I don’t think I’ve (yet) explained on these pages what options theory is in detail, but I have mentioned it in passing. I might come back to writing basic explanatory posts about the four basic kinds of options (long call, short call, long put and short put) some time later. The basic idea, however, is this:
It is always a good idea to have options.
You can complicate it by asking what kind of options under what kind of circumstances for what purposes – and that opens a rather large can of worms – but at is heart, options theory is really telling you that if you have choices to make, consider making a choice that opens up other choices later.
At it’s simplest, this is why Indian parents are so fond of saying take science in the 11th standard. They’re asking you to make a choice that gives you more options later.((“But you can always do arts after the 12th! This way, all three options are available two years down the line!” Yeah, right.))
Let’s talk for a while about the long put. A long put is – this is the technical definition – the purchase of an option to sell something for a fixed price down the line. Here is one way to think about it.
A Very Bad Man is hired to go put a bomb on the maiden flight of a brand new aeroplane, due to fly out of Miami airport. If that bomb had gone off as per plan, it’s safe to assume that the stock price of the airline in question would nosedive whenever markets opened next. So what, you ask? Here’s a simple example.
https://www.thinkpragati.com/housefull-home/housefull/6740/how-many-options-does-007-have/
Say pre-successful-explosion, the stock price of the airline in question was a hundred dollars. Le Chiffre, the villain in Casino Royale, would buy an option today to sell a share of the firm tomorrow at maybe ninety-nine dollars. What Le Chiffre has purchased is known as a long put. Translated into English, it is the purchase of an option to sell something at a predetermined price. Let’s say that this purchase of the option happens for the price of one dollar.
If the plane blows up, the price of that same share tomorrow may well be fifty. Le Chiffre, because he has the option to sell at ninety-nine, can make a whole lot of money by buying the share in the spot market at fifty, and selling it at ninety-nine, pocketing a cool forty-nine dollars in the process. And if forty-nine seems like a very non-Bond-villain number to you, buy one hundred million long puts.
Watch the movie after reading this, by the way. How many times do you get to watch Casino Royale and get to claim that you’re studying finance, eh?
Health insurance is another way of understanding the concept of a long put. Health insurance is effectively a bet that you will not fall ill, but if you do, the health insurance company picks up the tab. All that the health insurance company asks is that you pay them some money for them taking this bet. This is, of course, the health insurance premium. But like I said, in essence, a long put.
A long put in and of itself isn’t bad! Sure, a Bond villain can use it, but so can your parents when they purchase health insurance. Blaming options for a financial crisis is like blaming the atom for the atom bomb. It all depends on what you do with it.
Now, the question that I really wanted to ask: where are the long puts of our civilization?
What are we going to do, as a civilization, if we fall “sick”? Have we purchased insurance? Sick could mean mad climate change – so what happens if there is a catastrophe? Is there a “health insurance” scheme that we have purchased? As it turns out, yes, a rather extreme one.
A group of scientists are proposing that the inhabitants of Earth build a “lunar ark” as a global insurance policy against total annihilation. The idea, reminiscent of a backup hard drive to reboot a dead Earth, is to create a vault on the surface of the moon that would store the cryogenically frozen genetic material of our planet’s 6.7 million species of plants, animals and fungi, reports Harry Baker for Live Science.
https://www.smithsonianmag.com/smart-news/sending-dna-earths-67-million-species-moon-safeguard-life-180977256/
So for really and truly extreme events, there is at least talk of providing insurance. That’s good!
But I would argue that for other not-so-extreme events, we are not providing insurance. For example:
To get the giant container ship blocking the Suez Canal unstuck, engineers needed the stars to align. Actually, the sun, Earth and moon.
https://www.livemint.com/news/world/how-a-supermoon-helped-free-the-giant-container-ship-from-the-suez-canal-11617101603114.html
After several days trying to dislodge the Ever Given cargo ship, which had veered off course and embedded itself in the side of the canal, the salvage team pinned their hopes on this week’s full moon, when, beginning Sunday, water levels were set to rise a foot-and-a-half higher than normal high tides. That would make it easier to pull the 1,300-foot vessel out from the side of the canal without unloading a large number of the 18,000 or so containers it was carrying.
If, in the 21st year of the 21st century, our long put consists of consulting the lunar calendar in order to get big ships unstuck, then I’d argue that we are not quite doing things right. We need better plan B’s.
And so the question, worth thinking about at both the individual and the civilizational level: where are our long puts?
And another point, especially applicable as a student of economics: don’t get bogged down in the diagrams and minutiae of options pricing theory alone. That stuff is fun to learn, and cool to explore, sure. (Of course, if you are not a finance nerd, it is the exact opposite, and you can’t wait to be done with the subject. But then my point is even more applicable.)
Ask, instead, where else I can apply the idea of options theory, outside of finance. A lunar ark on the moon, a ship stuck in a canal and a Very Bad Guy in a James Bond movie are all great ways to learn about long puts – and certainly more entertaining than the ninth and the tenth chapter of John C Hull.
No?
EconForEverybody 