Options - If You Give Wall Street a Cookie

The Literary Hall of Fame

Believe it or not, I am in a book club. It’s been incredible because it encourages me to read outside of my textbooks and the Wall Street Journal articles that are my primary literary stack throughout the week. At this book club, we don’t all read the same book, we instead share what book we’re currently reading and gain insights into what we could possibly read next as individuals. I’ve learned about tons of new authors, books, and genres from this group, and it is truly the highlight of my Thursday night once a month.

However, most of the books, while incredible, seem to fit cleanly into a certain genre that is traditionally expected based on the author and their past literary history. There are very few books that span multiple genres and do it well. But when I think of multi-genre books, one masterpiece comes to mind. This is one that is a comedy, mystery, and culinary all in one.

If You Give a Mouse a Cookie.

It’s funny (comedy). You never know what will happen next (mystery). It has cookies and milk as central components that drive the plot (culinary). The versatility is unmatched. I think there was another book made about a moose and a muffin, but that doesn’t compare to the original tale of the mouse and his cookie. What’s interesting about the book is that it is all “if, then” statements

If you give a mouse a cookie then he asks for a glass of milk. The entire spiral after that involves subsequent “if, then” statements. While this is a silly example, it summarizes one tool on the financial markets known as options.

Coffee Shop Cookies

Now that we’re on the topic of cookies, one of my favorite cookies to get here in OKC is a salted chocolate chip cookie from my favorite coffee shop – Willow Coffee Co. I would attribute my love for these to the taste, but I think a secondary aspect of them makes one even sweeter when I secure it – scarcity. Yes, there is a limited daily supply of these and once they run out, they’re out for the day. If you swing by Willow at 3:00 pm, there is nearly zero shot you will be eating a cookie that day. It’s just the reality of a good thing.

Granted, I normally go to Willow in the late morning on Saturday which ensures as strong supply of cookies, but there are people who get to Willow at their early morning opening. If there was ever a run on cookies in the morning (which is a legitimate fear I have had) then I would be out of luck, even in the late morning.

Now this isn’t the ONLY cookie in OKC, in fact they have a similar cookie at Elemental Coffee, but that is a 20-minute walk from Willow – not something I’m trying to do on Saturday morning.

So that raises an interesting question – what is the best way to go about securing a cookie if I were to want to sleep in on Saturday for a change? I don’t know if there will be cookies or if there will not be, so I want flexibility with any deal I strike. The cookie may only be $3 but I am willing to go all in – the happiness it brings me is infinite.

Right to Buy I – Call Option

My friend Scott thinks that my concern is vastly overblown. He sees that I consistently come to Willow at 10:00 and doesn’t believe there will be a situation where cookies run out at all. He offers me a deal.

If I pay him $1 right now, he will guarantee I can secure a cookie at the same price that I pay for one at Willow. Let’s look at this deal in detail in two situations – one where all the cookies are in steady supply, and one where all the cookies run out.

(1)   Cookies in Steady Supply

Me: I still pay Scott $1. I must pay him ahead of time before I get to Willow. However, when I get to Willow, I go up to the counter like normal and get a cookie for $3. In essence, the cost to acquire a $3 cookie is $4 (cookie + payment to Scott). However, if I really want a cookie, that $1 is immaterial to me if it means guaranteeing my warm, Willow cookie.

Scott: Collects $1. He gets $1 out of me, and it costs him nothing. If Scott is CERTAIN that Willow will have ample cookies, he might give this insurance to 30 other cookie loving individuals who come at 10 AM.

(2)   Cookies Run Out

Me: It still costs me $4 to acquire a cookie. I have paid Scott ahead of time, but now I purchase the cookie from Scott. He has the obligation to give me a cookie if I want it since I paid him $1 for the right to guarantee a cookie.

Scott: Collects $1 BUT now he must walk to Elemental, buy me a cookie, and walk back to Willow to give it to me. He may have collected $1 as insurance and gets $3 because that’s the price I would have paid at Willow but considering the inconvenience and the fact he sold me a rare cookie for a measly $3, he has lost in this deal.

Scott shudders thinking about this outcome – what are some ways he could mitigate this?

Right to Buy II – Covered Call Option

Now instead of just selling the option to buy, Scott also purchases a cookie from Willow when he arrives at the coffee shop’s opening. Why would he do this? Let’s look at our two situations again.

(1)   Cookies in Steady Supply

Me: Still pays Scott $1, and I still buy my cookies at the counter for $3.

Scott: Gets $1 but he also paid $3 for a cookie when he first got to Willow. He loses in this deal since I don’t buy the cookie from him. He paid $3 for the cookie and got $1 in income from the option.

(2)   Cookies Run Out

Me: Still pay Scott $1, buy the cookie from Scott for $3. Note that this is the cookie he bought when he first arrived at the coffee shop!

Scott: Gets $1 and still pays $3 for the cookie when he first arrives, BUT now he gets $3 back from me since I am forced to buy from him after Willow runs out of cookies.

He now makes a $1 gain on this deal! This is the amount of the option payment I pay him to guarantee a cookie.

This is called a covered call because the obligation is already covered. Scott already owns the cookie he has to deliver to me. In finance a “call option” is the right to buy an asset at a certain price. Keep in mind if you buy a call option you are not obligated to buy the asset at the price, but you can if it makes financial sense.

Call Option Decisions

 So, when does Scott do a covered call versus a call option? It all depends on Scott’s risk tolerance and outlook on the market. If Scott is certain that cookies will not run out, he will sell a traditional call option. This is because he is confident that the cookie will be bought at the counter anyways, so he is happy collecting his $1.

