In a nutshell, an option gives the buyer the right, but not the obligation, to do something – for instance, the right to buy shares at an agreed price. For that right, the option buyer pays a one-off, non-refundable premium.
Meanwhile, the person on the other side of the trade – i.e. the person who accepted the premium from the buyer – has an obligation to fulfil his side of the deal – in this example, to sell the shares at the agreed price.
The advantage of options is that you pay a relatively small price up front to secure a chance at making a decent profit IF something turns out as you predict. If you’re right, you can make a mint. If you’re wrong, you lose an agreed amount. Options can be excellent tools for playing unpredictable markets that you have a hunch about, whilst knowing your maximum risk.
But let’s get back to Ancient Greece and the back story...
A great trade from a wise man with a hunch
It was the philosopher Aristotle who first recorded options. He tells the story of Thales –one of the Seven Wise Men of Greece – who made a fantastic trade using the same logic.
Thales predicted that there would be a bumper olive harvest. He offered to pay a one-off sum to the local olive refiners for the right (but not the obligation) to rent all available olive presses, for the standard, agreed fee, for the whole of that year’s harvest season.
Let me just say a bit here about the ‘right’ and ‘obligation’ distinction. That’s an important part of options. In the case of Thales, it meant that if he was correct in his prediction, he could take up his right and get his hands on those presses at bargain prices.
But if he was wrong, then he didn’t have to – he could walk away from the deal, with just the loss of the one-off sum he paid up front. Just think of it like an insurance premium – where the fee you pay up front protects you in the event of damage or loss… but if you don’t have to make a claim, you still lose the premium you paid.
The logic was that if Thales was correct, and there was a record olive crop, then the cost of renting the olive presses would go through the roof. By locking in the standard fee at the start, then he’d be ‘quids in’. That’s because he could then turn around and rent out the presses to the local oil producers for a big profit.
In the event, Thales’ prediction was spot on. That year saw Greece’s best-ever olive crop. Demand for the olive presses and refining facilities soared. That meant much higher fees could be charged for their use.
Thales had purchased an option to rent the olive presses. He had the right, but not the obligation, to take up his option – to rent the presses for the standard fee. Meanwhile, the people on the other side of the option ‘trade’ – the owners of the presses – were obligated to rent the facility to him at the specified price.
So by taking up this right, Thales was able to cash in on the bumper crop. He got to rent the presses at “rock bottom” prices… and then sublet them out to the hungry oil producers at a hefty premium.
Small up front cost – for a chance to make big money
The difference he made was huge – a substantial profit for putting down a small premium up front. Thales didn’t know that there would be a bumper olive crop. That kind of stuff is not predictable. But he took a view based on his hunch.
And that’s how options work today, too. If you have a view on where a market is going – whether it is shares or oil and whether it is up or down – then there is an option available for you to trade it. Owning options can be a great way to play unpredictable markets… with the comfort of knowing your maximum risk.
The thing to be aware of is that the premium you pay for an option costs more in times of extreme volatility and large moves. That’s because it’s more likely that what you predict could happen. The person who is taking the premium – and therefore assuming the risk (think of the oil press owner) – wants to be compensated for that risk
In future issues, we’ll look at some of the ways you can put the risk attached to options in your favour. There’s a whole variety of ways you can use them to your advantage – you just need to know what you’re doing.
Good investing,
Frank Hemsley
For The Right Side
P.S. Options aren’t just for speculating on massive moves based on a hunch. You can also use them to enhance your income on a share portfolio and to hedge your investments against an unpredictable move in the market. Keep an eye out for future reports on the many different options strategies you could use.
Further sterling gloom on the way
BY THEO CASEY
On Thursday the Bank of England’s Monetary Policy Committee will meet to decide on the country’s base rate of interest.
The chart below shows how far interest rates have fallen since September 2008. As you can see, UK rates have fallen by 350 basis points, or 3.5% – further than in the US, the Eurozone or in China.
The worse the economic outlook, the lower the rate. Cutting rates is one of the many approaches the Bank has to try and unfreeze the lending markets. Unfortunately, the lower the rate the further the pound falls.
Race to zero – UK interest rates fell faster than in any other major economy
Source: Barclays Global Investors
On a trade-weighted basis, the pound has fallen by nearly a quarter. Another cut could see that drop worsen.
Alas, it’s all but written in stone. A Bloomberg poll of 43 City economists shows that most believe the MPC will cut rates by 50 basis points to 1% on Thursday. And never mind the history lessons, we may be living through the lowest levels of interest rates in 300 years, but it is the effect on the pound you should be more concerned with.
You see, interest rates are the closest thing a currency has to a proper fundamental measure. Investors will typically buy currencies with a high rate of interest. This gives a yield, and if the strength of that currency also appreciates, it’s the equivalent of a stock that pays a large dividend and goes up in price.
This goes some way to explaining the almighty sell-off in the pound since last September. As you can see from the graph above, the Bank of England has cut rates further, albeit from a higher starting point, than any other major central bank.
However, it’s not just falling rates. The credit crunch has led to a nationwide slump in consumer and business confidence. Whatever happens on Thursday, the pound has a bleak outlook and is very likely to fall in the near-term.
My advice to investors would be to protect yourself against this continuing trend. Putting money directly into other currencies or investments denominated in other currencies can be an effective way to hedge your sterling exposure.
Editor’s note: To protect yourself from a further fall in sterling ahead of Thursday’s rate decision, I urge you to read Theo’s specific recommendation. Click here to access it.
The Daily Reckoning – In Gono We Trust
BY BILL BONNER
There it is, dear reader... the future of the United States of America.
This just in...
We have it from our usually unreliable source in Washington that Gideon Gono, now head of the Zimbabwean central bank, has been called in to aid the Obama administration. In secret talks, Gono has agreed to replace the out-going Ben Bernanke, who is said to be going to work as a helicopter pilot. Gono will take over the Fed. And a new bill has already been designed – our source was able to sneak out a copy of the new note – for 1 million US dollars. That’s Gideon Gono’s picture on it.
According to reports, Gono insisted on getting his face on the bill as part of the deal. “Dead presidents are a dime a dozen,” he is said to have remarked. “And this is just the beginning; we can add zeros later.”
*** Yesterday, we promised to take up a theme... hmmmm.... what was it...? Oh yes, the critical issue... when.
When? When what?
Oh yes... when will deflation turn into inflation?
You want a date, don’t you dear reader? You want to know exactly when you should switch out of Treasury bonds and into stocks, gold and freeze-dried food. Alas, that we can’t give you. Not even an approximate date…
To read today’s Daily Reckoning in full, click here.
P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.
