Understanding Options Through Everyday Decisions: The Concert Ticket Analogy
/I still find options difficult to understand. But I do find analogies to be helpful, so let’s develop another one.
To do that, let’s turn to another scenario most of us have experienced: buying tickets for a concert.
Imagine Taylor Swift announces she will be in your city six months from now and tickets will go on sale a week from now. We all know, Taylor Swift fans will pay ANYTHING. And while you really want to go, and you are willing to pay the big bucks, you are not willing to pay the big bucks for a ticket and then be unable to go because of your uncertain work schedule.
Wait, there’s a solution! A friend offers you a deal: for $100 today, he'll give you the right (but not the obligation) to buy his ticket at a fixed price of $1500 anytime before the concert. You don’t know how much he paid for his ticket. But you assume that it was meaningfully lower than $1500. But it doesn’t matter to you. What you get is the certainty that you could buy his ticket, in the future, IF you are able to make it. All in, you would pay $1600. That is $100 for the option, and another $1500 for the actual ticket. But in your mind that is better than paying even $1000 now for a ticket which you reasonably might not use.
The $100 that you pay your friend for the option is simply the price you pay for the flexibility.
But here’s another thought.
What if Taylor Swift becomes EVEN MORE POPULAR in the meantime, and even terrible tickets start going for $2,000, $3,000, $4,000? (Not unrealistic at all, by the way). All of a sudden, your $100 option to buy a $1,500 ticket makes you look like a derivative trading genius!
And if for whatever reason you end up not wanting to attend the concert, and end up not deciding to sell your option, well, you just let it expire. You’ve only lost your $100 investment. But truly, you had a lot of optionality that came with that $100.
This is an example of very successfully buying a “call option” (or buying the right to buy).