With a background in financial derivatives we’re going nerd out on some financial theory from time to time. I apologize in advance, but this is one of those times.
Option Pricing Theory
Stock options are equity derivatives that are frequently used for employee compensation or speculation within the finance realm. All of you tech bros out there should know what I’m talking about. A typical plain vanilla call option provides the upside of capital appreciation without any downside risk.
The upside potential provided by options frequently holds considerable value. Stock option are frequently valued using the Black-Scholes option pricing method, using variables such as the price of the underlying asset, the exercise price of the option, time to expiration, volatility and a risk-free interest rate.
For our purposes, we’re going to simplify things a bit by using a simple binomial option pricing model which determines option value by assuming the price of an asset can either increase or decrease by some estimated amount with some estimated probability.
Quick example: let’s assume Tesla is trading at $1,000 per share and they report earnings tomorrow. We know that depending on how many crappy trucks they sold, the price will either be $1,100 or $900 tomorrow with 50/50 probability. If one of your dull friends said “Hey, I’ll sell you my share for $1,000. Just let me know tomorrow if you want it” what should your reply be?
My reply would be, “Sure I’ll let you know tomorrow, chump.”And then I would wait to see how earnings went. If Elon sold a lot of crappy trucks (and the price increased to $1,100) I would go ahead and buy my friend’s share for $1,000. If earnings shit the bed, I would pass on my friend’s offer and not by the share. Basically, you have no downside, only upside. Visually that option looks as follows: