What are options?
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Options contracts traded in the financial markets are ultimately just options! A lot of people think of options firstly as complex derivatives, but the easiest way is to realise that a financial option is just a choice about whether to do something, no different to any other option we might have.
So let’s think about an option we might encounter in everyday life. Suppose your friend offers you the option to join him at a music concert. Let’s consider what this option might mean to you and what might affect its value. Firstly, this option may be intrinsically valuable to you. Maybe the concert involves your favourite musicians whom you have waited your whole life to see play? You would certainly think an option to go to this concert is going to be valuable to you. But for how long do you have the option? If the option is only good for this evening, then that is pretty short notice. Maybe you have another engagement and can’t attend. Clearly, it would be a better option if it lasted longer; if your friend can let you join him at the concert any time this week or month, it’s a lot more valuable to you. What if your friend can’t be sure who is playing at the concert? This changes things again. If you can’t be sure it’s your favourite band playing, going to the concert may not be as great for you as you originally thought. So that uncertainty about the outcome of exercising the option, reduces its value in this case.
Let’s tidy this up a bit. What we are saying is that if you have the option to do something, the value of that option to you is going to depend on a number of factors. Firstly, whether the outcome from exercising the option is intrinsically good or bad. If I give you the option about whether or not I stamp on your toe, then this option has no obvious intrinsically good value for you. Secondly, if there is uncertainty about the outcome, that can affect the value of the option. Suppose I give you the option that I will either stamp on your toe or give you $100, with a 50:50 chance of either outcome. This option might be valuable to you (depending on how highly you value your toes); so in this case, increasing the uncertainty of the outcome increases the value of the option. Thirdly, having an option to do something for longer, is generally more valuable than having it for only a short time. For example, if you have the “get stamped on/get $100″ option for a week, maybe you can go an buy some steel-toe capped boots and then exercise the option? But if the option is ‘now or never’, it’s value is lower to you.
Financial options are not just similar to options like these; they are options exactly like these. If you are offered a call option, this just gives you the option to buy a product for a certain price by a certain date. The value of this option to you is going to depend on whether the trade is intrinsically valuable (i.e. whether buying the product via the option is better than buying the product in the market), how long you have to exercise the option and also how much uncertainty there is in the price of the product. If the price of the product never changes and the option has no intrinsic value right now, then it never will have intrinsic value (because the price of the product will never move to make the option valuable). But a bit of uncertainty over the future price of the product could make the option valuable now even though it is not intrinsically valuable; because the price of the product may rise in the future above the price at which you have the option to buy.
So, what are options? Options in the financial markets are simply regular options, no different in essence to those we have in everyday life. Their terms and conditions are spelled out carefully in the form of a contract and they typically involve actually buying or selling something else. But a lot of the ideas around the pricing and risk of options can easily be understood by simply recognising that financial options are ultimately just options!
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