How does the Options market work and can you use a lifelike example of a put / call position which is relatable?
In: Economics
Examples. I’m going to use baseball cards.
My friend has a card that’s worth $100 today. It’s pretty rare but you can buy them on ebay for $100. Now this player, I think he sucks and that his card is WAY over valued. I think that this card will fall to $50 within the next year.
So my friend and I cut a deal. He will lend me his card, and I will give him back a card in 12 months time. Same player, same card condition. It won’t be his literal card, but he does not care as long as it’s the same player in the same condition. In exchange for borrowing his card, he charges me $5 for the year.
So I borrow my friends card, and sell it on Ebay for $100. I wait 1 year and it turns out I was right! I buy a card, same player and quality, for $50 and return it to my friend on time.
So I’ve made a profit of $45 ($50 profit less the $5 rental).
That’s a “put” option. The key concept is that one stock in a company is exactly equal to any other stock in that company. So I can borrow a stock, sell it, then purchase it at a later time and return it to the lender. The lender does not care if they get returned a stock that is not the literal stock that was borrowed as long as it’s the same class and the same company, stocks are interchangeable that way.
Therefore a put option is a bet on a stock (or baseball card) value going down over time. A bad thing to consider is that losses are basically unlimited. If I’m wrong and the stock price goes up and not down, I’m still obliged to purchase the stock and return it to the lender. Since the stock price “could” go up infinity, my potential for loss is also infinite.
A call option is basically the exact opposite. Rather than a contract to borrow a stock and return it at a later time, it’s a contract to purchase a stock at a later time.
Back to the baseball cards. My friend has a card that he thinks will keep a constant price or even fall a little but he does not want to sell it right now (for whatever reason). I think the price will go up, and I really want to buy it.
Currently the card is worth $100. So we write a contract. I have the option (but not the oblation) to buy the card in 1 year’s time for $100, and in exchange for this I’ll also give him $5 today.
If the card’s market price goes down, I lose my $5 but don’t have to buy my friends card, I can go buy some other card. If the market price goes up to $150, I can force my friend to sell me the card for $100. So (accounting for the $5 fee) I have now made a profit of $45!
Now these options don’t have to be at the current market price. Often these kinds of options are used as a form of employee compensation. Lets say I work for a large company and their stock price is currently $100 per share.
I’m working on a big project that will make the company a lot of money. If I’m not successful it will not make a lot of money. I want more money to keep doing this work for this company, but my company does not want to take the risk if I’m not successful. So we agree on stock options.
In addition to my salary, I get the option to buy stock at a later date. So in 1 year’s time I have the ability to purchase stock at today’s price ($100). If my project is a big success, surly the stock value will go up over that year. If my project fails, the stock price will not change. I receive 1,000 of these options.
2 scenarios:
First, one year later and my project is a smashing success. Stock price is up to $150. I take my 1,000 options and use the choice to buy stock for $100 each. I spend $100,000 to use all 1,000 options at $100 per option. I immediately own 1,000 shares of company stock. Stock that is currently worth $150,000. Effectivly my company has paid me a $50,000 bonus.
Second scenario. My project is a flop. Stock price stays at $100. I don’t do anything with my stock options and they expire. I don’t get a bonus and am sad.
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