Can options help us understand how investments work?
Sure they can. Options are choices: the right, but not the obligation, to buy or sell something. When you combine investment options with other instruments, you can see how the combination explains how another investment works.
First, we need a quick course on option pricing. An option price has four major components: the stock price, the exercise price, the time left until expiration, and the underlying volatility stock. If you wanted an option to buy or sell shares of Apple at $200 last week, you would pay $0.32 for the call and $0.28 for the put option. The options were cheap because they expired on Friday.
Apple option chain. Source: NASDAQ
There are all kinds of options strategies where you combine buys and sells to create a unique payout structure. The varieties and their associated names – call spread, put spread, back spread, butterfly, straddle, condor – are endless.
Source: Options Industry Council
We can also look at combining different instruments. A Corporate bond can be looked at as the combination of a risk-free bond and a put the bondholder sells on the company’s credit. The management has the right to sell ownership of the company to the bondholders by filing for bankruptcy. There are two important things to know with any option strategy: when you buy an option, time works against you, but volatility works for you. When you sell an option, time is on your side, but volatility works against you. So to go back to corporate bonds, when you buy a corporate bond, you want the world to be boring. You can earn more than the risk-free rate, as long as the world remains stable. You want the puts that you’ve written to management to expire worthless.
There are a whole host of financial instruments that can be considered combinations of options with other items – options on risk-free bonds, or on broad market indices, or even on economic growth. By looking at how options behave, we can see what makes market strategies work – and why they might not work.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”