4

I had been wondering lately what the economic value that financial Options (Calls, Puts, American, Bermudan, etc) give to the economy is. In essence, what good do they give us, vs. simply trading the underlying stock (or any other asset)?

A first-principles justification for Options I feel is what I missed in class (or it was so obvious that I missed it).

Now, I understand that Options lower the risk of trading stocks (which is balanced by a lower possible profit), by ensuring that your loss never exceeds the price of the Option you paid if the stock's trajectory goes off into an unplanned direction. However, one could also similarly lower one's risk (and reward), by only trading tiny amounts of any one stock, so Options do not seem unique in this regard.

In essence, could someone explain to me what unique advantages Options have over any other financial instrument?

4

Options allow placing bets to hedge or speculate on nonlinear risks. They can be viewed as a type of insurance market. For example, protective puts are useful because preventing the possibility of large losses may be worth slightly reducing gains. Of course, the price (premium) has to be sufficient to induce someone (the "insurer") to write the put.

More generally, people may want to hedge or speculate on virtually any uncertain economic or sociopolitical outcome that affects their livelihoods, approaching the ideal of a complete market. Options are one building block of a complete market, because almost any payoff profile shape as a function of a security or index can be constructed from them.

  • Couldn't any complex long/short portfolio achieve the same payoff profile shapes, though? – Coolio2654 Mar 23 at 0:12
  • 1
    @Coolio2654 No, because plain long and short positions can only have payoffs that are linear in prices at any given time. Now, by managing such positions (buying and selling conditional on events), you can somewhat simulate nonlinear payoffs (see options replication and portfolio insurance). But this assumes certain volatility models and isn't a true hedge (e.g., portfolio insurance won't protect you in a sudden crash but puts will). – nanoman Mar 23 at 0:38
  • I feel like I understand what you're going at a bit more now, but the non-linear aspect is still confusing me. If there is any book that you think elaborates this point well, could you reference it for me? – Coolio2654 Mar 23 at 0:40
  • 1
    @Coolio2654 - There is no complex long/short portfolio that can achieve the same payoff profile shapes as option strategies (and vice versa). Read "Options as a Strategic Investment" by Lawrence G. McMillan and "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg. Understand them and you'll have a solid grip on options. – Bob Baerker Mar 23 at 2:17
  • 1
    @BobBaerker What do you mean by vice versa? Options can replicate plain stock positions (synthetic long and synthetic short). – nanoman Mar 23 at 2:24
3

Your question is like asking:

What economic value do ETFs and mutual funds give to the economy? After all, they're made up of stocks?

Like ETFs and mutual funds, options are just another type of security, though in this case it's a derivative that reacts to a number of market factors (primarily price and volatility and secondarily to dividends and carry cost).

You've based your premise and question entirely on the strategy of buying options ('lowering the risk of trading stocks' and 'ensuring that your loss never exceeds the price of the option'). There are two sides of the equation. What about the seller's reasons?

Options can be used conservatively or speculatively. Options provide a variety of ways to execute a strategy with an acceptable R/R profile:

  • generate income (covered calls)
  • acquire stock at a better price (OTM short puts)
  • hedge long or short underlying positions (put or call protected equity)
  • leverage your position (buy a bundle of cheap puts or calls),
  • trade directionally (long options)
  • trade lack of direction (calendars, iron condors)
  • trade volatility -
  • take positions that mimic long equity with similar profit potential and much less tail risk (high delta call LEAPs).

They're so much more than the simple idea of just buying them that you offered.

1

Options primary purpose are for managing risk. The creation of non-linear risk profiles and non-zero sum outcomes in multi-legged and multi-expiration contract and asset combinations are very unique.

One could also similarly lower one's risk (and reward), by only trading tiny amounts of any one stock

Compared to starting with a lower position size in a linear long/short position, an options contract still limits your possible loss while retaining your maximum gain, when buying the options contract.

Given how people use them, and the temptations they offer, I've asked myself the same questions. Discipline is very important.

1

“In essence, could someone explain to me what unique advantages Options have over any other financial instrument?”

One word - Leverage. < TLDR answer

Over the years, I’ve entered a number of trades which would return anywhere from 4x to 10x with a move in the underlying stock of only 30% in 18 month’s time.

The most recent trade was on a stock trading at $160, and the option, a year out was $1, but would return $10 if the stock closed above $210 in 12 months.

$16,000 for 100 shares of stock would have a gain of $5000 if the stock were to go up to $210. 10 contracts on the options cost $1000 and will have a $9000 gain at the same price target. This risk/reward profile is shifted in an interesting way. No doubt it’s not an investment, it’s a gamble. I’ll be the first to say that, if only for the fact that such trades need to be right three times over. Right direction, right magnitude of gain, and right timing. Two out three, and the option expires worthless.

  • How's "leverage" a unique advantage of options? A ton of other instruments offer leverage, and sometimes considerably more leverage than options, especially for intraday positions. – Bruno Reis Mar 27 at 5:42
  • Your observation is correct. Leverage, in my opinion, is the most important feature. This is based on how I trade options. If you read Bob’s answer you will find uses for options for which the leverage is not particularly important. – JoeTaxpayer Mar 27 at 14:01

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.