Good morning! Today’s agenda is options. Before we get into the purpose of options, let’s look at a basic definition and terminology.
An option is essentially a contract in which a buyer purchases the option to buy (call) or sell (put) an asset at a predetermined price. The buyer does not have the obligation to buy or sell, but rather the option to do so if the price increases (call) or decreases in the case of a put.
Let’s go back to our oil example from yesterday’s lesson: If the price of oil is currently $50/barrel and a company wants to hedge its price, they can buy an option to buy the oil at $55/barrel. If the price of oil increases to $65, they exercise their option to buy at the strike price ($55). If, however, the price declines to $45, the option expires and no purchase is made.
After having covered futures and forwards, you may be wondering how options differ from these previously discussed instruments. The key distinction is that the option is an option to buy rather than an obligation. In yesterday’s example, the airline experienced a loss when the price of the future dropped, but options do not produce losses, only potential gains or at worst, expire null.
Since options are exposing the counterparty to higher levels of risk, they are sold for a premium. From this perspective, the buyer of the option’s losses are capped at the price of the premium.
Moneyness refers to three states of an option: in the money, at the money, and out of the money.
In the money: an option whose strike price is below the current market price (for a call) or above the current market price (for a put)—the option with the highest premium
At the money: an option whose strike price is at the current market price
Out of the money: an option whose strike price is above the current market price (for a call) and below the current market price (for a put)
Like forwards and futures, options are used to hedge a current position that an investor holds and thus, minimize future losses against unanticipated price fluctuations. The best way to think of options is as an insurance strategy. When you secure your car against devastating losses, you are paying a premium to purchase this insurance. Your insurance may never be needed and thus expire worthless. However, the peace of mind it provides may be invaluable.
Some investors purchase options to speculate on future price movements if they anticipate large movements but are unsure of the direction.
Option pricing and analysis utilizes intricate financial models and may be outside the scope of this course. But as a separate note, during my studies of option valuation models, one specific model (the Black Scholes Model) stood out to me, since it was originally conceived to study quantum mechanics. This has led to the subspecialty of quantum finance known in popular culture as “the Quants.”
Now that we’ve covered the more traditional financial instruments, tomorrow, we’ll learn about a new and intriguing concept: cryptocurrency. Stay tuned!
The Quants: How a New Breed of Math Whizzes Conquered Wall Street by Scott Patterson: for an in-depth analysis of the masterminds behind Wall Street’s operations
Share with friends