Capitalism 101: Options


I used to joke that I could wallpaper my bathroom with stock options. Back in the 90s, it seemed like every company was giving them away and everyone was either getting rich on options or wallpapering their bathroom, or both.

The big moment for stock options was during the early internet boom: there were lots of companies that basically were worth nothing, but were experiencing huge stock market price bubbles. So – since their stock was endlessly going up until they imploded and vanished (remember Netscape?) – the options didn’t cost the company anything, until and unless they decided to adopt a stable business model, in which case they suddenly were out a gigantic amount of money for the options they had been handing out like methamphetamine crackerjack since the company started.

Let me explain options to you, then. You may want to refresh yourself on valuations and market caps, because options depend heavily on that. [stderr] The ancestral option that crawled out of the pangaean soup is this:

You buy the right to pay a negotiated price for something, at a negotiated time.

If you’re familiar with a “right of first refusal” a right of first refusal is sort of an option: it’s just saying “I can buy this thing at some time in the future at any price that you offer to someone else.” The key to all options is that we assume things will change between now and the future, and we don’t know how they will change. If we knew how the future was going to play out, we’d have insider information and that breaks the whole way that speculative investing works – it’s like knowing which horse is going to win at Belmont: you make all the money.

Let’s suppose that one of you has fallen deeply in love with my milling machine, and you wish to own it for your ownself when I am done with it. You might try to get me to sell you an option on it: you sidle up (or, your attorney emails mine) and say “I’d like to offer $100 to buy an option on your bridgeport, to purchase it for $1,000 upon your untimely death. That’s below market, of course, but you will enjoy the $100 now, and who knows, you might outlive me, or bridgeports will have no value at all by the time you finally die.”

Now, I think about that deal and take your $100. Actually, that’s a lie: I think about that deal and conclude that you plan to kill me for my bridgeport, and I decline to sell you an option. There’s a lot of stuff tied up in this other than mortality – if the terms of the option are long enough, things could change dramatically – what if the US economy implodes into runaway inflation and $1,000 is the cost of a beer? You just made a very good deal. Or, maybe things go the other way, and $1,000 is the cost of a good house, and you’d be better off letting your $100 go, than spending everything you have, to obtain a piece of obsolete machinery.

That’s the basics of options: you’re establishing a gamble with an agreeable partner, that the value of something is going to change, and you’re going to be on the right side of that transaction.

That’s what the futures market is, at the commodity exchanges: it’s July now, but you might buy an option on 1,000 gallons of concentrated orange juice for $1/gal, in November. Let’s say the option costs you $500 – what you’ve done is hedged your bet – you have now fixed your price for orange juice ahead of the market. If you’re wrong, and the cost of orange juice goes down, you let the $500 go and buy cheaper orange juice (at a price low enough to offset your loss of $500). If you’re right, and the cost of orange juice goes way up, the seller has to honor your fixed price, and they wind up selling you the orange juice for much less than they could get on the open market. At the level where the big investment houses play, these contracts are all carefully written and are universally honored; even Donald Trump wouldn’t break one with impunity – it’s a career limiting move.

Whatever happened to “buy low, sell high?”

In the early 1990s, companies came up with the idea of giving employees “incentive stock options.” The way that works is, let’s say I am starting BadgerSystems.com and I need programmers. So to encourage programmers to come work for me instead of Google, I offer them stock options! You start working for BadgerSystems.com and you get the option to buy 1,000 shares of stock at their current value, which is close to zero and you have up to 10 years to do the transaction before the options grant expires. Let’s say BadgerSystems.com shares are worth $.10/share, so you whip out a checkbook and write our Chief Financial Officer $100. Now you own the shares. Another employee is less confident that BadgerSystems.com will succeed, and they just sit on the option and do nothing. Five years pass, and ReallyBig.com buys BadgerSystems.com for a share price of $500/share. The person who bought the shares to begin with has $500,000 worth of shares! Yay! The person who didn’t buy the shares whips out his checkbook and writes a check for $100, and is delivered shares worth $500,000! Yay! But the difference is: the first person owes long-term capital gains on their shares (about $175,000 even under Trump) and they end up with $325,000. The second person is basically handed $499,900 in income, and probably owes $250,000 on it because the taxes are different on short term capital gains versus long-term capital gains.

But it’s a great deal, everyone got something for nothing, right? No, not really, because the company just sold $500,000 worth of stock for $100 and that’s really stupid. It took a decade of wild speculation before boards of directors realized that companies were throwing money down the drain in the form of generous stock options grants. Oops.

