Calls and Puts
In the Politics, Aristotle tells the story of the philosopher Thales of Miletus, who lived in the sixth century BC. People laughed at Thales: if you’re so clever, why are you so poor? Philosophy, they said, is good for nothing. Thales decided to show them it was good for something.
He watched the stars, and while it was still winter he worked out that the next olive harvest would be huge. He didn’t have much money—not enough for presses of his own. So he went round every olive press in Miletus and on the neighbouring island of Chios, and on each one he put down a small deposit for the right to rent it at harvest time. In winter nobody needs a press, nobody haggled with him, and Thales got the rights cheap. When the harvest came and everyone needed the presses at once, Thales hired them out on his own terms. He made a lot of money. Aristotle concludes that he had shown how easy it is for philosophers to get rich if they want to—but that this is not what they’re after.
It’s no accident I’m starting with olives and presses. When Don Vincenzo heard this story, he said Thales was the only philosopher he respected.
The Right, Not the Duty
What did Thales buy? Not presses. He bought the right to use them if he wanted to. Had the harvest been poor, he simply wouldn’t have rented them and would have lost his deposits. Not much. The harvest came in huge—and the right was worth a great deal.
That is an option: the right, not the duty. The right to buy something in the future at a price agreed in advance is called a call. The right to sell at an agreed price is a put. You pay for the right up front, and that payment is called the premium. It doesn’t come in handy—you lose only the premium. It does—you can win many times over.
Look at the shape of the deal. In the forward we talked about, both sides are bound: one to buy, the other to sell. In an option only the seller is bound. The buyer chooses. That freedom is what he pays for.
The Put Everyone Buys
You’ve been buying options all your life without knowing it. Insurance is a put. You pay the insurer a premium for the right to “sell” him your burnt-down house at an agreed price. The house is fine—the right lapses and the insurer keeps the premium. The house burns down—the right is worth a whole house.
Gambetta writes about protection in almost the same terms. When we pay taxes or insurance premiums, we get nothing in return except the right to use a service if and when we need it. We even pay for a potential service: we insure a house for protection we may never need, and the machinery of protection has to be kept up even when it’s standing idle.
So the shopkeeper who pays for protection is buying a put on his shop. There’s just one problem. The seller of that put often decides himself whether the shop burns or not.
A Free Call
Now think back to the Bank of Sicily. Anonymous borrowers took out loans there against shares they were buying with that very money. The shares went up—the borrower took the profit. They went down—the loss stayed with the bank. That’s a call: all the upside with no risk of the downside, except that nobody paid a premium for it. The bank, without realising it, was handing out options for free, and that is what ruined it. It happens.
Every time the upside goes to one man and the downside to another, somewhere a call is being given away. A manager with a bonus for profit and no penalty for loss. A bank that knows the state will bail it out. A middleman handling “bets” the boss covers out of his own pocket. Find out who holds that call. And who sold it without collecting a premium.
A Market in Rights
For a long time options were sold privately—like Thales, striking a deal with each owner of a press. On 26 April 1973 the first exchange for standard options on shares opened in Chicago. On the first day nine hundred and eleven contracts were traded, on sixteen stocks. Calls only. Puts were added four years later, and today tens of millions of option contracts change hands around the world every day.
One useful thing you can grasp without formulas. Take a call and a put on the same share, with the same agreed price and the same date. Say they can be exercised only on that date, and the share pays no dividend before it. Buy the share and the put, and you get the same as the call plus money in the bank. Exactly enough money that, with interest, it grows to the agreed price by the date. Either way the share’s upside is yours, and you can’t fall below the agreed price. So their prices can’t drift apart for long, or someone will make money on it at once. Financiers call this parity. If the share pays a dividend, or the option can be exercised early, the equation needs adjusting, but the link remains.
An Offer You Can Refuse
In The Godfather—mind you, this is a film—there’s the famous line about an offer he can’t refuse. That’s the exact opposite of an option. The whole point of an option is that you can refuse it. That’s what you’re paying for: the freedom to say “no” if the world turns the wrong way.
Don Vincenzo understood options better than he thought. When a chance came up to take oil from a second mill, he didn’t sign a contract with it. Instead he paid the owner a small sum for the right to buy a set quantity of oil from him the following autumn at an agreed price. If our mill coped, the right would lapse and we’d lose a little. If something happened to it, we’d have a back-up supplier at a known price.
Our mill coped. The right lapsed. A pity? Not in the least. The owner of the second mill was happy: he’d been paid for nothing. So were we: we’d bought a good night’s sleep. “Thales bought presses he might need,” said the Don. “I bought a mill I might need. And cheaper than buying it for real.”
The Bottom Line
When the upside goes to one man and the downside to another, check which one you are. If you’re the second, you’ve sold a call and not collected the premium.