The need for options

A common misconception for newcomers is that the options market is designed for leverage and speculation. This notion could not be further from the truth.

Since the earliest days of organized capital, investors have looked for ways to manage their risks and returns. Whether they had an equity interest in a business, debt interest in a loan, commodity interest in rice, or virtually any other interest in an investment involving unpredictable variables, the future is unknowable. That uncertainty brings with it the potential for disappointing returns.

Sharing risk through equity

For centuries, capital markets have evolved to offer different solutions to better manage this uncertainty. One of the earliest public equity examples of this is from 1602, when the Dutch East India Company formed by consolidating a group of rival Dutch trading companies into one major entity. This effort substantially reduced the risk for the constituent business owners because they now shared in the profits across the new business.

Further, it would become the first publicly traded company, offering shareholders more flexibility in adding or reducing their exposure to the performance of the company by buying and selling shares on the open market. By 1637 it would be valued at nearly $10 trillion in 2020 US dollars, although much of that was driven by the infamous tulip bubble.

Unfortunately, many modern financial concepts were not yet developed at the time, which resulted in a variety of problems that contributed to the downfall of the company. Even worse, the lack of modern investment vehicles made it difficult for investors to enhance or protect themselves along the way.

Hedging with forwards and futures

Another instrument for managing risk/reward boundaries is the forward contract. At its core, a forward is simply an agreement to trade an asset for a set delivery price at a specific date in the future. The delivery price should not be confused with with the current spot price the asset is currently trading at. Forwards tend to be specifically tailored to a given scenario, much like a typical business contract. However, a popular type of forward is the futures contract, which is a standardized contract traded on an exchange. Futures exist for many popular underlying assets and derivatives, ranging from those destined for physical delivery (agricultural goods, energy, metals, etc.) to abstract hedges (interest rates, equity index values, etc.).

It’s beyond the scope of this course to dive into the details of forwards and futures. However, it’s important to understand that they offer an important hedging tool for real-world scenarios. For example, suppose you run a chain of restaurants that specialize in corn-based dishes. Since the price of corn may fluctuate due to unexpected events, such as unfavorable weather, political unrest, or even just standard market competition, you would need to protect yourself from rising prices. There are a few ways you could do this:

  • You could open a forward contract with a supplier where you agree to a given price for corn at given dates in the future. However, you would still run the risk of the supplier not being able to produce the corn for any reason. This agreement would also be over-the-counter between your two parties, so you would need to get the supplier to agree to cancel the contract in order to exit for any reason. There is a benefit, however, in that you can customize the agreement to specify details about the delivery, etc.
  • You could buy publicly traded corn futures contracts at the quantities you need. This would also guarantee your supply at a given price, although you would be locked in to buy at that agreed price. However, since the contract is exchange-traded and standardized, closing the position would be as easy as offsetting the position with a new trade.

The strategies above are just a few examples of ways you could potentially hedge your business against a rise in the price of corn. From the opposite perspective, there are also parties who would be similarly interested in hedging against a drop in corn prices, such as corn farmers. However, the fact that the contracts are standardized and traded through public exchanges means that anyone can participate, whether or not they have any real dependency on corn.

On a related note, there are futures contracts available for major market indexes, such as the S&P 500. We’re using corn futures here since it’s an easier scenario to visualize, although portfolio managers buying or selling S&P futures to hedge market risk follow a similar mindset.

The role of speculators

The availability of contracts on a public exchange also opens the door for speculators to bet for or against the price of corn without having any interest in the underlying commodity itself. Some have argued that speculators are a net negative force in markets, but that’s not entirely fair. They do present a risk to extract value from this particular market because their profits would have otherwise gone to corn producers and/or consumers. However, this profit earned by speculators is often analogous to an insurance policy for the other participants. When a corn producer sells the rights to their corn well in advance, it’s with the understanding that the spot price at that future date might be higher. They are effectively insuring the price of their crop.

The bottom line is that speculators are generally a net positive for markets because their participation means there are more buyers and sellers for the various securities available. The ability to easily enter or exit a position at a reasonable price is known as liquidity. When a security has poor liquidity, it will be difficult to find a buyer or seller, which means that you will have to buy at a higher premium or accept less when selling.

Obligations vs. privileges

If there’s one critical takeaway from the concept of forwards and futures in the context of this course, it’s that they’re an obligation to buy or sell. In other words, you are agreeing to buy or sell the underlying assets, regardless of whether the delivery price is above or below the spot price. While you can often close the investment by buying or selling an offsetting position, there is no option to just walk away.

Sometimes this obligation doesn’t offer the precision that investors need to hedge their investments, especially when it comes down to granular positions in specific assets. Instead, investors want the privilege to buy or sell if the delivery price is more favorable that the spot price. But if the current price for corn is above the delivery price, they would rather let the contract expire without fulfillment and sell their corn for the higher open market price.

The ability to acquire the privilege to buy or sell comes in the form of an option contract. Major futures and stocks have options available for trading so that investors can fulfill more specific scenarios.