In my last post, I shared some of my thoughts on eastern Australia’s emergence from lockdown and what that might mean for the economy. Over the next few posts, I will be introducing you to various topics in finance and tax, sharing insights from my experience as an accountant, as well as from my PhD studies. I will be drawing on examples from the pandemic, as well as current events, to help you understand some of the concepts.
This week’s post is all about options.
Option contracts are commonly used in finance as a hedge against uncertainty, something of which there has been no shortage due to COVID-19, as so much relating to the virus has been outside our control.
This post will not teach you how to make money (sorry!). But it will address something that is important if you do want to make money: namely, how to protect yourself from loss by minimising risk. I’m not only talking about the known risks that come with every investment; I’m also talking about the unknown risks – in other words, the things we don’t see coming, like pandemics. As the saying goes, always plan for the best and prepare for the worst!
What is an option?
Contracts similar to options have existed since ancient times. One of the first known option-buyers was Thales of Miletus (c.625–547 BC), an ancient Greek mathematician and philosopher.1 Deducing from his knowledge of the stars that there would be a good crop of olives one year, when it was still winter he paid a small sum to secure the right to use a number of oil presses in the spring. The time of the harvest came, and as the oil presses were in high demand, he was able to hire them out at a much higher price than what he had paid for his ‘option’.
In modern finance, an option is a contract that gives the holder the right, but not the obligation, to purchase shares in a company at some future date, at a specified price, known as the ‘exercise price’, or ‘strike price’.
For example, the right to buy Telstra shares in 12 months’ time for $4. This is known as a ‘call option’. In contrast, a ‘put option’ gives the holder the right, but not the obligation, to sell shares.
Options can be used to minimise potential losses from movements in a company’s share price.
For example, let’s say you were interested in buying Telstra shares in 12 months’ time, but you were worried that the share price may be about to rise. You purchase 10,000 call options to buy Telstra shares with an exercise price of $4 per share, maturing in 12 months. If over the next 12 months the Telstra share price increases to $5, then the option to buy at $4 per share would clearly be worth exercising, as this would be cheaper than buying Telstra shares on the market. (Such an option is said to be ‘in the money’, i.e., it has value).
On the other hand, if over the next 12 months the Telstra share price were to fall to $3, you would not exercise the option to buy the shares at $4, as it would be cheaper to buy the shares on the market. Such an option would be ‘out of the money’, i.e., it would have no value. The option would lapse, or expire, without being exercised.
Perceptive readers may have a couple of questions after reading the above:
- If there’s a chance that the option might not be exercised, then why would I buy it?
Excellent point! Because of the uncertainty surrounding their exercise (we don’t know what the actual share price will be in 12 months’ time), options are typically worth much less than the underlying shares you want to buy (or sell). You can think of options as a form of insurance – it may be worth paying a small price now to protect yourself in case share prices move against you in the future.
The price you will pay for an option varies depending on the share price of the company and its volatility, the option exercise price and the time until the option expires. A ‘rule of thumb’ is that the greater the uncertainty, the more valuable the option, due to the wider range of possible outcomes. (Recall our Greek philosopher friend – he wouldn’t have been able to ‘cash in’ to the extent that he did if the olive harvest was fairly predictable from year to year, as the demand for oil presses would be more stable.)
- Isn’t this just a form of betting on the future?
You’re quite correct, options can be used to speculate, but this is extremely risky, and I do not recommend it. That is why I’ll be focusing on how options can help us reduce risk in this post.
In finance, the concept of a ‘real option’ is used when deciding whether to undertake certain projects in the presence of uncertainty. Real options can include the decision to defer or wait, or abandon the project entirely.
A well-known example of a ‘real option’ is the decision to open and close a mine in response to price movements of metals2 (though many other investments can be real options as well). In a nutshell, because the profitability of the mine depends on the market price of the mine’s output, higher volatility in metal prices can affect the mine’s viability, and hence the decision to open or close.
Understanding ‘real options’
But how does all of this affect me, I hear you ask?
We need look no further than COVID-19. In addition to being a potentially deadly virus, COVID-19 is a difficult (and expensive) disease to treat, even for those patients who ultimately recover. Not only is there the cost of PPE and ventilators, but COVID patients tend to stay in hospital for longer. With ICU beds often at a premium, particularly in regional areas, a COVID outbreak can have devastating flow-on effects if hospitals are stretched. An outbreak also puts pressure on GPs, who are the primary care providers for millions of us.
To add to all of this, the impact of COVID-19 on an unvaccinated population is particularly difficult to estimate, as it is much more transmissible than the flu, and has varying impact on the population. Some people will only experience mild symptoms, while others will get very sick.
Before we had access to the vaccines, we relied on a combination of public health measures to limit the spread of the virus and minimise its impact:
- Travel restrictions
- The dreaded ‘Locky D’.
As we all know, none of these measures came without a cost. The measures that were most effective at limiting transmission of the virus, i.e., travel restrictions and quarantine, were also the measures that decimated the tourism and education industries, and are continuing to keep families apart. Lockdowns are also extremely costly, with Victoria’s lockdown alone estimated to have cost the economy around $100 million a day, not to mention job losses, business closures, and mental health impacts.
So why did our governments persist with such strict lockdowns, knowing the cost?
While this is not a typical example of a real option, the decision to introduce (and lift) COVID restrictions is an example of decision-making under uncertainty – due to the difficulty in quantifying the cost of living with COVID without an effective vaccine.
Unfortunately, this meant that governments were ‘damned if they did, damned if they didn’t’.
What would it have cost us in terms of lives lost and economic impact if we didn’t have to live with the restrictions? No-one knows. But I believe that our COVID experience highlights the importance of ‘preparing for the worst’ when it comes to our money and our health.
As we have seen, when it comes to money, options contracts are one way of ‘preparing for the worst’ in case share prices move against you.
Similarly, when it comes to our health, regular Pearlers would recognise that we have a number of low-cost options available to us for improving it. Buying fresh, green vegetables and carrots, fresh fruit and healthy carbs; reducing consumption of sugary drinks and ‘empty’ carbs; getting enough sleep and exercise can all keep us healthy. This doesn’t mean we’ll never get sick. In this regard, the public health system can be thought of a form of insurance, as are vaccinations, which provide protection from infectious diseases. It is having this insurance that enables us to invest and do business with greater confidence!
1. Protect yourself from losses by minimising the downside.
2. Consider the cost of waiting, or not acting, when making decisions under uncertainty.
3. Look for opportunities where the costs are small relative to the potential benefits.
I will be exploring some of these ideas further in my next post.
I am indebted to Max Hewitt, who was my tutor for ACCT3563 Issues in Financial Reporting & Analysis at UNSW (2003), for his clear explanations of options and other derivatives, as well as lecture notes for this course prepared by Associate Prof. Richard Morris.
1 Poitras G. (2009). The early history of option contracts. In Hafner W., Zimmermann H. (eds.), Vinzenz Bronzin’s Option Pricing Models. Springer: Berlin, Heidelberg. Retrieved from https://doi.org/10.1007/978-3-540-85711-2_24
2 Moel, A. & Tufano, P. (2002). When are real options exercised? An empirical study of mine closings. The Review of Financial Studies, 15(1), pp.35–64.