options at scattered thoughts

options

Published by stephan.com June 14th, 2004 in writing

I’m writing this because I just got some paperwork about stock options from the company I used to work for, and I thought I might write a primer about what options are. Economists and other interested readers - be gentle this is a layman’s view.

Short introduction to options. Futures exchanges (i.e. options) mean that you are buying and selling, not a commodity, but the RIGHT to buy or sell that commodity at a certain price. Let’s say gas is $2.25 at the pump right now. Let’s also say you know that you’re buying 10 gallons next week, and you’re afraid the price might go up - the market is thinking $2.30. You might buy an option for 10 gallons of gas next week at $2.25, and you pay 50¢ for the option. So, if gas is, in fact, $2.30, you only pay $2.25 (10 gallons = $22.50) and you already paid the 50¢, so you break even. If gas goes up to $2.50, you win. In fact, you probably don’t even bother getting the actual gas, you just sell the option to someone else for $2.50 and you made $2. If the price goes DOWN, you’re fucked, you lost your 50¢.

The whole thing works because the guy who owns the gas station sold you the options (actually, he bought the option to sell, but that’s more confusing - you can buy or sell the right to buy or sell, those are called, I think “puts” and “calls”). The price of the option goes up or down depending on the market’s prediction of what will happen on the spot market, specifically, what the “strike price” will be when the option expires. In my gasoline example, let’s say you paid 50¢ for the option to buy 10 gallons of gas at $2.25 on Thursday. On Monday, there’s an attack in Saudi Arabia, and people think the price of gas might go up, they’re guessing $3 by Thursday. Your 50¢ option would now be worth $7.50. By Tuesday, this has blown over, the price estimate goes back down to $2.30, your option is worth 50¢ again. If you had sold on Monday, you’d make money, but really, you just want to KNOW that the gas will be $2.30 on Thursday, so you don’t sell, you just sit on your hands and count yourself lucky.

The math of this is actually far more fucked up, just figuring out how much the option or derivative SHOULD be worth takes a messy formula, which is why Merton and Scholes got the 1997 Nobel Prize in economics for “a new method to determine the value of derivatiives”. It’s called the The Black-Scholes (1973) option pricing formula
Values for a call price c or put price p are:

No, I don’t understand this at all, it just looks cool

It sounds bizarre, but this is how our economy works these days. Why bother, you say, why not just take your chances? Well, if you’re Betty Crocker or McDonalds and you have to buy a jillion kazillion bushels of wheat to make burger buns or whatever, and you need to make financial projections for next year, you’re in big trouble if the wheat goes up in price. Sure, it might go down, but really, you don’t want to make or lose money on the price of wheat - you want to know NOW what you’re going to pay next year for the wheat, so you can plan everything else down the road. When next year rolls around and the CURRENT price of the wheat (the “spot market”) is up or down, the winner and losers cash in their chips.So, the guy with the wheat field buys the option to sell, the guy who makes buns buys the option to buy, and it all balances out. (actually, I think the wheat field guy SELLS the option to sell, and gets cash in his pocket to buy fertilizer with, but I get confused about that part)

Almost. The trick is, both parties want to get rid of uncertainty and risk. They don’t want to roll the dice. They don’t want to care about the weather driving the crop price up and down, or if people start doing the Atkins diet and don’t want the buns anymore. They are paying a premium for reliability. They are, in other words, selling the dice to someone else. This someone else is the traders.

They are lunatics.

Shortly after learning all this stuff for a project, I was given a brief tour of the Chicago Board of Trade, including getting to walk on the floor of the exchange, surrounded by screaming men in tacky coats. I finally got it. There are institutional buyers and sellers, some wanting security, some wanting to make money, but the root of it all is a bunch of, basically, compulsive gamblers. They get in the middle, buying the uncertainty, the dice, from both sides, and winning or losing their own personal fortunes (or at least their jobs) based on the aforementioned weather or eating fashions or whatever.

I asked my host, “what happens to these guys when they run out of money?” He replied, “they drive cabs, go home to their wives, whatever.”

Our entire economy rests in the sweaty palms of a bunch of compulsive gamblers. Dig that.

You want to gamble? Forget blackjack, texas hold-em and pai gow, THIS is gambling! The stakes are high, and the house basically doesn’t keep much.

Commodity exchanges like this are simple to understand for normal items like gold, wheat, pork bellies, cocoa. In fact, when you buy an option, you’ve got the right to buy a certain commodity for a certain price, delivered to a certain place. In theory, you could demand to cash in that option with actual pork bellies that you’d have to ship from, in fact, Chicago (the big exchanges are in Chicago for the historical reason that it was the meat packing and shipping center back then). However, in general no one - not even McDonald’s or Sara Lee - actually takes delivery of the underlying commodity, they just cash in the option.

Because the actual commodity ended up being more abstract than real at this point, the idea was extended to far more abstract things like stocks, interest rates (”T-bonds”), currency, mortgages (”Ginnie Mae”), electricity (root of the Enron problem) and even more recently to carbon dioxide emissions and insurance.

This has grown into ever more byzantine schemes where people buy and sell the right to buy and sell the right to buy and sell commodities - like options on the options. And so forth, weirder and weirder, which I believe is called “derivatives” If you’ve taken calculus, you can see there is a certain relationship between the underlying commodity and its spot market (the price TODAY) and it’s futures, and the value of a function and its integrals and derivatives.

Tell the masses all about it