CME Group Inc plans to offer the trading masses options to punt on whether stocks, gold, oil – or virtually any other asset – will rise on a given day.
These will be yes/no contracts, such as: do you think stocks will rise today? If you answer "yes," and the market finishes up, the contract pays off. If you answer "yes," and the market goes down, the option expires worthless.
Contracts like these have been popularised by sports- and politics-betting sites. And so, with every passing day, the markets asymptotically approach the financial sophistication of DraftKings Inc.
The new CME contracts will encourage pure speculation, serving practically no economic purpose. There is lots of economic utility in plain vanilla options.
You can buy puts to protect a bet on a stock rising; or sell calls against a long stock position to hedge it and earn a premium; and you can construct more complex wagers involving different strikes and maturities to obtain the risk profile you want.
Betting on whether stocks, oil or gold will be up or down in a day is just a punt, the kind you make with a friend over beers. It is simple and easy to understand, which is what makes it so dangerous. Lots of money has been lost at the roulette wheel betting on red or black.
It is another step toward the gamification of investing – a trend led by brokerage Robinhood Markets Inc that sparked the meme stock frenzy – which risks breaking the link between price and value for the chimera of democratised markets, and a tidy profit.
Plain vanilla options are also dangerous, but everyone knows this, and their complexity acts as a barrier to entry. When that barrier falls, disaster strikes.
Like when retail investors were caught holding very expensive GameStop Corp. calls as the stock plunged. The coin-toss CME options will either payout or expire worthless. Losing 100% on a series of trades can be devastating for a retail investor.
What CME is really offering is a binary option. Intuitively easier to understand than plain vanilla options, but more difficult to hedge. Variations of binary options are naturally occurring in the currency world, where one-touch and barrier options are common.
They have been responsible for some violent currency moves, as market participants attempt to trigger them around the strike price, and the amount of hedging required is enormous.
In the event that these yes/no contracts gain popularity (and I do not think they will), they could provide a lot of excitement in late-day trading if the underlying asset is approximately unchanged.
The options are another example of the unstoppable growth of derivates, which have eclipsed the listed stock market. In 1999, at the height of the dot-com bubble, the average daily options volume across all exchanges was about 2 million contracts.
So far this month, we are averaging 42 million contracts, according to the Options Clearing Corp. That is 42 million options contracts controlling 4.2 billion shares, which means that the options tail is now wagging the stock market dog.
Then again, you cannot stop progress. When the first US stock options were listed in the early 1980s, there were warnings that the leverage and hedging activity would crash the equity market. That turned out to be false. The options market has held up just fine through a series of crashes and panics.
The same was said of leveraged exchange-traded funds in the late 2000s. During the financial crisis, those leveraged ETFs amplified volatility, but nothing broke. Every financial innovation is greeted with some skepticism.
Binary options are no different. And maybe "How can I make a clean bet on the stock market going up or down?" is a problem that some people have. It is not a problem that Ray Dalio's Bridgewater Associates has.
Derivatives exchanges have become indistinguishable from sports betting sites. As usual, the only people who will make money in the long run are the bookmakers, in this case quants who build the market-making platforms, taking 50 cents out of every $100 bet.
It is a good thing we are not too squeamish about legalised gambling anymore, because that is exactly what this is. I worked with some folks at Lehman Brothers Holdings Inc who would get bored during the day and start betting $100 on coin tosses.
That was degenerate behaviour. When an exchange encourages it, it is still degenerate behaviour, but with a veneer of respectability.
Jared Dillian is the editor and publisher of the Daily Dirtnap. An investment strategist at Mauldin Economics, he is the author of 'All the Evil of This World.'
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.