Put and Call Options
We’re in pre-Socratic Greece, somewhen around 600 BC. A certain Thales of Miletus, convinced that the forthcoming olive harvest will be bountiful, purchases a contract (for 5 drachma) that bestows on him the right – but not the obligation – to reserve an olive press in Miletus for 100 drachmae. When the 599 BC harvest is indeed abundant, the demand for olive presses pushes rental prices up to 150 drachmae. Thales exercises his contract, rents out his olive presses, and makes a tidy fortune (of 45 drachmae per olive press, to be exact).
The option contract is born.
To add fruit to the stone, notice that if Thales’ prediction had been wrong and the olive harvest poor, his contract expires unused: it is the right but not the obligation. His maximum loss would be just the 5 drachma paid for each contract, regardless of how far rental prices fell. Note also that Thales’ return is very substantial: a 45 drachmae profit from each 5 drachma spent is a profit of 800%. Compare these results to simply renting the presses at 100 drachmae at the outset: the return on the prices rising to 150 drachmae is just 50% of his invested capital, and he could lose up to 100 drachmae (if prices fall to zero). Thales’ contract limited his downside and gave super-charged leveraged upside.
Thales’ deal was a “call” option; the right – but not the obligation – to buy an asset in the future at a price that we agree today. A “put” option is identical except that it affords the owner the right to sell said asset. Both types of contracts will state: the underlying asset, the time period, the exercise (or “strike”) price, and the option cost (or “premium”).
Thales’ purchase was speculative – he bought the contract on a bet that prices would go up. Note that this contract is hugely risky: if prices had remained at or below 100 drachmae, Thales would have lost (indeed, prices needed to rise to 105 drachmae just to break-even and cover the option premium).
Aside from speculation, however, options – in particular put options – can be used to provide portfolio insurance. An investor with a portfolio of UK equities concerned about the outlook for the market could choose to buy an equity index put with, say, an exercise level of 7,000. If the index falls below 7,000, our investor can exercise her option and recoup the losses on her portfolio: in effect she puts a floor under the value to which her portfolio can fall, while leaving the upside unhindered (save for the cost of the contract).
One of the most frequent ways in which retail investors meet options is via enhanced income funds, such as one of our favourites, RWC Enhanced Income. These funds will typically sell (or “write”) call options on the stocks that they hold. This earns an immediate premium (a bird in the hand) but gives up the potential future rise in the share price (two in the bush). If stocks fall, losses made in the portfolio will be partly offset by the premium received on the unexercised call contract. In effect, such funds limit their upside in return for a higher yield, and do particularly well when markets move sideways.