The value of having options

Financial independenceFinancial independence gives you options.  

Options are valuable in finance and in life. 

Here’s why.

Let’s play a fun game.  I’m going to ask you to guess the value of an option.

I’ll then show you how to calculate the answer, so you can compare your guess to the model answer.

The FTSE 100 index is currently at 6,190. So, for this example, let’s say that 1 “unit” of the FTSE 100 would cost you £6,190 to buy now.

If I offered you the chance to buy the FTSE 100 at £6,191 your first reaction might be to tell me to go jump in a lake. The market price is £6,190…so why should you pay over the odds?

But what if I now told you that option lasted 10 years?  With this option, you would have the right (but not the obligation) to pay £6,191 for the FTSE 100 at the end of the 10 year period.

Bear in mind that at all times you have the ability to buy / sell the FTSE 100 in the market (for example via a Vanguard index tracking ETF like VUKE). So it would only make sense to exercise the option if the FTSE 100 had risen above 6,191.

What, if anything, would you pay for that option?  Have a guess and write your answer down on a piece of paper.

If you’re struggling, don’t worry; that’s normal.  We humans aren’t designed to do calculations like this in our heads.  There wasn’t much call for it on the African Savannah.

So if I asked people on the street to guess, I would get baffled looks and a wide range of answers.  I expect a lot of people would answer zero because the option is currently “out of the money”.

Someone that answered zero might say…

If the FTSE 100 is currently at 6,190, why would I pay anything for an option to buy it at a higher price?

Or maybe something like:

Well Britain will vote to leave the EU and then interest rates will go up and that would cause a recession and then there will be another financial meltdown and the FTSE will be at 5,000 in 10 years time…so I don’t want to buy an option that allows me to buy it at 6,191

Wow. My head hurts just writing stuff like that.  The problem is not that it’s impossible that the FTSE 100 could be at 5,000 in 10 years time (although I think it’s pretty unlikely). It’s that nobody knows what’s going to happen. The value of an out-of-the money option lies in the fact that things change. So a rational investor would still put a positive value on an out of the money option.

But most people are not purely rational investors.  And, as Nassim Taleb explains in Fooled by Randomness and The Black Swan, we consistently tend to undervalue options and underestimate the impact of unforeseen changes while overestimating our ability to predict the future.

The problem with many conversations about investing is that people end up as amateur forecasters.  Because investment returns happen in the future, people often assume that some ability to forecast the future must be an important part of investing. Don’t get me wrong, it would be great to know in advance which horse is going to win the 3.30pm at Haydock or what level an index is going to be on a future date. It’s just that I’ve never met anyone that can actually do this.

I have noticed however that a lot of people talk as if they could.  If you watch any financial TV or visit a pub, you will find pundits (mostly middle aged males) recycling what they read in the paper earlier that day and then making confident predictions about the future, safe in the knowledge that no one is ever going to check on the outcome.

Financial indepedenceThe only thing worse than an amateur forecaster is a professional forecaster.  They’re dangerous because they look and sound like they might know what they are talking about.

If you are watching TV news and you see an interview with clowns disguised as economists or analysts from an investment bank, the sensible thing is to turn your TV off and do something useful.  If you can’t find the remote control, run out of the room with your fingers in your ears shouting LA-LA-LA-NOT LISTENING, NOT LISTENING!

One of my ex bosses had a talent for this stuff.  Whenever a client asked for his view on the economy he would flow smoothly into an eloquent speech about The Fed, non farm payrolls, house prices, interest rates, investor sentiment blah blah blah…always culminating in the same conclusion that, on balance, he was cautiously optimistic and now was a good time to do whatever he was trying to persuade the client to do.

The Escape Artist claims no ability to see the future.  If I have an edge when investing, it’s that I realise how little I (and everyone else) actually know about the future.

Back to the option. The reason it has value is that there is always uncertainty. Prices can always move by enough to bring the option into the money (the FTSE 100 is trading above 6,191) by expiry.

