Thinking with Options

I came across this piece on EarlyRetirementNow that I found really intriguing:

If you currently own stocks and/or corporate bonds you already own options, whether you realize it or not. Equity in a corporation is essentially a call option on the enterprise value (the sum of all the firm’s assets) with a strike price equal to the firm’s debt. The firm’s bonds are a risk-free bond with a short put option where the strike price again equals the debt face value. In other words, as a bondholder, you lose money if the value of the assets drops below the debt load and the firm declares bankruptcy. If you think that this is thought-provoking and brilliant, thanks, but unfortunately it’s not my invention. It’s called the Merton Model, named after Robert Merton, the famous finance researcher, professor and Economics Nobel Laureate.

I indeed thought this was thought-provoking and brilliant. I think options are a really cool way of expressing different risk profiles and trading them based on what risk curve you personally want to achieve. This got me thinking about what other financial instruments could be thought of in the framework of options.

Insurance comes to mind, which is essentially buying a put option. It even uses the same “premium” terminology as options.

As a renter, I can view this as essentially buying a put option to own access to that house over a certain period. Rent is the premium paid — on top of that I am completely protected from all other expenses and value drops.

A lottery ticket would be an example of buying a call option, where the cost is the strike price.

Working at a salaried job is similar to selling a call option to your company, where you get a fixed “premium” in exchange for your labor, which may end up being more or less valuable than the premium you receive.

This is not financial advice.