Now comes the part we always have to talk about when we talk about stock options: derivatives. A stock option is a derivative, as is an option on a bridgeport milling machine. Derivatives are interesting because they add money to the economy that is out of control of the government, sort of. Or, it’s money that certainly ought to make governments uncomfortable, if they care about their banking systems (the US economy is owned by bankers, so it cares about derivatives, but not in the way it should) – derivatives add money because, in the example of the bridgeport, I now have $100 and I still have my bridgeport – there’s money moving in the market and nothing of value has been exchanged. Or (and now it gets weird) what if you take the contract I sold you for $100 and you sell it to someone else for $200? You just created $100 out of thin air! Basically, where that $100 came from is – it was squeezed like golden juice from the speculative difference in the future value of my milling machine.

A milling machine is not a great example; I should have done better. But you can see how an entire company can be monetized in parallel, by people who are basically using it as a marker in a gambling game.

That’s where short selling and “puts” come in: they’re outright gambling. Suppose the person who has the $500,000 worth of BadgerSystems.com is worried that they might go down, but he hopes they’ll go up. He can ask around and maybe find someone who’s willing to agree to buy his shares any time he wants to sell them, for $450/share ($450,000) against $50,000 now – for $50,000 he has “hedged” against a loss. He can’t wind up with less than $450,000 but the shares need to go up to $600/share before selling them looks attractive again.

A “short” is when you think an asset is going to go down – let’s say BadgerSystems.com is a company you don’t like: sell someone options on BadgerSystems.com at $400/share and pocket their money. Then let’s say you think the market is going to crash – BadgerSystems.com plunges down to $350/share and you clean up: you buy the shares for $350/share on the open market and cover the short sale option and make $150/share – $150,000 (assuming stock was at $500 when you wrote the option) that’s real money. When we took V-One Corporation public in 1997, Janney-Montgomery Scott, and Piper Jaffray, the companies that financed the IPO, shorted the company on its own IPO – in other words, they knew it was going to go down so they positioned themselves to snap up shares when it did. Then, they placed blocks of IPO stock with people they knew would immediately sell it – and the price went down and they cleaned up. That’s illegal as hell, and they got fined almost 10% of what they made. That’s capitalism for you!

Company officers and small investors often get riled about short-sellers, because they appear to be horrible blood-sucking market manipulators who are driving down the value of their stock. Well, they are. But the whole system is corrupt and is built to be manipulated that way – the short-sellers are just the visible tip of the iceberg.

There is another kind of option-selling (that is now illegal) which is called a “toxic preferred share.” One of V-One’s investors talked the Chief Financial Officer – who didn’t know about them – into issuing such shares. The way they work is that those shares come with a liquidation preference – which means, if there are shares to sell, the preferred shares get sold first. Also, they come with a “note” which is essentially an option: the company guarantees the share price for those shares to be not less than a certain amount or the company will cover the difference.

Now, pause and think that over. See how clever you are; see if you can see the razor blade in the apple.

The way a toxic preferred works it means that the shareholder can deliberately drive the price of the stock down any time they want to, by using their liquidation preference, and the company has to cover the spread. So, what the shareholder does is takes up a short position – let’s say $10 below the current share price – then they sell their preferred shares as fast as they can. The company’s stock starts going down and the company has to write checks to the seller, as they drive the price down until they can cover their short position. So, if they had 100,000 shares of toxic preferred, the company just lost $10/share (which is the kiss of death for a small company that has just done an IPO) and the seller made $2 million, $1 million of it from the company and $1 million from whoever took the option.

Do not turn your back on a capitalist. Especially if they have a knife or a fork on their hand – they will eat you. And they’ll blame you for it.

------ divider ------

I just found that cartoon by google searching for “predatory short seller.” Everyone hates them but they’re really normal people like Mitt Romney and Michael Milken. Donald Trump is not smart enough to play derivatives. He couldn’t even make money on hotels and casinos with tax subsidies – derivatives sellers would eat him alive.

Gambling on the stock market is much much less risky than going to a casino, where the house always has a slight margin over you. If you’re in an economy that is growing, you can basically bet with the house – bet on growth – and you’ll do fine, as long as you’re not trying to make a huge killing.

Comments

  1. says

    That’s illegal as hell, and they got fined almost 10% of what they made.

    Why do lawmakers even bother outlawing something if they aren’t willing to actually punish people for doing that thing. . .

