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visitor to a small town noticed some activity on a street corner. Some loiterers outside a saloon were having some fun with the village idiot. A barfly held some money in each hand and said, "which would you like? The nice, shiny 50-cent piece or the dirty old dollar bill?"
The village idiot replied, "The shiny 50-cent piece." Everybody laughed as the loiterer handed him the coin. Another barfly stepped forth. Same question. Same answer. More laughter as the alleged, dunce got another half-dollar.
After watching this four times, the out-of-towner could stand it no longer. He walked up to the village idiot and said, "Don't you know that the dollar bill is worth twice as much as the 50-cent pieces?" "I know that." "Then why do you keep picking the coin?" "Because when I pick the dollar bill, they stop playing the game."
That street corner-sharp-in-disguise knew two things: (a) economics, and (b) psychology. Someone once said, "Mention economics and everybody is bored. Mention money and their eyes light up." Many a trader and gambler and man on the street are interested in money but not in economics, with the result that he has no money.
The easiest thing in the world: Inventing a game in which you always win. The hardest thing in the world: Getting other people to play it. You can create a form of wagering in which you always win, but you will make no money at it because you will be the only one at the gaming table. Both psychology and economics require that the other people who play must at least think that they have a chance of winning.
The seedy gambler sets out to "break the bank" and claims to have a system that "can't lose." Remember that a thousand dollars has to double only 10 times to become a million, another 10 times to become a billion, another 10 to become a trillion. If such a system existed, if there were a sure and quick and easy way to double again and again, what would happen? Mr. Gimme-Some-Chips with the rent past due would soon have all the money in the world, or at the very least, would bankrupt casino after casino and track after track.
Alas, this is an economic point, something not readily grasped by people whose fingers itch for money. There also exists a psychological point toward which many traders and gamblers have a mental blind spot. They think of the exchange or the track or the other participants as "my source of income" at least potentially.
In finance, so easily the hunter becomes the hunted and the cannibal notices that the main course on the menu resembles himself.
The stock, futures & options exchanges, the casino & race track--the eye of the economist sees that there is not nearly enough money in all these places to make every participant a multi-millionaire. The total amount of capital ventured by everyone collectively may seem vast, but it is small compared to everyone's dreams of wealth totaled. The unwanted but inevitable outcome: Multitudes of disappointed people. Such a setup mass-produces also-rans, though nobody wants to be one.
Yet the eye of the economist also sees opportunities. After the races, thousands of discarded pari-mutuel tickets litter the grandstands. Torn by people who had wanted to stuff their pockets but who became "somebody else's source of income" without intending to be.
A good receiving end? No easy find. In recent years, holders of casino stocks and race track stocks have had little to sing about while awaiting a repeat of Resorts International. Other forms of gambling beckon, but dice and roulette in your basement could make you an "income source" for a bail-bondsman. Selling junk bonds or IPO shares for a chain of empty restaurants requires an office with high overhead. Also, piles of negotiable paper sit unsold because many potential investors "stopped playing the game."
Let us imagine, however, that the very day you spend the $5,000, acquiring that deed entitles you to print another deed bearing a March expiration date and to sell it for $3,000. You can either put that $3,000 in your pocket or you can credit it toward your purchase of the June deed and then pay only $2,000 out of your own capital. The deed you sold expires on the third Friday of March, entitling you to print and sell another deed bearing an April expiration date for maybe more, maybe less cash than the March. Maybe more, maybe less because fluctuations affect both Junes and Aprils. April expires, sell May.
But take another look at that buy-the-June/sell-the-March deal. If you simply bought the June, it would eventually have to become worth more than $5,000 for you to make a profit. If, however, you also sold the March, you are ahead if the June is worth anything more than $2,000 after the March expires. Thus a "spread" is called that because your actual investment is the amount between the buy figure ($5,000) and the sell figure ($3,000), the aforementioned two grand.
The procedure is not risk-free because the June could drop in value to below $2,000 or even to zero. Yet funding an investment with 60% other people's money and only 40% your own is one hell of a head start, not even counting what you sell after March expires. Thus with spread strategies, put & call options are the race track tickets which, once you buy a batch, entitle you to print and sell more batches. The ones you bought could lose the race, but you can re-sell them before the final furlong, i.e., before the expiration date. The others you sell are bookmakers' revenues.
Value-oriented investment legend Benjamin Graham once said, "When you can buy a dollar for 40 cents, you don't have to worry about what the stock market is doing." The "dollars for 40 cents" were depressed stocks in solid companies, shares selling at market prices substantially below their estimated "true value." Something similar could be remarked about option spreads: The 10-dollar horse-racing ticket for four dollars. The 10-dollar ticket allowing you to now sell several two-dollar ones. If the ticket wins, fine. If not, well, you are part bookie working mostly with other people's money, and with the mathematical odds far more in your favor.
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