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Options: Characteristics and History
The rocket scientists of finance are far more likely to be found in options rather than futures and forwards. Given the obligatory delivery and cash settlement rules of futures and forwards, these instruments pose the same financial consequences of having actually bought or sold the underlying asset. Figuring out, then, the appropriate price for those contracts is simply a matter of consulting the going market rate for the underlying asset and then adjusting for the fact that it is still to be either delivered or monetarily settled. However, options involve the right, and not the obligation, to engage in delivery or settlement in the future at a price established beforehand. Now, rights need not be exercised. so the question in pricing an option becomes whether or not delivery or cash settlement is apt to take place and, if so, what the terms might be. To make this calculation, one needs to have some idea of where the price of the underlying asset might travel between now and the expiry date of the option. It turns out that this requires a fair bit of statistics, probability, and calculus. Illustrating this is the Black and scholes option pricing formula, a model that won a Nobel Prize in economics for its creators.
Options are divided into calls and puts. Differentiating these is the fact that calls involve the right to buy an underlying asset at a pre-determined level, whereas puts involve the right to sell an underlying asset. That predetermined level is called the strike price. Option rights at this strike price can be exercised either through delivery of the asset or a cash settlement, similar to forwards and futures. Options are also time limited, usually in two ways. Where one can exercise the right either at expiry, or any time up to that point, we have an American-style option; where the right can only be exercised at expiry, we have a European-style option. Whichever type we are talking about, the rights embedded in options have value because of the potential to lock in a better price for the underlying asset than that prevailing in the marketplace. Hence, options trade at a price, which is known as the premium. For both calls and puts, this premium will partly be a function of the time remaining on the option. The premium will also depend on the expected volatility of the underlying security. All this is because time and volatility each add to the probability that the option will eventually end up “in the money”—to wit, at a level where the stipulated buy or sell point is attractive relative to the going market rate of the deliverable security. With calls in particular, the premium will be higher to the extent that the underlying asset price rises. This is owing to the fact that the option becomes more likely to expire “in the money”. With puts, the premium will be higher to the extent that that the underlying asset price declines. For that raises the chance of the put options ending up “in the money”. Calls thus represent a bullish bet, whereas puts are a bearish bet.
Concretizing all this with a couple of examples, consider first a December 110 call option on Disney. Suppose that the premium, or price, of that option is quoted at $4.50. With equity options, each contract represents 100 shares of the stock. Hence, one call option on Disney would cost $450 ($4.50 x 100 shares). To buy this call, then, is to obtain the right to buy 100 shares of Disney at $110 per share. Since it is an American-style option, one can exercise that right to buy prior to or at the December expiry (normally the third Friday of the month). From whom exactly can we buy these shares? It is not from Disney. Companies do offer options on their own account to compensate and incentivize employees, but these are not exactly the same as exchange-traded options. As a mode of seeking financing, companies also sometimes issue warrants, which are effectively call options with especially long life spans. But as we are dealing with traded options, the shares underlying an exercised call would have to be bought from someone who originally wrote that option. Once again, like futures and forwards, options are created from nothing but the mutual willingness of two parties to take opposing sides of a prospective exchange. As for an illustration of a put option, consider the December 110 strike on Disney quoted at $4.50. Everything about the purchase of such a put is the same as with the call except that the right acquired will be that to sell 100 shares of Disney. The party obligated to buy it from them consists of anyone who originally wrote a put.
Let us now travel forward in time near the option expiry time in December. If Disney then is at $130 per share, the December 110 call option will be in the money. It will be worth $20. Meanwhile, the December 110 put will be out of the money and so worth nothing. The value of the call reflects the fact that someone could buy the call, exercise the right to buy Disney at 110, and then immediately sell the shares at the going $130 rate to net a $20 profit. Any other price for the call would not last very long because it would create an arbitrage opportunity to earn a riskless profit. As for the put, that is now worthless inasmuch as there would be no point buying that option and then exercising the associated right to sell the shares at $110. After all, one can fetch a better price to sell at $130 by simply trading in the shares market. Conversely, if Disney were to end up at $90 per share, the call option would be zero, while the put option would in the money by $20. Arbitrage would again ensure such a price would prevail near the expiry date of the option.
One of the earliest instances of an option is mentioned in Aristotle’s The Politics. Even two-and-a-half millennia ago, the political significance of options was glimpsed. Aristotle, to be sure, did not use the term options to denominate the commercial transactions he described. The description arises when Aristotle attempts to demonstrate how securing a monopoly is the key to reaping huge profits. Secondarily, the description is also put forward to show that philosophers can make money if they apply themselves. Thus, Aristotle relates how Thales, a thinker known for his metaphysical claim that all things are reducible to water, used his knowledge of the heavens to gauge that it would be a good year for olives. It being still winter when Thales made this assessment, he was able to put down small deposits to secure the rights to the use of all the oil presses in Miletus and Chios. When summer came, and his forecast proved correct, he was able to sell his usage rights over the presses at a pretty price.  In effect, Thales bought oil press calls and then subsequently sold them to those willing to exercise the rights to use them in making olive oil. Closer to our epoch, we find Joseph de la Vega, the Jewish writer who recounts the seventeenth- century Dutch financial scene in his Confusione de Confusiones, describing options as better way than shares to bet on the fortunes of the Dutch East India Company.4 5 By the nineteenth century, American advertisements were referring to puts and calls, as an OTC market overseen by the Put and Call Dealers Association took shape. After surviving a brush with a legal ban after the 1929 crash, the options market was a sleepy business after World War II. What changed that was the founding of the Chicago Board Options Exchange in 1973. Other exchanges, including the AMEX and Philadelphia Stock Exchange, soon followed as the emergence of listed options trading gave a boost to the OTC market. At $63 trillion notional outstanding value, the OTC arena is about double the size of the $32 trillion exchange-traded market. Options are traded on just about everything for which there is a futures contract. Indeed, there are even options on futures—a derivative that derives from another derivative.
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