There are 2 parts to the value of an option.   Firstly, the intrinsic value.  Think of this as the value if the expiry date were today.  So in our example, an option to buy the FTSE 100 at 6,191 has zero intrinsic value when the current market price is 6,190.

Secondly, the time value.  The more time there is left on the option, the more time there is for the world to change and the share price to rise, bringing the option “into the money”.

Fortunately, we don’t have to rely on guessing to value options.  The Black–Scholes options pricing model is based on some fancy maths and won its inventors the Nobel Prize in Economics.  The model is not perfect.  It tends to underestimate the value of an option where the underlying probability distribution of stock returns is not a normal “bell curve” distribution and instead has “fat tails”.

Financial independenceIf shares really had a normal distribution then we would only see an index like the S&P 500 or FTSE 100 move by 7% in a day once every 300,000 years on average.

But in the real world, big market moves are pretty common.  During the crash of October 1987, the S&P 500 fell by 29% over the course of 24 hours. With a normal distribution, this should happen less than once every billion years.

But despite tending to understate option values, versions of the Black-Scholes model are widely used. And, to be fair, most of the time it works a lot better than guessing.

So if we make a few assumptions, we can input these into a model and calculate the value of the option. In my example, the model values the option at about £1,600 (or ~26% of the value of the FTSE 100, the underlying asset).

So those people that guessed zero for the value of the option would have been way off. And remember this may understate the true value. Still wondering why CEO’s are so fond of option packages?

The reason this matters is not because I think you should use traded options in your investing.  Option trading is best left to daytraders like Frankie or hedge funds.

The first reason option valuation is important is that it reminds us that things that at first glance don’t look valuable, might be (and vice versa).  And that things change. We humans tend to try to predict the future using simple extrapolation of the recent past.  If the sun has shone everyday for the last month, you’re less likely to take your umbrella out with you tomorrow.

Financial independenceThis encourages investors to “reach for yield”. Investors in peer to peer lending, high yield bonds and emerging market government debt are usually hoping that the future will be like the recent past.

They focus on a juicy promised yield, hoping it will be maintained and their capital won’t be wiped out in a default.  Taleb compares this to a turkey looking at recent past in the run up to Christmas and expecting the farmer to continue to feed him.

So whenever you lend money, remember that the borrower has an (unofficial) option to default.

I also avoid callable bonds:  where the borrower has an early repayment option.  If interest rates go up (ie move against you) you take the downside. And if interest rates go down (ie move in your favour) the borrower can call its option, refinance its debt at lower rates and you lose the upside.

The second reason that option pricing is important is that it reminds of the uncertainty inherent in life and prompts us to look for valuable “real options” in our lives. The ability to recognise options wherever they crop up is a useful skill.  Most options that we run into in everyday life are not clearly labelled as options…they just look like life choices.  But these real options are valuable.

One reason that experimentation is valuable in life is that it’s like being given free options. As an example, if you write a blog as an experiment, you gradually get the option of taking some of the material, adding new material and turning it into a book.  By writing this blog, I’ve met new friends and interesting, smart people who I would never otherwise have met.  More options.

Or think about someone who trains as a plumber. As well as a new skill, they gain new options: to set up their own plumbing business, or get a job with an established plumbing company or perhaps to write for about plumbing for a trade magazine.  You don’t have to know at the start which path you will end up taking…you get options. (Talking of training as a plumber, I discovered a few years ago that one firm of London plumbers paid some of its experienced plumbers £250,000 a year: good for them!).

The beauty of financial independence is that it removes the timesuck of having to work to pay the bills.  This allows you to explore options that might otherwise seem too risky or time consuming.

But I don’t think you need get to full financial independence to get most of the benefits.  Just being debt free with a frugal lifestyle gives you loads of extra options in life.  And if you can add even a modest Escape Fund then, as Del Boy used to say, the world is your lobster.

Notes:

Here’s an example of a hidden option that may be relevant to some UK readers.  The lifetime allowance for pensions is being reduced from £1.25m to £1m. But you can take Fixed Protection 2016 which means that if you don’t contribute any more after 5 April 2016, you keep the £1.25m higher limit.  If you might hit the £1m limit when you take pension benefits in the future, taking Fixed Protection gives you the option of keeping the £1.25m higher limit.  It’s an option because it’s reversible at any time. So you can always choose to make more contributions in the future when you have more information and if you want to.

