In order to understand real options, you need to understand financial options. Financial options are the biggest tectonic shift in finance of the 20th century. The main concept behind financial options is simple. In non-financial terms, an option gives you the right, but not the obligation, to buy or sell something at a pre-specified price, only up until a pre-specified time.
Options give you many new opportunities to make money and customize exactly which risks you want to bear. You can:
- position for a large market move upwards, with a much lower level of exposure to risk.
- minimize your future losses if you expect the market will go south.
- prepare to buy something for a lower price, if you predict certain conditions will arise.
- lock in a cash flow stream, without being exposed to market risk.
- allow for a core exposure to market risk, while still dabbling in various options on the side.
- conserve capital via limiting risk, so that there is more cash available for future investment.
In short, options allow you to assemble the exact financial risks you want to bear while discard those you don’t. As a result, you customize your risk profile in a more powerful (and accurate) way than investors who don’t use options. This high granularity will clearly make you more profitable in a highly volatile environment.
Types of Options
When you initially buy an option, you aren’t sure what will happen. Instead, you have a hunch that it will. You are betting on a particular event happening in the future, without bearing the full risk of it happening. With financial options, this typically refers to how the price of the something in the market changes.
There are two main types of options: puts and calls. From the point of view of an option buyer, a put prevents a big loss, but costs a bit up front. It’s the option to sell something at a pre-agreed price.
A call is the opposite. It enables you to get a big gain, but it also costs a bit up front. It allows you to buy something in the future at a pre-agreed price.
In both cases, when you exercise the option, you already know what happened. You know why you want to use it-when you do.
The asset an option gives you the right to buy or sell is called an underlying. It’s the “what” of an option. What are you betting about?
What can be an underlying?
The price of the option is actually different than that of the underlying itself. It’s independent. This is because of the unique characteristics of each option.
Every option has a couple of characteristics which affect its price, not just the underlying, i.e. the pre-specified price & time at which you can buy the underlying.
For example, consider these two bets (options):
1. betting that Poland will win the world cup at the next world cup
2. betting that Poland will win the world cup at least once in the next 100 years
If Poland does win the next world cup, you would win both of these bets. They have the same underlying. Simultaneously, they have different pre-specified expiry dates. Because of this difference, each bet will have a different value, even though the underlying is the same.
If you look at a variety of options for the same underlying but expiring on different dates, you can see this pattern. As you go further out in time, typically the later option will be more expensive. It compensates or charges you for the value of time. a bank also compensates or charges you for holding your savings with them or taking out a loan for the same reason.
Assuming you have the same underlying, as the strike price (the pre-specified price) is lower on a put, the cheaper it is. Everyone thinks it’s unlikely the option will ever need to be used. There is less demand for each option where the strike price is further away from the current market price of the underlying.
Conversely, as the strike price gets lower on a call, the more expensive it is. Remember that as it gives you the ability to buy the underlying at a lower price. If it’s compared to the underlying, and the strike price is much lower than the underlying price, then you can buy the option and exercise it.
How options are different than stocks
Unlike stocks, all of the money you invest into an option will disappear when the option expires; this is the worst case scenario. Stocks have no predetermined lifetime, as they represent a claim on a company that is expected to be around forever. Accountants call such a company a “going concern”. In contrast, options always have a date by which they expire. It’s a necessary part of the option. Having the option to do something by next month or by the end of next year, even if it’s the same thing, will not cost the same amount. By holding an option, you might lose everything you invest, or you stand to gain a very large amount relative to the amount invested if the foreseen scenario happens.