In my post, Platforms and Leverage, I mentioned the concept of optionality. Optionality is the essential quality of options, something I have spent a good part of my career thinking about and writing software to value and analyze.
Very basic review: in the financial world, options are contracts which pay off in some circumstances and pay nothing in other circumstances. The simplest option contract might be the lottery ticket, which is a kind of digital option that pays a fixed sum if you ‘win' (i.e. a certain random event takes place) and pays nothing otherwise. Of course, there is no free lunch, so you have to pay for that chance of winning. The value of a lottery ticket is simply the chance of winning x the payoff amount. Of course, lottery tickets are generally worth far less than the government changes for them, which is why governments make a lot of money off lotteries. Another common form of option is insurance, which pays off when something bad happens. Since you have to lose something in order to get the payoff (i.e. insurance is a ‘hedge'), it does not generally feel like winning to get that payoff.
In the trading world, the most common types of options contracts are called (Vanilla) Calls and Puts. They give the owner of the option the right but not the obligation to buy (in the case of a Call) or sell (in the case of a Put) an asset at a predetermined price (called the Strike Price). Lets say you own a Call and at the end of the option’s life (the Expiration Date), the asset is worth more than the Strike Price (it’s ‘in the money’). Then you will exercise the option to buy the asset cheaply and can then sell the asset in the open market at the higher going rate, pocketing the difference. If, on the other hand, the asset price is less than the Strike at the Expiration Date (‘out of the money’), then you do nothing and let the option expire worthless. The option may have some value, potentially unlimited value, if the asset price goes up, and no value if the asset price goes down. Of course you have to pay for this chance of gaining value while taking no risk, and this upfront payment is called the Premium. Like the lottery ticket above, the Premium exactly equals the expected value of the option (but is rather more complex to calculate given the variable upside payoff amount). So the payoff is asymmetrical. Unlimited upside with downside limited to the fixed Premium you pay upfront. The fact that the upside return is unlimited, in exchange for a fixed investment, means that there is tremendous leverage in the upside.
This asymmetry means that options become more valuable in risky situations. With only upside and no downside, the chances of a big payoff grow as volatility in the market increases, while the payoff of the downside risk remains flat (limited to the Premium you paid). That is why options are inherently antifragile — they gain from chaos (hence their use as insurance). They may be the purest expression of antifragility that exists.
Options are more than financial contracts. They are a concept that we can use to help us understand situations. Being long (owning) options is good. They give us asymmetrical returns and make us antifragile. But you never get something for nothing -- you have to pay the Premium to get into that situation. I previously pointed out that investing in a platform and successfully attracting an ecosystem of partners to participate in that platform, gives us positive optionality: potentially unlimited leveraged upside with fixed downside (our investment).
If you believe that you the chance of gaining the upside does not equal or exceed the value of the Premium you pay, then you should not buy an option. Lottery tickets are overpriced, given your actual chance of winning, and thus make no financial sense to buy. In Extreme Programming, Kent Beck says 'don’t buy options’, meaning: don’t invest in overgeneralizing your software unless you are confident you will leverage that generality (e.g. you are building a platform). Then you are paying Premium for nothing.
For every buyer, there is a seller, and the seller faces a situation that is the exact opposite of the buyer, of course. The seller of an option collects the Premium (fixed upside) but faces potentially unlimited downside. The seller hopes that the option expires worthless and they simply pocket the Premium and move on. If the option ends up in the money, then the seller has to supply the asset at a price far below market rates.
You sometimes 'sell options’ in business as well as buy them. For example, when you outsource, you are effectively selling an option to the outsourcer. You collect some form of savings (Premium) from the outsourcer. The outsourcer now ‘owns’ an option which will pay off if they can deliver the service for even lower cost than they are charging for it. The lower their costs, the more their upside. Generally, outsourcers are betting that their scale, industry trends, and innovation will allow them to achieve this and they’ll get their payoff. As sellers, you give up (sell) the ability to gain from scale, industry trends, or innovation.
These are just a couple examples of being long (buying) and short (selling) options in business. In general, you should be on the lookout for situations that naturally make you long options and give an asymmetrical (‘unfair') advantage -- as long as the Premium investment is worth it. Selling options makes sense when the Premium you receive outweighs the likely expected downside (for example the government overcharging for lottery tickets), but keep in mind that you bear potentially unlimited risk when you sell an option (no matter what it might feel like at the time).
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