Options are economic tools that allow you to manage future uncertainty and maximize returns. They are useful not only in financial products but also in everyday life, and understanding them can help you make better decisions.
When we think of options, we tend to think of financial instruments, but there are many phenomena around us that can be characterized as options. From everyday choices to business decisions, the concept of options is utilized in a variety of situations. A good understanding of the nature of options can help us understand economic phenomena involving risk. Essentially, an option is defined as “the right to buy or sell an instrument (the underlying asset) at a predetermined price (the strike price) at a certain time in the future (the time of exercise).” This makes options a flexible economic tool that can be exercised in favorable circumstances and abandoned in unfavorable ones.
The first options in history date back to the time of ancient Greece. Thales of Miletus, known to many as the father of geometry, is said to have developed an option on an olive oil press. At the time, people had to pay to rent a press to get oil from olives. “Thales of Miletus bought the right to rent a press at harvest time for a certain rent for a small amount of money in advance during the sowing season. If there was a bumper olive harvest, many people would want to rent the presses and the rent would rise. Thales of Miletus could then make a large profit by renting out the presses at the contracted rent during the sowing season and then renting them out to people at the newly established rent during the harvest season. However, if you have a bad harvest, you can give up the right to rent the press. “We can see that the rights that Thales of Miletus contractually buys during the sowing season are in the nature of options, the right to buy.
As such, options create asymmetries in returns because they are options that can be exercised when circumstances are favorable and given up when circumstances are unfavorable. This is an important concept not only in modern finance, but also in various business and investment strategies. For example, when investing in a new project or product development, companies can apply the concept of options to minimize risk and maximize potential profits, creating a structure that allows them to reap large profits if the project is successful, while only losing their initial investment if it fails. These options strategies play a key role in a company’s financial management and strategic decision-making process.
It’s easier to understand the nature of options if we look at the example of stock options, which have a stock as the underlying asset. For example, suppose you buy the right to buy a share of a company’s stock at $10,000 per share in two years for $1,000 today. If the price of the company’s stock is above $10,000 in two years, it’s in the option holder’s favor to exercise the option. If it’s at $15,000, you’ve made a $5,000 profit on your $10,000 purchase, so your profit is $4,000 per share, minus the $1,000 purchase price of the option. However, if it falls short of the $10,000 mark, you can give up the option and only lose $1,000.
Here we can see that the profit of a stock option holder is dependent on the price change of the underlying stock. This illustrates why options are important not only in the stock market but in many other financial instruments. This is why companies give stock options to executives as an incentive. It’s easy to think that there is no option premium in this case, but the option premium is the cash that the executive gives up in exchange for the option.
Because of the asymmetry of returns, options allow you to react to price movements in the underlying asset with less money. Because of this, options can be a risk management tool that allows you to deal with future uncertainty. However, if the option holder can influence the price of the underlying asset, options can also encourage the holder to take on greater risk. For example, a manager with the right to buy shares has a strong incentive to choose a business that has a high probability of increasing the price of the underlying asset, but also a high probability of decreasing it. This means that the interests of shareholders and managers may not be aligned, and understanding the structure of options is key to effectively managing this conflict.
Understanding these characteristics of options is crucial to understanding a variety of economic phenomena, including the behavior of shareholders and managers. In addition, individual investors and consumers can make better decisions by incorporating the concept of options into their financial strategies. For example, when buying a house or a car, you can use option contracts to manage the risk of price fluctuations. As you can see, options are a concept that can be used not only in the financial markets, but also in our daily lives. Therefore, a deeper understanding of options can help you broaden your financial acumen and make smart decisions in a variety of situations.