If Scott is risk averse, he may do a covered call. He does not want to walk to Elemental, so he will buy the cookie. Although he may lose out on the position if I buy my cookie at the counter, he is comfortable maximizing his gain at $1 (value of the option) at the mitigation of not having to walk to Elemental.

However, this doesn’t sit right with Scott. He still has risk if I buy my cookie at the counter. Now he’s holding a Willow cookie he wouldn’t have otherwise bought. But he has a mitigation strategy – enter Scott’s girlfriend.

Right to Sell I – Put Option

Scott strikes another deal with his girlfriend who loves cookies. In fact, she agrees with me that Willow has some of the best cookies in the area. She believes cookies running out are very likely. In fact, she would buy all the cookies in supply if she could.

She makes a deal with Scott. She will offer him the right to sell her the cookie at $3 if he pays her $1. Let’s run through this deal with our two situations. For our example let’s assume Scott goes with a covered call strategy.

(1)   Cookies in Steady Supply

Scott: Collects $1 from me and pays his girlfriend $1 ahead of time. He then pays $3 for the cookie when he arrives, but since the cookies are in steady supply I buy at the counter. However, Scott instead sells to his girlfriend for $3. Scott gets out of the position free and clear. He has made nothing and lost nothing.

Scott’s Girlfriend: Collects $1 from Scott. However, when Scott sells to her, she must buy for $3. She loses $2 on this position.

(2)   Cookies Run Out

Scott: Collects $1 from me and pays his girlfriend $1 ahead of time. He pays $3 for the cookie at open. Since there are no more cookies, I pay Scott $3 for my cookie. He gets out of this deal free and clear as well!

Scott’s Girlfriend: Collects $1 from Scott. However, Scott sold the cookie to me so he cannot exercise his right to sell the cookie to her for $3. She makes $1.

Put options are simply the right to sell at a certain price. It is different than a call which is the right to buy at a certain price.

Put Option Decisions

So, you may ask, why would Scott even do this? Well, the difference with our cookies and real put and call options on the financial markets are three main things.

(1)   Costs can differ for puts and calls

(2)   The price of exchanging the cookie can change

(3)    The price of the cookie can change based on supply and demand

Collars

Willow’s owner sees that his cookies are in high demand, so he raises the price of the cookie to $5 and lets the baristas change the price of the cookie throughout the day based on supply and demand. Instead, Scott now buys a cookie at $5 when Willow opens.

Let’s say Scott still buys the right to sell (to his girlfriend) and sells the right to buy (to me).

However, we set different prices we exchange the cookie for (called the Strike Price in options) and the right to buy and sell at different exchange prices are different (these right to buy or sell payments are called option premiums).

Scott buys the right to sell the cookie for $3 for $0.50. His girlfriend just saw Scott buy the cookie for $5 and thinks he would be insane to want to sell it for $3. She can’t demand a whole $1 since the cookie is worth above $3, but she will happily take $0.50. This is called an out of the money put option since the right to sell is far lower than what the cookie is currently being sold at.

He also sells the right to buy it for me at a $7 strike price for $0.75. The market really likes the cookies and while $7 is far above what I could buy the cookie at for now, I still think the cookie will move upward in price throughout the day so it is more likely it moves up $2 than down $2. Hence why this option is more valuable.

Let’s look at this in 3 different scenarios. It is key to note that Scott is buying a cookie at open and holding it.

(1) Cookie Falls to $2

Regardless of what happens it is important to first note that Scott gets $0.75 in premium (from me) and pays $0.50 in premium (to his girlfriend). He is at a $0.25 gain on his premiums.

If the cookie falls to $2 I would not exercise my right to buy at $7. Why would I buy a cookie for $7 when I could buy one from Willow for $2?

However, Scott exercises his right to sell at $3 since the cookie is worth less than he bought it for. Although he loses $2 on the asset (paid $5 for the cookie at open and sold it for $3) he collects $0.25 in premium Gains

Total Loss = ($3-$5) + $0.25 = -$1.75

Keep in mind he has the right to sell at $3 no matter how low the price falls. His losses are capped at $1.75

(2) Cookie Rises to $10

The premiums are the same. Scott is still netting $0.25 on the premiums.

If the cookie rises to $10, I was right about the cookie moving up in price and I exercise my right to buy Scott’s cookie for $7. Scott now recognizes a $2 gain on his sale of the cookie.

However, Scott is upset because he could have sold his cookie for $10 on the market but is forced to give it to me for $7. He has given up $3 of potential gains.

Total Gain = ($7-$5) + $0.25 = $2.25

His upside gain is capped at $2.25

Scott has created a collar where the most he can lose is $1.75 and the most he can gain is $2.25. However, if he is holding the cookie he is comfortable with this position as it reliably allows him to estimate his gains and losses within a range.

If You Give Scott a Cookie

Ultimately, the collar is one of the many strategies in options. Mixes of arranging strike prices and collecting premiums can yield a variety of incredible strategies. While that complexity is great, for now all you need to know is that

Call = Right (not obligation) to buy asset at a certain price

Put = Right (not obligation) to sell assets at a certain price

That is all options are. The right to buy/sell and the cost (premium) you must pay for that right. So, when you hear the discussion about options on the news or amongst friends, this is what they’re talking about!

Don’t worry, I’m not encouraging you to go and try and sell options to your friends and girlfriend in the hopes of making some money off premiums and cookie trading. However, if I were to give you advice along that line, I would encourage you to find a hungry mouse. I’m betting the option premium you’d collect on that cookie deal may be hefty!