This blog post explores how options work in daily life and investing, and how they aid economic decision-making.
While options often bring financial instruments to mind, many phenomena around us actually possess option-like characteristics. The concept of options is utilized in diverse situations, from everyday choices to corporate decision-making. A solid grasp of option characteristics greatly aids in understanding risk-related economic phenomena. Fundamentally, an option is defined as “the right to buy or sell a specific commodity (the underlying asset) at a predetermined price (the strike price) at a specified future time (the exercise date).” This allows options to function as flexible economic tools: they can be exercised to one’s advantage when conditions are favorable, or forfeited when conditions are unfavorable.
The earliest recorded options in history date back to ancient Greece. Thales of Miletus, known to us as the father of geometry, is said to have developed options for olive oil presses. At that time, people had to pay to rent a press to extract oil from olives. Thales of Miletus paid a small amount of money in advance during the sowing season to secure the right to rent a press at a fixed rental fee during the harvest season. If the olive harvest was bountiful, demand for the presses would increase, driving up rental prices. In this scenario, Thales of Miletus could rent the presses at the fixed rate agreed upon during the planting season and then lease them to others at the newly inflated market rate during the harvest season, reaping substantial profits. Conversely, if the harvest was poor, he could simply forgo exercising his right to rent the presses. The right Thales of Miletus acquired through his contract during the sowing season is, by its nature, an option—a right to buy.
Because options are choices that can be exercised when advantageous and abandoned when disadvantageous, they create asymmetric returns. This is a crucial concept not only in modern finance but also in various business and investment strategies. For example, when investing in new projects or product development, a company can apply the concept of options to minimize risk and maximize potential profit. This creates a structure where significant gains are possible if the project succeeds, while only the initial investment is lost if it fails. Such option strategies play a pivotal role in corporate financial management and strategic decision-making.
Examining the case of stock options, where stocks serve as the underlying asset, makes understanding the nature of options even easier. Suppose you purchase the right to buy a company’s stock at $10,000 per share two years from now for $1,000 today. If the company’s stock price exceeds $10,000 two years later, it is advantageous for the option holder to exercise the option. If it reaches $15,000, they buy at $10,000 and gain a $5,000 profit. Subtracting the $1,000 option purchase price, the net profit is $4,000 per share. However, if the price falls below $10,000, they can simply abandon the option, limiting their loss to the $1,000 paid.
Here, we see that the holder’s profit depends on changes in the price of the underlying stock. This clearly demonstrates why options are important not only in the stock market but across various financial instruments. This is precisely why companies grant stock options to managers as incentives. While it might seem like there is no option premium in this case, the cash the manager forgoes by receiving the option instead can be viewed as the option premium.
Due to the asymmetry of returns, options allow one to respond to price fluctuations of the underlying asset with relatively little money. This makes options a risk management tool that helps cope with future uncertainty. However, when the option holder can influence the price of the underlying asset, options also have the aspect of encouraging the holder to choose greater risk. For instance, a manager with the right to buy shares has a strong incentive to choose ventures likely to significantly increase the underlying asset’s price. Yet, such ventures also carry a higher probability of causing substantial price declines. This highlights potential misalignment between shareholders’ and managers’ interests, making understanding the option structure crucial for effectively managing such conflicts.
Grasping these characteristics of options is vital for comprehending various economic phenomena, including the behavior of shareholders and managers. Moreover, individual investors and ordinary consumers can also make better decisions by incorporating option concepts into their financial strategies. For example, when buying a house or a car, option contracts can be used to manage the risk of price fluctuations. Thus, options are a concept that can be widely applied not only in financial markets but also in our daily lives. Therefore, a deep understanding of options broadens economic insight and greatly aids in making wise decisions in various situations.
