What is an “Option”?
When an investor has the right without any obligation to do something, the investor owns an option. Put simply, an option grants the owner the right to either do something or do nothing in the future depending on which action will yield the larger return. In financial markets, an option is usually the right to either buy or sell a security at a fixed price.
There are generally two types of options. A call option is the right to buy and a put option is the right to sell. Suppose an investor buys an option that gives her the right to buy one share of stock for $100 one year from the purchase of the option.
Two general scenarios are possible in one year’s time:
- The stock is selling for less than $100 in which case the investor would do nothing (not exercise the option) because it would be foolish to buy something for $100 that is worth less than $100.
- The stock is selling for more than $100 in which case the investor would exercise the option to buy the stock because it is wise to buy something for $100 for something that is worth more than $100.
By exercising the option, the investor will make an instant profit. Of course, real options allow for the purchase or sale of many more shares than just one. Put options are similar but they give the investor the right to sell rather than buy.
Cost of Options
Car insurance is a kind of put option in which an owner can, essentially, sell the car to the insurance company in the event of an accident. The insurance company is willing to take the risk for you (and many others). However, car insurance is not free and neither are options. Owners of options have paid a price for the right to buy (call option) or sell (put option). Options are still valuable, however, because the most the owner can lose is the price paid for the option.
Once purchased, a call option is worth the greater of zero or the difference between the current selling price and the strike price of the underlying security. The strike price is the price specified in the option for which the underlying security can be purchased. Options whose value is zero are considered “out-of-the-money” and options worth more than zero are considered “in-the-money.”
Some options are not necessarily formal documents governed by contract law. These hidden options, for example, can exist as laws of governmental agencies at the local or national level. For example, the option to declare bankruptcy is an option in the event a firm’s current debt can not be covered by current assets and the organization is in danger of default. Bankruptcy is a legal protection from creditors and is an option offered to organizations by law. Although bankruptcy represents serious problems for corporation, it is a viable option when no other alternative is available.
Value of Options
Options are valuable because they represent the right without an obligation to do something. Exercising an option that is in-the-money can return huge cash flows if the investor was correct about the future direction of the underlying security. Options which are out-of-the-money are not exercised and the investor loses only the amount paid for the option.
This post is part of the series: Principles of Value and Economic Efficiency
The main purpose of a firm is to create value and only part of creating value involves making money. The four principles of value and economic efficiency illustrate that making money is an outcome of creating value.