Insights Out: Options With Options—The Basics

…When Paul Samuelson was originally studying options, he went out to the brokers to understand these contracts.

And at the time, a lot of these dealers were European refugees.

So he's asking a lot of questions. And apparently one of these dealers was quite skeptical of his efforts, and he told them that he would never understand options because it requires a sophisticated European mind.

And so when Samuelson started publishing on this topic, he named the more complicated version the American version. As sort of a revenge to get back at this former slight.

Hello, and welcome to Insights Out, our new video series focused on quantitative insights from the various research teams here at T. Rowe Price.

My name is Stefan Hubrich, and I'm the head of global multi-asset research at our firm. Our first episode today is titled “Options With Options.” We'll be looking at options securities and how they can be used in portfolios. That's a really complex topic, and so I'm lucky that I don't have to tackle it alone. In fact, today, I'm joined by my colleague Gerard Brunick, who recently wrote a really relevant paper in this very area.

The paper is titled “Subjective Distributions for Tactical Asset Allocation.”

Let's talk about you a little bit before we jump into the content. So, how come you know so much about options?

So I did a Ph.D. in financial mathematics, and I've done some academic work related to option pricing. I've also worked in the energy industry and now in the asset management industry, where I've managed option models and done research related to option-based investment strategies.

Okay. I think we're in good hands. Now I feel very confident. So let's start with the basics. Not everybody in our audience may know what an option is. So what's an option?

All right. So an option is a contract that gives the holder the right, but not the obligation, to buy or sell a security at a future point in time at a fixed price.

And so that fixed price is called the strike of the option. And the act of choosing to buy or sell is called exercising the option. And so, more generally, there's two dimensions in which we classify options: We have put and call options. So a put gives you the right to sell something; a call gives you the right to buy something.

And we also have American and European options. And so that relates to when you have to make the exercise decision. So with the European option, there's a fixed maturity date, and you choose whether to exercise on that maturity date. Whereas, with an American option, you can choose to exercise at any point up to and including the maturity date.

Let's start with an example first that has nothing to do with finance. Let's say I've got my old Ford F-150 truck in my garage.

Let's say I want to sell you a European call option on that.

Right.

So that would give you the right—let's say, a one-year maturity…

Right.

So that would give you the right to buy that old truck for that agreed-upon price one year from now, no matter what, then, I think it's actually worth.

Exactly.

Is that the way to think about it?

Right.

Or alternatively, I could sell you an American put option on that truck. And so we would agree you'd pay me a premium right now. We’d also agree on the price that you could sell it to me. And then at any point over the next year, you could choose to force me to buy it from you.

For example, if you got in a wreck, you could then force me to buy the truck, even though it's no longer worth what we've agreed to as the price.

And so one thing is that has a bit of an insurance feel to it—the put option, right—because it protects you against a loss in the value of your truck.

And so what we're going to talk about today is the underlying is not so much a truck; it's going to be a financial security. And, in particular, we're going to think about a broad equity index.

Think the S&P 500. So say the S&P 500 is at 6,000 today. Right. That a put option struck at 5,000 would mean in, say, three months, would mean if three months from now the S&P has dipped down below 5,000, you'd still be able to sell it at 5,000. So it'd be a kind of downside protection on the value of your portfolio.

Alternatively, if you wanted upside, you could buy a call option struck above 6,000. And in the event that the market was above that value at maturity, then you'd exercise and you'd be able to buy this basket of securities for less than its price.

Now, in the event that neither of those events happened, you'd pay the premium upfront, but then you wouldn't exercise, and so you essentially lose the premium. So there's a cost to this optionality.

Gotcha. And so that premium is important for us to keep in mind because that's the other side of the equation.