Yet more reverse convertibles: positive sum games?

June 19, 2009 in Finance

Did Felix Salmon really just write this in defense of his reverse convertibles stance??

For one thing, stocks generally go up over time: they’re a positive-sum game.

...

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game.

I am Jack's stunned silence.

Felix's post is an excellent overview of why reverse convertibles are a terrible investment. However it gives no backing to the argument they should be banned rather than avoided. In particular, I don't follow this logic:

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

Why is it a problem if the transfer of wealth is from client to broker? Since when do people care (or, indeed, even know) whom they face on a trade? Moreover, options are more profitable for brokers simply because they are less liquid; they charge higher commissions, not because of any inherent security characteristic. Indeed, commissions are likely what the last "truism" is premised on, but that seems a stretch to me - like saying on aggregate, baseball fans lose because they buy tickets to watch their team play.

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