So, You Don’t Deal in Options, Eh?

Some traders apparently believe a number of myths about options. They break into cold sweats and begin twitching uncontrollably when the subject of options is raised. This reaction is remarkable to watch and difficult to understand,because every American who has capital or good credit, whether he trades in any market or not, implicitly deals with options almost every day of his life, one way or another.

Do you own a car? Do you own your home? Do you own rental property?Unless you bought these assets for cash, you deal or have dealt in options.Don’t shake your head at me, you do deal in options. Can you pay down, or pay off, your loan on these assets any time you wish? If not, you have my sympathy,and I retract the preceding statements (and you really should have someone advise you, before taking out another such loan).

If so, however, whichever lender financed your purchase of any of these assets also sold you an option to prepay all or part of the loan you made. It’s your choice to prepay or not, correct? This is the precise definition of an option.In this case, the lender sold you a put option on your interest payments,and a very interesting one, too, because it’s a variable option. To exercise your option, you don’t have to pay off the whole amount of your loan; you may do so in pieces, month on month as you find convenient, merely by paying an amount above the required monthly payment.

When you elect to prepay a loan, you lower your capital debt immediately, but you also effectively sell back some amount of future interest to the lender for the intriguing price of only the time value of money, the expected interest rate over the remaining term of the loan. If interest rates, which by definition are the time value of money, are beginning to increase generally at some point, and if you’ve no other use for your capital for the moment, you might well consider prepaying part or all of your loan.

Naturally, your decision to prepay will be influenced by the current interest rate charged on the loan, and whether this interest rate is fixed or variable, but you absolutely own an option here, because it’s your choice to prepay or not.You’ve paid for this option, certainly; it’s not a free lunch at all. Lenders used to charge hard-dollar prepayment penalties as a matter of ordinary business, but no more. With the deregulation of interest rates and the fuller disclosure of lending practices beginning in the late 1970s, lenders cannot these days freely pick our pockets just because we wish to reduce our level of debt.

Instead, they fold the cost of the prepayment option into the interest rate of the loan. So, what does this option cost? The practical way to discover its cost would be to approach two lenders and ask one for a standard loan, however defined and of a specific term, which we can prepay when and as we wish, and ask the second for an identical loan that we specifically cannot prepay. It would be very instructive to learn how much the second lender would discount the interest rate on his loan.Loans are just one way in which you deal in options.

Very possibly, especially during the recent bull market in stocks, your company might have granted options to you on its own shares, many times with an exercise price below (or way below) the current market price of the shares. These are call options by definition, of course. You have the right but no obligation at all to purchase your company’s shares, under stipulated conditions, and prior to a certain date. The cost of these options to you is the expenditure of your time working for the company.

Obviously, you will make your own decision as to whether this is a fair and worthwhile expenditure, and whether these options, in combination with your wages and any available non-wage benefits,represent good value regarding your time and effort. Regardless of the decision you ultimately make, though, you are dealing in options.Do you use retail stores’ coupons? You deal in a type of call option if you do.

A store will sell you merchandise X at a reduced price Y on or before a particular date if you hand in the coupon when you buy X. These coupons are partial call options having the wonderful immediate price of  zero. If you’ve a coupon in hand, you have the right, but no obligation whatever,to buy that merchandise at that store at the named price or with the named discount, on or before the named date.

Your actual cost of this option is the incremental time and expense of going to the store that honors the coupon, which may well be zero if you had intended to go to that store anyway. The retailer or the manufacturer of the underlying product is writing this type of option in the hope that you’ll purchase other products while you’re in the store.You don’t deal in options, eh? Pardon me, but that’s simply a false belief, if you still hold on to it at this point.