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Options 101
Part 23
Now that you understand the concept of volatility, we can figure out why options have value while pizza coupons do not. Many are inclined to think that it’s due to the prices; stocks are far more expensive than pizzas. That’s partly true, but the bigger reason is due to the uncertainty of prices. You can be pretty sure that pizza prices will be the same price next week or even next year. And as competitive as the pizza market is, there’s even a good chance that prices may fall. Because we’re pretty certain about the price we’ll pay for pizza in the foreseeable and they don’t make up a large portion of our incomes or net worth, there’s no reason we’d want to “lock in” the price of a pizza. Consequently, pizza coupons have no value. With stocks, it’s a different story. One day the stock is up 2%, the next it could be down 10%; we’re never really sure what’s going to happen. And because stock portfolios typically do make up significant portions of our wealth, investors and traders are willing to pay to hedge those risks. They are willing to give options value. Options have value because stock prices fluctuate. Options were designed to control these fluctuations and therefore reduce risk.
Risk and Reward
While we’re learning about options pricing, this is a perfect point to introduce one of the most misunderstood concepts in option pricing – risk and reward. It is, in fact, so misunderstood that you will find it misinterpreted even among professional traders. Because of this, it is also one of the biggest reasons for option losses by new and seasoned traders. If you are to trade options successfully, you need to understand the indisputable relationship between risk and reward.
Will Rogers once said, “Why not go out on a limb? That’s where the fruit is.” This is one of the simplest ways of expressing the relationship between risk and reward. He was, of course, referring to the fact that in order to get the fruit (reward) you must venture out onto the tiny, unstable limbs. You must take some risk. The same concept applies to every financial decision you will ever make. In financial terms, if an investment is considered risky, that means there is a chance you might lose some or all of your initial investment. The greater the chance for loss, the greater the risk of the investment.
Risk and reward are the inseparable dynamic duo of finance, and they always increase and decrease together. If the potential reward from an investment is great, you can be sure that it comes with a lot of risk. And if the risk is low, you can forget about making a lot of money.
While the concept of risk and reward may make intuitive sense, it is one of the most overlooked concepts among investors and causes many problems for those who only consider the reward side. If you want to succeed in investing, it is crucial that you understand the risk-reward relationship and why this pair cannot be separated. We can easily convince you why risk and reward go hand-in-hand by playing a simple game.
Pricing Game
Imagine that you are offered the chance to play the following three games. An auction is held to play each game for which there is a $100 cash prize. The highest bidder is allowed to play the game one time and does not get his bid amount back. Think about each of the games and then jot down your answers on a piece of paper:
1. For the first game, the highest bidder is guaranteed to win $100 cash. No risk. No hidden strings attached. If you are the high bidder, you walk up and collect $100. How much would you bid to play this game?
2. For the second game, you must correctly call heads or tails at the flip of a coin in order to win the $100 prize. How much do you bid to play the game now?
3. For the third game, you must draw the ace of spades from a well-shuffled deck of cards in order to win $100. How much would you pay to play this game?
Even though we don’t know the particular answers you chose for each game, we are 100% certain that you elected to pay the highest price for the guaranteed game, the next highest amount for the coin game, and the least amount for the card game. How do we know this? It’s because of the relative risks involved in each game. The first game has no risk; we know that the winner always wins $100. And because of this, most people will bid this game up fairly close to the $100 reward. For the coin toss, we know that you would win $100 half the time and lose your bid amount half the time, which is certainly not as good as winning all of the time. In other words, we are less confident in the outcome – there is risk. There is no chance of losing with the first game but a significant chance of losing with the coin game. Because of this, you should be willing to spend less for this game. For the card game, we know you would win $100 only once out of every 52 tries, on average. This means you are almost certain to lose your money. On a comparative basis among the three games, this is the riskiest so you should be willing to spend the least to play it.
We just reviewed each game in terms of risk and found that the higher the risk, the lower the price you are willing to pay. We can also look at the three games in a positive light as we did when considering which strikes should cost more. We do that by simply asking which game is more desirable;that is the one that will carry the highest price. The guaranteed game is more desirable than the coin game and that’s why its price is higher. Or conversely, the coin game is riskier (it is less desirable) than the guaranteed game so it is cheaper. It doesn’t matter which dollar amounts you picked for each game but, just for the example, let’s assume you bid the following amounts:
Guaranteed game: $99
Coin game: $49
Card game: $1
These are results that we typically get when this game is presented at Option University seminars. Once we have some prices to work with, we can look at the three games in a different light. If you were willing to pay $99 for the first game, that’s the same as saying you were willing to invest $99 in order to make a $1 profit. The coin game, on the other hand, represents a game where you could invest $49 for the chance to make a $51 profit while the card game represents an opportunity to invest $1 in hopes of making a $99 profit. These costs and potential profit opportunities are summarized in Table 2-7:
Table 2-7
|
Game
|
Cost
|
Potential Profit
|
|
Guaranteed
|
$99
|
$1
|
|
Coin
|
$49
|
$51
|
|
Card
|
$1
|
$99
|
Notice the relationship between the prices and the rewards: The higher the price (cost), the lower the reward (potential profit). The guaranteed game carries the highest price of $99 and comes with the smallest reward of $1. The coin game has a lower price and a correspondingly bigger reward. The card game has the lowest price of all and also has the biggest reward. You can see why it would be easy for someone to just look at the prices and potential profits in Table 2-7 and wonder why they should play anything but the card game. After all, it doesn’t seem to make sense to pay a high price to get a small reward when you can pay a tiny bit and possibly make a fortune. People who interpret the numbers in Table 2-7 this way are unintentionally assuming that the risks are equal across the board. That is easy to do if you’re just looking at the numbers. But once you understand the nature of each game, you start to see why people are willing to pay higher prices for some of the games.
To be continued…
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