    A friend of mine once told me this story about a person he knew (meaning: I cannot be completely sure about how accurate it is; “somebody told me about somebody they knew” isn’t exactly verifiable). Anyway, a guy living in the USA at one point found himself without a job and without money. He didn’t want to get one of those low paying shitty jobs, so he decided to earn money the illegal way. He got himself a copy of the criminal code with a list of crimes and what punishments people get for each one of them. His reasoning went approximately like this: “Commit this crime and they’ll give me 10 years in jail, that’s not worth it. Do this, and I’ll get 5 years. Oh, for this one crime they only give a small fine. Great! Let’s do that.” Basically, he did a cost/benefit analysis about how much he could earn by committing various crimes and how severe punishment he would get for each one of them. I suppose that while doing this analysis he also factored in the probability of getting caught.

  2. Curt Sampson says

    I think it’s fair to point out that short-selling, put options, or any other derivative or other contracts are not always “outright gambling;” it depends on what else you’re also doing that affects your position. As you point out, they can be (and often are) used to hedge a position so as to reduce your risk. This was (very roughly) actually the whole point behind derivatives in the first place: to allow farmers to offload risk on to those better able to handle it so they could get on with long-term farming, rather than quite literally betting the farm with every crop. And anybody who ever buys insurance of any kind should be happy that there are people out there willing to take a fee to handle their risk.

    Short selling and derivatives in general are also essential tools to help avoid bubbles in markets.

    That’s not to say that these tools can’t be misused, or that any particular market will work well (in terms of of economic efficiency, fairness, and any other criteria you care to bring in). Markets are, after all, just inventions of social relations between people, and each one will tend towards particular goals, good or bad, by virtue of its design. Socialists are often as happy to use markets as “capitalists”; everybody just wants markets designed to align with their particular goals.

    The level of analysis of this in public discourse is generally pretty poor. Most “free market capitalists,” even as they are raging against government interference, blindly accept one of the largest and most dramatic instances of government interference in markets, so-called intellectual property rights, which in most conceptions (including that in the U.S. constitution) is a directly and overtly socialist scheme. Yet they’ll be utterly opposed to things that would directly support wide-spread entrepreneurialism such as universal health care and basic income or similar schemes.

    So let’s make sure we’re pointing out that it’s not “markets” themselves that are bad, but that specific markets are designed (or anyway, grew) to prioritize certain social ends over others and it’s generally those ends about which we’re making value judgements.

    And I can’t post about this without mentioning Peter Bernstein’s Against the Gods: The Remarkable Story of Risk. It’s a great introduction to the history and use of financial tools for risk management, and a long time ago inspired me to learn more about all of this.

  3. komarov says

    even Donald Trump wouldn’t break one with impunity – it’s a career limiting move.

    Warning: Suspension of disbelief exceeds maximum safe tolerances!

    If anything that man has shown that – for some – there is no such thing as a career limiting move. He’s also demonstrated that it is possible to have a successful career (weeell) that it is impossible to take pride in. “You used to be president? Wow … no, wait. You’re him, aren’t you? Get out!”

    Do not turn your back on a capitalist. Especially if they have a knife or a fork on their hand – they will eat you. And they’ll blame you for it.

    It is your fault for being so delicious.

    Re: Ieva Skrebele (#1):

    Why do lawmakers even bother outlawing something if they aren’t willing to actually punish people for doing that thing. . .

    Because it makes everybody feel better. You get headlines saying that Company Inc. paid hundreds of millions in fines, wow! And a big hurrah for the government officials who sniffed them out and punished them To The Full Extent Of The Law (TM)!

    I suppose if Company Inc. paid the fine somewhat casually by having the groundskeeper melt down a few of the golden garden gnomes then that’s an insignificant detail. It doesn’t make for a good story, especially if it ends in “happily ever after” for the company. So we’ll skip it.

    Your possibly apocryphal acquaintance-of-a-friend’s buisness model seems disturbingly reasonable. I guess we’ll never know but, if successful, he probably ended up with an office job far up on the corner of a many-storied building.

  4. jrkrideau says

    OT but back to plastering walls. A friend of mine said that while knocking around Germany in the 1960’s he once had a bedroom wallpapered with Weimar Republic marks.

  5. says

    jrkrideau@#4:
    OT but back to plastering walls. A friend of mine said that while knocking around Germany in the 1960’s he once had a bedroom wallpapered with Weimar Republic marks.

