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I've studied the derivatives market, and I've heard of a number of huge losses by firms; I've heard of individuals forewarning against investing in this market.

I never hear about the big winners. Where does the money go? Who wins the billions?

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What kind of derivatives are you talking about? There are many type of derivatives. There are options, futures, warrants and CFDs just to name a few. Just as with stock there are winners and there are losers. –  Victor Apr 3 at 10:58
    
Derivatives are bets. Somebody wins the bet. The loser pays the winner. –  NL7 Apr 3 at 18:18

4 Answers 4

Unlike the stock market which offers growth long term, the derivatives market is a zero sum game.

This phrase is how one describes a poker game. 7 people walk in, and walk out with the same total amount of money (note, the 7th guy is the 'house', and with nothing at risk, he gets his cut). No money is created, the total value doesn't change.

When I buy or sell an option, there is someone on the other side of that trade with a gain or loss equal and opposite to my position. At option expiration, or a repurchase that closes an open contract, the whole series of trades resulted in no net gain of wealth.

The huge losses were spread among the banks, the investors, the insurance companies, and the government. By government, I mean the taxpayer. You paid your share, my friend, as did I.

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The stock market may also be viewed as a zero-sum game over any fixed period of time. The "growth" in value of (non-divided-paying) stock is defined as what someone is willing to pay for it now minus what you paid for it. So over any fixed period of time, the total realized gains by all people who bought and then sold a particular share of stock are equivalent to the total realized losses of those people, plus the amount that the last buyer spent to get the share. (There's always someone left holding the hot potato.) –  dg99 Apr 4 at 0:37
    
Sorry, I disagree. My answer makes a point of the distinction between the zero sum derivative and stocks. I thought my answer was pretty compelling. –  JoeTaxpayer Apr 4 at 1:02
    
A fundamental consideration is not just the value of the derivative. To be sure, as you say, the derivative is little more than a bet (or an insurance to be more polite!) between two participants. However, while the writer has earned fixed premium the holder can, potentially, be given increased margin based on the EoD value of his derivatives holdings. Also relevant to the OP's point is that "huge losses" on derivatives don't inherently mean they were exchange-traded. When I hold an option written by another firm the value is based on the worthiness of the writer; if they go under... –  Matthew Apr 5 at 0:43

In addition to JoeTaxpayer's answer there are articles that describe the writing of options as "being the casino". When you write, or sell to open an option, you are selling one of the most desirable things in the world to sell: a depreciating asset.

Writing options are not without risk, but they can be a very conservative strategy.

Who wins these massive losses? Sometimes run of the mill investors, myself being one of them.

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Focusing on options, many people and companies use them to mitigate risk(hedge) When used as a hedge the objective is not to win big, it is to create a more predictable outcome.

Option traders win big by consistenly structuring trades with a high probability of success. In this way, they take 100 and turn it into 1000 with 100 small trades with a target profit of $10/trade. Although options are a 'zero sum' game, a general theory among options traders is the stock market only has a 54-56 probability of profit(PoP) - skewed from 50-50 win/loss because the market tends to go up over a long time frame. Using Option trading strategies strategically, you have more control over PoP and you can set yourself up to win whether the security goes up/down/sideways.

A quick and dirty measure of PoP is an options' delta. If the delta on a call option is 19, there is roughly a 19% chance your option will be in the money at expiration - or a 19% chance of hitting a home run and multiplyimg your money. If the delta is 68, there is a 68% chance of a profitable trade or getting on base. There are more variables to this equation, but I hope this clearly explains the essence.

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Where does the money go Who wins the billions

Ever heard of The Wolf of Wall Street , theres where the money goes . In short ,bankers, traders who are paid millions to take make leverage bets using the banks money regardless of whether they do well .

If they screw up and lose millions , they get paid to leave ( compensation package ) . If they do well , they get bonus.

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This answer contains no technical content or references in answer to the OP's question. –  dg99 Apr 4 at 0:31
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@dg99: This answer (bankers overhead) predicts big losses combined with small profits, which is sufficient to explain the observation. –  MSalters Apr 4 at 16:30
    
-1. The "extra money" from the derivatives isn't won by the people at the prop desk. –  Matthew Apr 5 at 0:55

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