The option valuation model below is sourced from Professor Damodaran of NYU. The assumptions  can easily be changed in the model – feel free to play with your own assumptions.

 

You can follow The Escape Artist on Twitter here

 

16 comments

  1. Another great post EA – I’m really enjoying your blog these days. I was guessing all over the place and then decided that I’d just buy the stocks on day 1, then forget about it. Obviously not the point but mange-tout, eh?

    1. Mange-tout indeed Rodney 😉

  2. Hi, regarding the pension LTA, the 1 million limit is linked to inflation (CPI) so if you have a decade or so before reaching retirement there is a chance that it may be at 1.25million or thereabouts anyway depending on the path of inflation.

    1. Great example of an option by the EA in using the LTA. I faced this very issue, in terms of ‘giving up the option’. My wife took the option of fixed protection at £1.5M (in her 30’s!) . She switched jobs that came with a defined benefit pension scheme and a starting salary that was 6-figures, but with no extra pay if she didn’t join the pension scheme! (this was completely unexpected and unrealistic scenario when we took the fixed protection at £1.5M).

      My wife let the option of £1.5M LTA lapse and will now revert to the £1M LTA.

      A very valuable option for those with larger pensions at a young age is QROPS as (a) LTA is tested on transfer, rather than taking benefits and (b) it is reversible, you can transfer back from QROPS to a UK pension scheme. [Fees no doubt make this far from a ‘free’ roundtrip!]

      One of the most valuable options I took advantage of (for free) was to switch my mortgage to be payable on an interest only basis (reverting to the old style BoE base rate, rather than lender made up rate) and also extending the term significantly at the same time – this was in 2009. In practice, I was giving up nothing, since I could always switch back to a repayment basis and if I wanted a shorter term, then I could remortgage if the lender refused to reduce the term. I lot of people will have had these options but have been unaware of how valuable they were.

  3. dawnmartyne · · Reply

    Once again i enjoyed reading this blog, it made me laugh out loud espcially the bit about ‘clowns on TV’.
    Even though we are meant to ‘know’ these things it helps to be reminded
    I had a great feeling of FI when i paid my mortgage off a few years ago.

    1. Thanks…glad it’s not just me laughing at my jokes(!)

  4. Interesting post. I must be an optimist because my guesstimate at the fair price of the option was £3k! I reasoned like this:

    – the option is basically to buy at today’s price in 10 years
    – given 5% growth, the rule of 72 says it will double in about 14 years
    – so after 10 years it might have gone up about 50%
    – so in 10 years time I could exercise the option and make half the current value as profit
    – there’s time value of money, but I can’t so that in my head and 50% after 10 years was probably on the low side if we expect it to have doubled in 14, so ignore that
    – so the option is worth half of 6191 or about £3k

    I’m still pleased I got within half of the “correct” figure in my head. (I just did the calculation properly and after 10 years it would have gone up 62%.)

  5. FI Warrior · · Reply

    A few years ago a workmate took an option on property in London when I was too timid to do the same and we were both renting. He took out an interest-only mortgage he couldn’t really afford to pay off but explained that he couldn’t lose because the monthly payments would be the same as his rent and effectively gave him an option to own the place if he could find the money at the end.

    Since then, I am still stupidly renting while his ‘rent’ is almost negligible as it was a variable rate deal, (and the interest rate collapsed since then) so by now paying off the principle to mimic a realistic ‘equivalent rent’ amount, he’s well on his way to owning a property in London. If he sold to downsize, he’d be done in half the time even by cashing in on the capital gains too. So basically, if you have an option on property ownership in the city-state of London, you really should go for it.

    The financial wizards of the square mile standing shoulder-to-shoulder with the budget mandarins will ensure the equation holds up, in that demand for accommodation eternally exceeds supply; it’s the basis of the economy.

