Photo: William S. Farrow. Source: US Army
Options are choices. They represent the ability, but not the obligation, to buy or sell something. Financially, we know that options are complex instruments that have strike prices, an implied leverage and time-decay. They’re priced according to a complex formula that only folks with high-powered math or finance degrees really understand. But they show up in all kinds of unexpected places.
Take mortgages, for example. Most of us have a mortgage on our homes – a secured loan which we pay monthly to the bank or mortgage company. And we know that we can pay it off any time. That ability to prepay (or refinance) our mortgagesis a prepayment option. It gives us the ability (but not the obligation) to reduce how much we pay to own our homes.
Sometimes folks give family members a “right of first refusal” if they want to sell a family property. That right gives the others the chance to purchase the property – and keep it in the family – before the seller goes to the outside market. These come up in business transactions, too, often between partners. If one of the partners wants to sell their stake, they must first give the other a chance to buy them out before offering it to someone else.
Investments can have options, too. There are convertible bonds, which the holder can exchange for stock if the shares take off. Convertible stock is sometimes issued by start-ups to investors who want a more senior position in the capital structure if things don’t work out. These call options often get exercised if the company does well and the bondholders want to be equity holders. After all, bonds only pay principal and interest. Equity investors are the ones who get the growth.
Probably the most common investment options are callable bonds. In this circumstance, the issue has the right to pay off the bond before it matures. Issues usually do this when interest rates fall. Most municipal bonds are callable after 10 years, and many corporate bonds have call provisions. Treasuries almost never have call options; conversely, US Agency bonds are almost always callable. These options all can be valued according to the standard financial formula
Black-Scholes options pricing formula. Source: Wikipedia
Options are all around us, in our personal and financial lives. Every time we make a choice, we’re exercising an option. Once we know what to look for, we start to notice options everywhere.
Options all have value, and they have curved profit and loss profiles. If you own an option, you want the market to move. If you sell an option, you want it to expire worthless. Understanding how options work and where we can find them gives us a lot of insight into how our finances work. And sometimes, they can tell even more.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”