In this blog post, we’ll explore how options work in everyday life and investing, and how they can assist with economic decisions.
While options may immediately bring to mind financial products, upon closer inspection, there are actually many phenomena around us that share the characteristics of options. The concept of options is utilized in various situations, from everyday choices to corporate decision-making. A solid understanding of the characteristics of options is extremely helpful in understanding economic phenomena related to risk. Fundamentally, an option is defined as “the right to buy or sell a specific commodity (underlying asset) at a predetermined price (strike price) at a specific future date (exercise date).” As such, options serve as flexible economic tools that can be exercised to one’s advantage when circumstances are favorable and abandoned when they are not.
The earliest recorded options date back to ancient Greece. Thales of Miletus, known to us as the “father of geometry,” is said to have developed an option for olive oil presses. At that time, people had to pay to rent a press to extract oil from olives. Thales of Miletus paid a small amount of money in advance during the planting season to secure the right to rent the press at a fixed rental rate during the harvest season. If there was a bumper crop of olives, the number of people wanting to rent the press would increase, driving up the rental price. In this scenario, Thales of Miletus could rent the press at the price agreed upon at the time of sowing and then sublet it to others at the newly established market price during the harvest season, thereby making a substantial profit. However, if there was a poor harvest, he could simply forgo the right to rent the press. It is clear that the right ‘Thales of Miletus’ purchased through a contract during the sowing season is, by its nature, an option—a right to buy.
Because options are choices that can be exercised when advantageous and abandoned when unfavorable, they create asymmetry in returns. This is an important concept not only in modern finance but also in various business and investment strategies. For example, when investing in new projects or product development, companies can apply the concept of options to minimize risk and maximize potential profits. In other words, they create a structure where they can reap significant profits if the project succeeds, while only writing off the initial investment as a loss if it fails. Such option strategies play a pivotal role in corporate financial management and strategic decision-making processes.
It is easier to understand the nature of options by examining the example of stock options, where stocks serve as the underlying asset. For instance, suppose you purchase the right to buy shares of a company at $10,000 per share two years from now for $1,000 today. If the company’s stock price exceeds $10,000 two years later, it is advantageous for the option holder to exercise the option. If the price is $15,000, they would buy the stock for $10,000 and make a profit of $5,000; subtracting the $1,000 option purchase price, the profit per share would be $4,000. However, if the price falls below $10,000, they can simply forgo the option, limiting their loss to $1,000.
Here, we can see that the holder’s profit depends on changes in the price of the underlying asset—the stock. This clearly illustrates why options are important not only in the stock market but also in various financial products. This is precisely why companies grant stock options to executives as an incentive. In this case, it is easy to assume there is no option premium, but the cash that the executive forfeits in exchange for receiving the option can be viewed as the option premium.
Due to the asymmetry of returns, options allow one to respond to price fluctuations in the underlying asset with a small amount of money. For this reason, options can serve as a risk management tool to cope with future uncertainty. However, when the option holder has the ability to influence the price of the underlying asset, options can also encourage the holder to take on greater risk. For example, a manager who holds the right to buy shares has a strong incentive to choose a business venture that is likely to significantly increase the price of the underlying asset, but such ventures also carry a higher probability of causing the price to drop sharply. This implies that the interests of shareholders and managers may not align, and understanding the structure of options is crucial for effectively managing such conflicts.
Understanding these characteristics of options is extremely important for comprehending various economic phenomena, including the behavior of shareholders and managers. Furthermore, individual investors and ordinary consumers can also make better decisions by incorporating option concepts into their financial strategies. For example, when buying a house or a car, one can manage the risk of price fluctuations through option contracts. As such, options are a concept that can be widely applied not only in financial markets but also in our daily lives. Therefore, a deep understanding of options greatly helps broaden one’s economic perspective and make wise decisions in various situations.
