed similar to gambling, except that there is nearly continuous action, a wider array of potential wagers, and transaction costs that are a small fraction of those charged by bookmakers.  Can you blame commentators for comparing the current nature of the markets to an overheated casino?

The most significant difference between markets and a casino is that the gamblers can actually influence the outcome.  Odds will change if a sufficient imbalance of wagers pile up on one side or another, but that should have no bearing upon the outcome of a fair contest.  In the markets, however, an imbalance of money flowing into or out of an investment will indeed move the price of that product.  That gives a self-fulfilling character to the relentless advance of the stock market and those who buy call options leveraged to it. 

As of now there has been virtually no consequences to those who have helped propel the markets.  And that is where the problem lies.  I don’t know when markets will pull back – today, tomorrow, next month or sometime in the distant future – but they always do.  Just as ever-increasing participation in the bull market has propelled its advance, a reversal of fortune could accelerate its decline.  Investors usually do not appreciate market risks until they have been through a full bull-bear market cycle.  The newest crop of investors has been taught that the riskier the bet, the bigger the payoff, and that any downside is short and shallow.  That may have been true since March, but it was not accurate in the past – or even earlier this year!  We need to hope that these new investors will not panic if markets turn against them.  That may be the case in theory, but those who employ leverage do not necessarily have that luxury when facing a margin call.  This is why I stress the importance of risk management even in a rising market. 

As for my son’s gambling debut, I have no choice but to think that it influenced his behavior since.  He is the only member of our family who has an interest in gambling, and has learned an expensive lesson to avoid pachinko parlors now that he lives in Japan.  He never turned into a problem gambler though, nor do I think that many investors will do so.  But most successful investors and gambler alike learn to balance risk and reward.  I certainly hope that most newly minted investors learn that lesson, and not the hard way after seeing their early long shot bets pay off handsomely.

Related reading:

Greed Can Be Good as Long as You Manage Your Risk (

Did Anyone Make Dow 30,000 Hats? – Traders’ Insight

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