Options – a history

Although the options market as we know it commenced operations in 1973, the earliest trades can be traced back to Ancient Greece circa 332 BC when philosopher, astronomer and mathematician, Thales of Miletus, predicted a bumper year for olives. He knew that if he was correct, olive presses would be in high demand to process the fruit into olive oil. He couldn’t afford to buy up all the available olive presses; instead he put down a deposit to use all of the presses in his region. This transaction is widely considered to be the world’s first call option. He bought the right, not the obligation, to use those presses.

The tulip mania of the seventeenth century is often cited as the first speculative financial bubble, but did you know it was another early example of options trading? Tulips imported into Europe from Turkey and Holland became a symbol of affluence; the hype caused tulip prices to skyrocket due to overwhelming demand, with some tulip bulbs selling for more than 10 times the annual income of a skilled craftsman.

As prices skyrocketed, Dutch dealers started tulip bulb options trading so that producers could own the rights to owning tulip bulbs in advance and secure a definite buying price. In other words, call options on tulip bulbs.

Mass speculative interest in tulip bulb options led to people to buy those options with everything they owned, including food stores, property and household goods. Like all speculative bubbles, it collapsed, turning the buying frenzy into a selling frenzy. The price of tulip bulbs quickly collapsed and almost all speculators were wiped out as their options became worthless. The Dutch economy collapsed and people lost their money and homes.

While there are numerous examples of trading options throughout history, the modern financial options market commenced in 1973. Although an over the counter (OTC) options market had existed for 100 years prior in the United States, the establishment of the Chicago Board of Exchange (CBOE) and the Options Clearing Corporation signalled a milestone in exchange-based options trading.

What is an option?

An option is a contract that gives the owner the right, but not an obligation, to buy or sell an underlying security at a specific price on or before a certain date.

Just like a stock or a bond, an option is a security. It is also a binding contract with strictly defined terms and properties. If you buy an option, you have a right – but not an obligation – to do something.

It’s the equivalent of buying an insurance policy for your car – if nothing happens you lose the premium. If your car gets stolen or written off, the insurance company gives you an agreed value for your car. Buying call options or selling put options are akin to buying protection for an investment.

The underlying instrument can be a stock, an exchange-traded fund (ETF) or even an index – although because though you can’t actually buy an index, these options settle in cash. The ownership of an option does not represent ownership of the underlying asset; generally the holder is not entitled to any rights associated with that asset, such as voting rights or dividends.

Like many financial instruments, options have their own language – refer to the glossary if you’re unsure of a definition.

Glossary

Different types of options

There are two types of options: calls and puts.

Call options

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock.

An investor who expects the price of an asset to increase can buy a call option to purchase the asset at a fixed price (the strike price) at a later date, rather than just purchase the asset immediately.

The cash outlay is the premium, which is much lower than what would be required to purchase the asset. The investor has the right but not the obligation to buy the asset.

The risk of loss would be limited to the premium paid, unlike the possible loss had the stock been bought outright.

An investor who expects the price of an asset to decrease can sell or write a call option.

The investor selling a call has an obligation to sell the asset to the call buyer at a fixed price (the strike price).

If the seller does not own the asset when the option is exercised, he is obligated to purchase the asset at the then market price.

If the stock price decreases, the seller of the call will make a profit in the amount of the premium.

If the stock price increases over the strike price by more than the amount of the premium, the seller will lose money, with the potential loss being unlimited.

Put options

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are similar to having a short position on a stock.

An investor who expects an asset’s price to decrease can buy a put option to sell the asset at a fixed price (the strike price) at a later date.

The investor will be under no obligation to sell the asset. If the asset’s price at expiration is below the exercise price by more than the premium paid, the investor makes a profit.

If the asset’s price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

An investor who expects an asset’s price to increase can sell a put option.

The investor selling a put has an obligation to buy the asset from the put buyer at the strike price. If the asset’s price at expiration is above the strike price, the seller of the put will make a profit in the amount of the premium.

If the asset’s price at expiration is below the strike price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the strike price minus the premium.

Why use options?

Options are used by investors for a number of reasons, including:

• An investor can potentially generate positive returns from rising and falling markets.
• An investor can profit on changes in an asset’s price without having to actually buy the asset.
• The potential to earn additional income from shares – writing options against shares an investor already owns can provide additional income.
• Hedging against share price falls – options can be used to offset potential falls in share prices.
• When buying options, the risk is limited to losing the premium paid for the option, regardless of how much the asset’s price moves.

What are the risks?

As with any investment, there are risks associated with using options:

• Loss of the premium paid – for investors buying options
• Potentially unlimited losses when selling options, particularly where the underlying asset is not owned and has to be purchased to finalise the transaction.
• Margin calls – for investors selling options, the ASX may require extra security to be provided to ensure that obligations can be met if the options are exercised; this may hold for overseas exchanges as well.
• Complexity – some options trading strategies can be complex and risky if the strategy is not fully understood.
• Time consuming – the need to continually monitor options positions, markets and the macro-environment, which can impact option prices, can require a significant time investment.

Although there are significant benefits to be gained from using option strategies, it’s not for the faint hearted – or those who don’t have the time and expertise to closely monitor the relevant market/s and their option positions.

For this reason, many astute investors leave the option strategies to specialist managers. However, even if you’re not ‘hands on’ managing options strategies, it is still important to understand how options work and the benefits and pitfalls of using them.

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Disclaimer: This article provides general information only and has been prepared without taking account the objectives, financial situation or needs of individuals. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management ABN 14 125 715 004 AFSL 317587 (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Transactions in options carry a high degree of risk. Purchasers and sellers of options should familiarize themselves with the type of option (i.e. put or call) which they contemplate trading and the associated risks. Purchasing options may result in a loss of the premium paid plus any commissions or transaction costs. Selling an option may entail considerably greater risk than purchasing options and requires a margin deposit. Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of the premium amount.

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