    1. Thank you for the comment. I think there is a lot of truth in what you say. When I got on the housing ladder in London I had to swallow hard (even though prices were lower in those days) and jump in. Funnily enough, I also rationalised it to myself as an option back then….I figured that if in the future I couldn’t afford it, I’d just sell / hand the keys back. I’m not sure my 25 year old self even realised back then that the mortgage lender could come after me for any shortfall(!).

      I have a lot of sympathy for anyone trying to get on the ladder in London right now. And I’m not saying that my option approach was prudent or “sensible”…but it worked for me. And it certainly explains why in the US (where mortgages are often non-recourse) sub prime crisis a lot of homeowners figured they could always post the keys back to the lender if they couldnt make the payments.

      For what its worth, it’s my understanding that if a borrower is open about any financial problems with their mortgage lender and they keep paying even a small amount of the mortgage obligations, the lender won’t foreclose / repossess the property in practice. So there is an option to re-negotiate / re-schedule. That’s why debt isn’t as secure (for the lender) as it sometimes seems at first glance.

  6. Matthew Butcher · · Reply

    Sorry that last email was not intended for you, I meant to forward it to a friend! Great post by the way!

    Sent from my iPhone

    >

    1. Thanks – its great when people pay it forward!

  7. The Rhino · · Reply

    hey, you’re right, life is all about keeping your options open, even in the absence of a handy black-scholes calculator.

    Hope the talk at TSOL is a success. Give my regards to alain and hodgkinson if you bump into them..

  8. The pension LTA is supposed to go up with inflation, but that’s a promise that’s unlikely to be kept.

    Options are used to manage risk profiles for professionals. Most amateurs seem to manage risk by just keeping a fraction of their wealth out of the market. Private investor funds that try to offer risk protection never seem to take off, I suspect because they are complicated to follow, and everyone suspects, like me, that the fund management premiums are high. Never bet with bookies, as they set the odds…

  9. A great article TEA, but I have to disagree with your comment on peer to peer lending.

    I’ve been involved in P2P since the early days. I knew it was risky, particularly then, but I liked the idea of cutting out the banks who I consider can be greedy and unethical, and figured unless people supported it, then it would never get off the ground. So I took a risk and put some money in.

    Since then I have lost a four figure sum in bad debts on P2P loans. You might think that’s a good reason to stay out of P2P, but in fact the bad debts were very much as predicted (annually about 5% of total interest for my loan book) which I consider a good thing, in the same way I would be concerned if a tracker fund outperformed the index it was tracking. You do not need to be Fisher Black or Myron Scholes to know that 95% of £5 is more than 100% of £1. Money lending is probably the worlds second oldest profession, so there are very good stats on default rates. It has everything to with the past but little to do with the recent past and default rates are a lot more predictable than share prices.

    P2P lending is real lending. Unlike bank loans, which are in effect a number created on a banks computer, someone who borrows from a P2P company is actually borrowing from others. The loan agreement is between the individuals even though the administration is by the P2P company. If a P2P company goes bust, it is extremely unlikely all the loans will go bad too. Knowing what you are funding brings a personal touch and there is also some pleasure to be had from knowing you are funding somebodys wedding, car or holiday at a better rate than they could get from the banks. Bank loans essentially depend on the mood and confidence of the banks, and we all know from Northen Rock, RBS and HBOS what happens when they get it wrong and who pays to fix it.

    Just before the financial crisis in 2007-8 I was considering getting out of P2P as the underlying value cannot go up so it is not an ideal investment. When the crisis happened I was glad I hadn’t. The income from P2P and other non equity investments meant we didn’t have to sell shares to finance our living, and we were able to ride it out and watch them recover, so my experience from someone who no longer has a salary is that it does have a place as part of a portfolio.

    1. Simon

      Thanks for your comment….diversity and different opinions are welcomed here…especially when expressed as intelligently and courteously as you have done.

      All the best with your investing

      TEA

  10. […] having a job while looking for another one. But still, trite or otherwise, this reminds me of the value of optionality. Perhaps even more so, it reminds me of the value of the other party in a negotiation being able to […]

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