In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explains why financial markets invented options and how they function.
A historical perspective on options
The history of options is surrounded by legends.. This story is linked to human’s desire to control the unpredictable, sometimes to protect himself from it, often to profit from it. This story is also that of a flower: the tulip. At the beginning of the seventeenth century, in the Netherlands, the tulip was at the origin of the first known speculative bubble. Furthermore, this was historically the first time that options contracts were used on such a large scale. The possibility of profiting from the rise in the price of tulips by paying only a small part of the price aroused great interest on the part of speculators, thus increasing the price of the precious flower tenfold. Soon the price of the tulip reached levels completely unrelated to its market value. Then, suddenly, demand dried up, causing the price to fall even faster than the previous rise. The crisis that followed had serious consequences and confirmed Amsterdam’s loss of world leadership in finance to the benefit of London, which had already taken over the Dutch capital as the world’s center for international trade. Educated by the Dutch experience, the British became increasingly sceptical about options, so much so that they eventually banned them for over a century. The ban was finally lifted towards the end of the 19th century. It was also at this time that options were introduced in the United States.
The American options market entered a new dimension at the end of the 20th century. Indeed, 1973 was a pivotal year in the history of options in more ways than one. In March 1973, a floating exchange rate regime was adopted as the standard for converting international currencies, creating unprecedented instability in the currency market. This was also the year of the “first oil shock”. Also in 1973, the Chicago Board Options Exchange (CBOE), the first exchange entirely dedicated to options, opened its doors. The same year saw the birth of the Options Clearing Corporation (OCC), the first clearing house dedicated to options. Finally, 1973 saw the publication of the work of Fischer Black and Myron Scholes. This work was completed by Robert Merton, leading to the Black-Scholes-Merton model. This model is of capital importance for the evaluation of the price of options.
What’s an option?
There are two types of option contracts: calls and puts. Since these contracts can be both bought and sold, there are four basic transactions. Thus, in options trading, it is possible to either go long (buy a call contract, buy a put contract), or to be short (sell a call contract, sell a put contract). An option contract can therefore be defined as a contract that gives the counterparty buying the contract (the long) the right, but not the obligation, to buy or sell an asset (the underlying) at a predetermined price (the strike price), date (the maturity date) and amount (the nominal value). It is useful to note that the counterparty selling the contracts (the short) is in a completely different situation. This counterparty must sell or buy the underlying asset if the transaction is unfavorable to it. However, if the transaction is favorable, this counterparty will not receive any capital gain, because the counterparty buying the contract (the long) will not have exercised its call option. To compensate for the asymmetry of this transaction, the counterparty selling the option contracts (the short) will receive a premium at the time the contract is initiated. The selling counterparty therefore has a role similar to that of an insurance company, as it is certain to receive the premium, but has no control over the time of payment or the amount to be paid. This is why it is important to assess the amount of the premium.
The characteristic of an option contract
Options contracts can have as underlying assets financial assets (interest rates, currencies, stocks, etc.), physical assets (agricultural products, metals, energy sources, etc.), stock or weather indices, and even other derivatives (futures or forwards). The other important feature of an option contract is its expiration date. Options contracts generally have standardized expiry dates. Expiry dates can be monthly, quarterly or semi-annually. In most cases, the expiration date coincides with the third Friday of the expiration month. In addition, options whose only possible exercise date is the maturity date are called European options. However, when the option can be exercised at any time between signing and expiration, it is called an American option. Ultimately, what will drive the holder of an option contract to exercise his right is the difference between the underlying price and the strike price. The strike price is the purchase or sale price of the underlying asset. This price is chosen at the time the option contract is signed. The strike price will remain the same until the end of the option contract, unlike the price of the underlying asset, which will vary according to supply and demand. In organised markets, brokers usually offer the possibility to choose between several strike prices. The strike price can be identical to the price of the underlying asset. The option is then said to be “at-the-money” (or “at par”).
In the case of a call, if the proposed strike price is higher than the price of the underlying, the call is said to be “out of the money”.
Are you “in the money”?
Let’s take an example: a share is quoted at 10 euros. You are offered a call with a price of 11 euros. If we disregard the premium, we can see that a resale of the call, immediately after buying it, will result in a loss of one euro. For this reason, the call is said to be “out of the money”. On the other hand, when the strike price offered for a call is lower than the price of the underlying asset, the call is said to be “in the money”. Another example: the stock is still trading at 10 euros. This time you are offered a call with a strike price of 9 euros. If you disregard the premium, you can see that you earn one euro if you sell the call immediately after buying it. This is why this call is called “in the money”. Note that our potential gain of one euro is also called the “intrinsic value” of the call. Of course, the intrinsic value is only valid for “in the money” options. For puts, it is the opposite. A put is said to be “out of the money” if its strike price is lower than the price of the underlying asset.
Finally, a put is said to be “in the money” if its strike price is higher than the price of the underlying asset. If you are one of those people who think that you can make money with options by simply buying and selling calls or puts “in the money”, I have bad news for you! In reality, the premiums of the different contracts are calculated in such a way as to cancel out the advantage that “in the money” contracts offer over other contracts.
Related posts on the SimTrade blog
▶ Verlet A. Understanding financial derivatives: futures
▶ Verlet A. Understanding financial derivatives: forwards
▶ Verlet A. Understanding financial derivatives: swaps
About the author
Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).