Explain Option Trading: Farmer Fred invents the option
For a while now you’ve probably been thinking that there is now way that Miller Miles and Gas station Gus will want to make these deals with Farmer Fred. They are sure to lose money if they do. If Miles agree to let Fred decide if he wants to sell wheat to Miles or not Fred would only sell it to Miles if the market price is below 100$ (strike price) at harvest time (delivery date). If the wheat market moves up Fred would sell the wheat to someone else. Miles would end up buying for 100$ from Fred if the market price is below 100$ and in the market if the market price is above 100$.
Of course Gus and Miles think the same thing as you when Fred proposes the agreement. Then Gus has a thought: If Fred is keen to make the deal he should be willing to pay Gus a bit of money for doing it. After all, that is only fair considering that Gus can’t possible profit from this agreement at delivery date.
Gus just invented what option traders call the OPTION PREMIUM or OPTION PRICE. Or simply PRICE for short.
This is where we get into the fascination subject of OPTION PRICING. The science and art of valuing an option. Countless books have been written on the subject. Many of them using sophisticated mathematics and jam packed with algebra page after page.
Gus has not read any of these books but he tries for him self to figure out how much he should ask Fred to pay him. This day Gus is selling fuel for 10$ per gallon. The price varies a bit up and down but it’s mostly been between 9$ and 11$ lately. Gus remembers back in 1998 when fuel was only 5$ per gallon. But hey, that was a long time ago and it’s only a few months (time to delivery) till harvest time. To make things a bit easier, Gus assumes that the fuel price will either go up to 11$ or down to 9$ by harvest time. If the price goes up to 11$, Farmer Fred would surely ask Gus to sell fuel to him at 10$ per gallon so Gus would lose 1$. If the price goes down, Fred will not use his right to buy at 10$ and Gus will lose nothing. So it looks like Gus risks losing 1$ but he might end up losing nothing at all. Gus guesses that the price is pretty much equally likely to go up as it is to go down. With a 50% probability of 1$ loss and a 50% probability of no loss at all Gus figures it makes sense to ask Fred for 0.5$ to give Fred the right to buy at 10$. Gus is a little worried about if his assumptions are really valid so he decides to call Farmer Fred back and offer to do the deal if Fred pays him 0.7$ today. Fred and Gus of course also need to agree how much fuel Fred should have the right to buy at 10$. Having been a farmer all his life Fred knows for certain that he will need exactly 100 gallons so this is what they agree on. Happy that he does not have to worry about fuel costs anymore, Fred agrees. Fred pays Gus 0.7$ and Gus writes a note for Fred saying that Fred has the right to buy fuel from him at 10$ a gallon at harvest time. The act of issuing an option like Gus did is called to WRITE or SELL an option.