Equity and Index Options Explained:

it is worth considering the evolution of options.rnMany people consider options as a relatively recent phenomenon; complex financial instruments traded by advanced traders in high-tech dealing rooms. Options have been about for a very long time. Options have likely been traded since man first assigned values and prices to gains and assets; indeed, there is evidence that grain and metal options were traded by the Phoenicians as quick as the second millennium BC. The driver behind this early option use was almost certainly hedging, a desire to guard against adverse price changes. Farmers have always been exposed to fluctuating crop prices; derivatives such as grain options developed as a way of managing this risk. While hedging may be viewed as the “correct” or “true” use of options, the reason why options were “invented”, it is nonetheless true that options also offer tempting opportunities to speculators. In his book entitled Politics, Aristotle tells the story of Thales, the first known Greek philosopher, mathematician, and scientist (though, incidentally, to be the teacher of the better known Pythagoras). Thales is said to have anticipated a bumper olive harvest and therefore decided to take out options on all the olive presses in the region, which he was then able to rent out at highly profitable rates. This happy conjunction of philosophical and financial acumen is echoed in the modern-day successes of uber-speculators such as George Soros.rnPost-Renaissance, there are plentiful examples of options use, both speculative and protective. There is written evidence of Dutch tulip-bulb traders and Japanese rice traders using options as speculative instruments during the 17th century, while currency options (based upon the French franc) were used for hedging purposes during the American Civil War. That said, it was in the early 1970s that options use took off. This was a time of market deregulation, oil price shocks and, crucially, technological advance. As we will see in a later chapter, you don’t need a computer to trade options. USING OPTIONS TO HEDGE: AN INTUITIVE EXAMPLErnConsider a wheat farmer. At the beginning of the year, the farmer has a good idea of his costs; rent, seed, machinery, fertilizers and so on. What he doesn’t know is the price that he will receive for his crop when he harvests in September. A high price will be good for the farmer, a low price bad. The farmer is exposed to the price of wheat falling between sowing the crop and harvest; he is exposed to “price risk”. What are the farmer’s choices? Do nothing! Simply hope for the best, hope that the wheat price rises. In doing this, whether he knows it or not, the farmer is “taking a view”. Specifically, he is taking a “punt” on the wheat price staying at its current level or rising. And “punting” is not the farmer’s business. If he gets it wrong and the wheat price falls significantly, he may find himself out of business. By the very nature of his business, our farmer is exposed; he really should hedge, but how? He could sell his wheat “forward”. That is, he could find someone to buy his wheat for delivery at harvest time. The price is agreed today but delivery doesn’t take place until September. He has sold his wheat forward. The counterparty has bought wheat forward. The written agreement exchanged between the two parties is a “forward contract”. Such agreements are common in the farming world, both OTC as in the above example, or traded on exchanges like the CBOT and LIFFE. A forward contract traded on an exchange is known as a “futures” contract.