Jargon Busting: Call and put options

Jargon Busting: Call and put options

We are in pre-Socratic Greece, somewhere around 600 BC.

A certain Thales of Miletus, convinced that the forthcoming olive harvest would be bountiful, purchased a contract that bestowed on him the right – but not the obligation – to reserve all the olive presses in Miletus for 100 drachmas apiece. The contract would cost him five drachmas per press.

When the 599 BC harvest turned out to be indeed abundant, the demand for olive presses pushed rental prices up to 150 drachmas. Thales exercised his contract, rented out his olive presses, and made a tidy fortune (of 45 drachmas per olive press, to be exact).

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And there the option contract was born.

It’s important to point out that had Thales’s prediction been wrong and the olive harvest poor, his contract would have expired unused: it was the right he was agreeing to, not the obligation.

The maximum loss he would have incurred would be just the five drachmas paid for each contract, regardless of how far rental prices fell.

Note too that Thales’s return was very substantial: a 45-drachma profit from each five drachmas spent was a profit of 800 per cent.

Compare these results to simply renting the presses at 100 drachmas at the outset: the return on the prices rising to 150 drachmas was just 50 per cent of his invested capital, and he could have lost up to 100 drachmas (if prices had fallen to zero).

Thales’s contract limited his downside and gave him supercharged upside.

Thales’s deal was a ‘call’ option: the right – but not the obligation – to buy an asset in the future at a price that was agreed earlier.

A ‘put’ option is identical except that it affords its owner the right to sell said asset.

Both types of contracts will state the underlying asset, the time period, the exercise (or ‘strike’) price, and the option cost (or ‘premium’).

Note that Thales’s contract was hugely risky: if prices had remained at or below 100 drachmas, he would have lost his bet that prices would go up (indeed, prices needed to rise to 105 drachmas just to breakeven and cover the option premium).

Aside from speculation, however, options – in particular put options – can be used to provide portfolio insurance.

An investor with a portfolio of UK equities concerned about the outlook for the market could choose to buy a FTSE 100 index put with, say, an exercise level of 7,000.

If the index falls below 7,000, our investor can exercise her option and recoup the losses on her portfolio: in effect she puts a floor under the value to which her portfolio can fall, while leaving the upside unhindered (save for the cost of the contract).

One of the most frequent ways in which retail investors meet options is via enhanced income funds, such as the RWC Enhanced Income.