Options 101

I have been thinking about a particular topic, and I have an idea about it. This idea involves financial options. As not everyone will be familiar with these, I’ll first have a post up on the basics of options, and then write the main posts.

Let’s start.

An option is a contract to buy or sell something at a fixed price. Stock options are the best known sort of options, thanks to things like Employee Stock Option Programs. An option is not the thing itself- just the right to trade in that thing.

Let’s illustrate this. Suppose I run a company called Maajorly Shadymax Arbit Fundaes Public Limited, which employs lots of people to post arbit fundaes on blogs all over the internet (we can debate the profitability of this business model elsewhere). MSAF Ltd. currently has a share price of Rs. 100.

I now issue options on MSAF Ltd. to all my employees. This option allows them to buy a share of MSAF Ltd. at Rs. 120 on June 1, 2007.

What happens on June 1, 2007? Two possible things:

  1. The share price is below Rs. 120- Rs. 110, say. The option is worthless. Buying the share at Rs. 120 makes no sense when you could buy it on the market for Rs. 110
  2. The share price is Rs. 120 or more. Now, the option is worth something. In fact, it is worth exactly the difference between the market price and Rs. 120. If the market price is Rs. 125, then the option is worth Rs. 5. If it’s Rs. 130, the option is worth Rs. 10. How do we get this? Simple, you use the option to buy a share at Rs. 120, and then immediately sell the share at the market price. The profit you make is what the option is worth.

What we’ve just discussed is called a call option, since we’re talking about the right to buy an asset. What if the option had not been to buy a share at Rs. 120, but to sell it? The same thing, but in reverse. If the market price had been above Rs. 120, then the option would have been worthless- why sell at Rs. 120 when you can sell at a higher price in the market? If the market price had been Rs. 110, the option would have been worth Rs. 10- you could have bought a share at Rs. 110 and sold it at Rs. 120 thanks to the option. An option like this which gives you the right to sell an asset is called a put option.

I’ve talked about the special case of what the option is worth when you have to use it, but it’ll be worth something even before June 1, 2007- what it will be worth will depend on people’s estimate of what the stock price is actually going to be on June 1, but it will have a value- and you can sell the option itself for that value.

One final thing before this little primer is complete. My example used shares, but it could have been anything else. I could have an option to buy a barrel of oil for seventy five dollars on August 1, 2006. Or I could have an option to sell a million dollars at 45.5 rupees a dollar on July 1, 2006. It’s easiest to explain with shares, but you can have an option on virtually any kind of asset.

That’s all you need to know about options in the context of the post I’m going to make. For a more detailed discussion, do read the Wikipedia entry, which also has some very user-friendly diagrams.

0 Responses to Options 101

  1. Shrik says:

    I just hope the main posts are due out before June 1, 2007…

  2. Just me says:

    Hey, that was a very clear article. Thanks for the (not so majorly shady or arbitmax) fundaes!

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