Explain Financial Options To Me Like I’m An Idiot

This is the first article I’ll be doing on the series of financial options and derivatives.

Options govern every aspect of your life, even if you don’t realize it. Thales traded the first known option in the the sixth century BC – even back then, it was either retirement on a yacht, or food stamps for him.

Let’s get some definitions out of the way before jumping into an example. In this article I’ll explain an option in two ways – one in terms of every day life, and the other in terms of financial jargon.

Definitions:

Expiration date: the date at which all the terms of the contract are set to expire.
Exercise: when the buyer of an option invokes his rights as defined in the option contract
Strike price: the predetermined price, as stated in the options contract, that the buyer can exercise his option at.
Underlying asset: the asset on which the option contract is based on. Options are derivatives, so their value is derived from an asset that the contract tracks.
Option premium: a fee that the buyer pays the seller upfront, in exchange for the right to exercise the option through the expiration date of the contract.

How would a trader on Wall Street explain financial options?

An option contract gives the buyer the right, but not the obligation, to buy or sell (depending on the type of the option) and underlying asset by a certain date (expiration date) at a predefined price (strike price).

Now explain it to me like I’m an idiot:

Think about an option as an insurance contract. If the event the buyer insures against happens, then the seller has to pay out… big time.

This “insurance” gives the buyer of an option a choice. In exchange for paying the seller of the contract a fee, he has the choice to exercise his terms of the deal up until the expiration date.

Let’s walk through a simple example to get the point across. For more advanced readers, this intentionally leaves gaps in option profitability and pricing to lay a base level of understanding.

In the spirit of my love for the Levant and current events, let’s go to Syria circa 2012 to work through an example.

Syria circa 2012. War torn but not completely blown to hell.

Pericles is a farmer in Aleppo, Syria. Due to the ongoing civil war, he is nervous that his wheat crops will be bombed by the rising insurgency, or a stray predator missile. Given the climate of warfare, and Pericles financial condition, banks are reluctant to give him insurance on his wheat.

Pericles if he was an actual Syrian farmer.

The market price for an acre of wheat is $100. However, his wheat crop won’t be able to be harvested until some point in the next 30 days, depending on how much water President Bashar Al Assad decides to release from Aleppo’s reservoir.

The price of wheat isn’t expected to change much, given the currently stable state of the Donbas in Ukraine, the world’s bread basket.

Donbas, Ukraine is the world’s powerhouse for wheat exports, which includes major Ukranian cities Luhansk and Donetsk.

Pericles is faced with a binary outcome, his crops could be worth $100, or nothing.

Pericles approaches Tyus, a wealthy merchant from Aleppo, with his predicament.

On January 1st, Tyus offers Pericles a deal. For the next 30 days (through February 1st), in exchange for an upfront fee of $5 per acre, Pericles can sell his crops to Tyus, regardless of the condition they’re in, for a set price of $99 an acre.

So, if Pericles’ crops are poisoned by the regimes use of chemical weapons, he will exercise his option will Tyus to receive the $99. Since the strike price of the contract ($99) is below the market price of wheat, Pericles will simply sell his wheat on the open market if it is not the site of a predator missile crater come February 1st.

Let’s put this example in terms of our option definition:

Pericles has the right, but not the obligation, to sell his wheat to Tyus for $99 an acre at any point in the next 30 days. If an F-22 Raptor bombs Pericles field tomorrow, making the crops worthless, Pericles can exercise his option with Tyus, giving him the charred crops, in exchange for the $99 Tyus promised in the contract. Pericles loses this option on February 1st.

The F-22 Raptor has conducted numerous combat missions within the Syrian border.

It’s important to acknowledge the differing incentives by Tyus and Pericles. Although an options contract always has a clear winner and loser, each party receives value out of the contract, regardless of the outcome, since each party has different incentives and risk tolerance.

Differing incentives makes the contract rational for both parties, even if the contract differs from the mathematically optimal solution.

Pericles is very risk averse – even if the odds of the US Air Force bombing his field is very low, he cannot afford to lose a month’s wages to feed his family. In essence, Pericles is buying insurance.

Tyus can afford to be risk seeking. Based on his conversations with local Kurdish militants who share intelligence with the Department of Defense, he thinks the risk of an American drone bombing a crop field is low. In exchange for the premium (the $5 upfront fee he receives from Pericles) he will happily insure the crop field, since he thinks the probability of wheat being worth less than $99 is lower than the fee Pericles had given him.