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By: Christopher R. Madel, Senior Vice President and Director, Investment Implementation
One of the earliest known users of financial derivatives was Thales, a poor philosopher from Miletus. Thales had great skill in forecasting, and he predicted that the upcoming olive harvest would be exceptionally good. Confident in his prediction, Thales made agreements with area olive press owners to deposit money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices for the olive press options because the harvest was in the future, and no one knew whether it would be plentiful or not. In addition, the olive press owners were willing to protect themselves against the possibility of a poor yield.
Thales' forecast was correct. When the harvest-time came, many olive presses were wanted at once. Thales then rented them out at any rate he pleased and exercised the first known options contract some 2,500 years ago. He was not compelled to exercise the options. If the olive harvest had not been good, Thales could have let the options contract expire unused and limited his loss to the original price paid. But as it turned out, a bumper crop came in, so Thales sold his claims on the olive presses at a high profit.
The most common financial derivatives are call options and put options. And just as Thales and the olive press owners bought and sold options in 600 BC, individual investors now do so today.
A call option gives its holder the right to purchase a specified number of shares of stock (usually 100) at a designated price (strike price) within a set time period (expiration date). The price of the option is known as the premium. The owner of a call has the right to call forth the shares of stock and purchase the shares at the specified price. If an investor believes the value of a stock will rise, he will do as Thales did and purchase call options.
Why not just buy the stock?
Leverage is the advantage call options offer over the direct purchase of a security. For instance, 100 shares of a $60 stock would cost $6000. However, a call options contract to purchase the same 100 shares of stock at $60 per share in 60 days may cost only $300 ($3 per call). If the stock had been purchased and rose to $65, a profit of $500 would be realized-an 8.3% return on the investment. In the case of the call options contract, if the underlying stock increased from $60 to $65, the option's premium may have risen to $500 ($5 per call) resulting in a profit of $200 ($500 - $300 = $200)-a 67% return on the investment.
What's the risk?
In the above example, if at the expiration date (60 days), the stock is worth less than the strike price ($60), the call would be worthless and the investor's $300 lost. Thus, for a call to be profitable, the price of the stock must increase over the call's lifetime.
A put option provides the owner the right to sell stock at a certain price within a specified time period. It is an option to place or put with someone else shares owned by the holder of the option. Investors purchase puts when they believe the price of a stock will decline.
As with all options, leverage is the attraction. To illustrate, a put contract to sell 100 shares of a $60 stock for $60 in 30 days may cost $300 ($3 per put). If the price of the stock declined to $55 by the expiration date, the put contract could be sold for $500 ($5 per put) providing a profit of $200 ($500 - $300 = $200) - a return of 67%.
On the other hand, if the stock's price rose or stayed at $60 by the expiration time, the investor would lose his money.
While options are sometimes used to hedge or reduce risk, they can be an aggressive investment and may not be appropriate for every individual. However, they do offer an opportunity to take advantage of market moves, both up and down, along with the possibility of high rates of return and a predetermined limit to the amount of potential loss.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.