    There were probably a few people who did OK for a while, paying off mortgages with increasingly worthless money. But in the long run, having a nice seat on a sinking ship still means you’re on a sinking ship.

    You can buy worthless paper money on ebay. Unfortunately, it’s smallish lots. But you can get some crazy demoninations – I used to have a couple 1 billion-something bills, but I stopped carrying them because I didn’t want some cop to think I was a drug kingpin.

  6. says

    Curt Sampson@#2:
    And I can’t post about this without mentioning Peter Bernstein’s Against the Gods: The Remarkable Story of Risk. It’s a great introduction to the history and use of financial tools for risk management, and a long time ago inspired me to learn more about all of this.

    Let me second that. It’s a great read.

    In my professional field (computer security) there used to be a lot of talk about “risk” but it became clear to some of us that those talking about risk didn’t really understand what they were going on about. The Bernstein book was instrumental in clearing that up. For me a huge take-away was that people in ancient times played “bones” (craps, basically) but didn’t understand probability distributions well enough that they shouldn’t have been doing that.

  7. says

    komarov @#3

    Why do lawmakers even bother outlawing something if they aren’t willing to actually punish people for doing that thing. . .

    Because it makes everybody feel better. You get headlines saying that Company Inc. paid hundreds of millions in fines, wow!

    That was a rhetorical question. I understand why the current punitive system is designed so as to allow wealthy people get away with stealing. It’s just that this is not how it ought to be.

    Your possibly apocryphal acquaintance-of-a-friend’s buisness model seems disturbingly reasonable.

    Yes, that’s the problem. Committing crimes can be a reasonable business model if the punishment costs you less compared to what you managed to earn/gain by doing the illegal action. Harsh punishments aren’t effective at deterring crimes that people commit without prior planning while being angry or drunk or desperate or whatever. However, they are effective at deterring crimes that are carefully planned and executed over a prolonged time period (at least as long as the would-be-criminal believes that their chances of getting caught are high). Wealthy people steal because they know that they can get away with it—even if caught, the fine will be smaller than the amount of money they successfully stole. The end result is that committing crimes becomes a reasonable business model.

    Marcus @#5

    I used to have a couple 1 billion-something bills, but I stopped carrying them because I didn’t want some cop to think I was a drug kingpin.

    Did you have any reason to fear a cop putting their hands inside your pockets? Weren’t they doing that exclusively to black people who looked poor?

    Not carrying a piece of paper out of fear of some cop finding it seems alien for me. Here cops don’t have a right to put their hands inside citizens’ pockets, and even in airports security guards pay no attention to paper, they just send you through the metal detector and that’s it.

  8. cvoinescu says

    even Donald Trump wouldn’t break one with impunity – it’s a career limiting move.

    Warning: Suspension of disbelief exceeds maximum safe tolerances!

    Usually, you, as an individual or a non-huge company, can’t break those contracts. This is because you can’t really trade them without the involvement of a clearing firm, and they won’t let you enter into the contracts (i.e., trade the options) unless you have a deposit with them that they deem large enough. (In fact, things have moved from end-of-day trade clearing to realtime or near-realtime checks by the clearing firm.) And if you fail to honor an options contract, the clearing firm will do it for you, with your own money, and they’re not gentle about it.

    The big companies, they’re allowed to clear their own options trades, obviously.

    Curt Sampson @ #2:

    I think it’s fair to point out that short-selling, put options, or any other derivative or other contracts are not always “outright gambling;” it depends on what else you’re also doing that affects your position.

    I’m also of the opinion that derivatives have many valid uses. Farm product price insurance, for one, as you point out; also, your power company can sell you a kilowatt-hour for a fairly constant price because they trade derivatives. Options allow investors to trade some growth for lower risk, like many pension funds do (or should do), or vice-versa; they’re very useful this way, and can be fine-tuned quite well. They also allow manufacturers to focus on what they’re making, without also having to get good at playing the market of raw materials: derivatives allow them to pay others to take those risks.

    As with everything, the less the laypeople understand what’s going on, the easier it is for the unscrupulous specialist to fuck them over. As with everything, the solution is more education, more transparency, and sensible regulation (that’s not in bed with the potential scammers — as if).

  9. call me mark says

    Isn’t it true that “punishable by fines” just translates to “legal for the rich”?

  10. says

    call me mark@#9:
    Isn’t it true that “punishable by fines” just translates to “legal for the rich”?

    I need a better “thread won” icon but you get what you get.

  11. