What are Options?
In order to understand what options are, let’s start with an example:
Bill likes the car but he wants to check out some more cars before he buys Zoe’s car.
So Bill requests from Zoey to give him the right to buy the car from her at 15K in cash anytime during the next month.
Zoe might agree on the condition that Bill pays her 2% of the value of the car, which is 300 dollars, for waiting out the month without a transaction.
Zoe cannot sell her car to anyone else during this waiting period.
Bill does not have to buy the car in this time frame, but he does have the right to do so.
Let’s look at the definition:
An Option is a contract allowing the recipient the right, but not the obligation to transact a known transaction (buy or sell) of a known Asset at a known price in a known pre-defined time frame.
A contract – The Option agreement between two parties.
A recipient (of the Option right) – in our case it’s Bill – also called “option buyer” or “the option holder.”
A known Asset – The core of the option – in our case, it’s Bill’s opportunity to buy a car from Zoe.
The person giving the right and taking upon himself the obligation (in our case Zoe) is sometimes called the “originator” or “option writer” or “option seller.”
At a known price – $15,000, also called “strike,” and $300, which is the price of the option.
In a known pre-defined time frame – in our case – One month, after that time, the option has no value. This pre-defined time frame in which the option will be exercisable is called the option’s Term or Duration.
Options that can be exercisable at any time during the time period are called American Options. Options that can be exercised only at the end of the period are called European.
The technical name of an Option that involves the right to BUY an asset at a price is a CALL Option. In our case, Zoe sold a Call Option to Bill.
There is however another type of options which is PUT options, which we will demonstrate with an example:
Margaret owns a coffee shop chain.
One day, a competitor approaches her with a proposal to purchase 50% of her business.
Margaret is happy to accept the cash offer and negotiates a two million dollar company valuation. For some reason, the buyer doesn’t want to buy the whole company, and Margaret worries that differences in business approaches and management styles might pose a problem.Jeff, Margaret’s friend, comes up with an Idea:
Jeff, Margaret’s friend, comes up with an Idea:
The Buyer will purchase half the business for $1,000,000 but will also Grant Margaret the right but not the obligation to SELL her full remaining stake in the business for $1,000,000 (based on the existing valuation times 50% remaining stake) for a term of five years. Margaret had the option to SELL her share at a price they agreed to before; this option’s technical name is a PUT option.
Think of the Option recipient (Margaret in our case) putting the now worthless remaining shares in her partner’s hands and taking the money from his pocket.
If Margaret executes the Option, the buyer must comply.
The buyer awards Margaret the Option and the deal is executed. The competitor buys 50% from Moonbucks Coffee Shop. Margaret is 1,000,000 dollars richer.
The new partner demands to improve profitability and takes drastic measures such as firing two critical high-cost employees.
Profits promptly plummet resulting in an operational loss.
Margaret is devastated, but Jeff reminds her of her Option to sell the remaining stake in the company so Margaret promptly exercises the Option to sell.
The Partner competitor finds to his dismay that now he has to assign the option, can’t back out from the deal, and must shell out an additional $1,000,000 to buy a now worthless, loss-generating business.
Options are very useful tools in business and are indeed used to help execute all sorts of transactions and help reach all sorts of business goals.« Back to Glossary Index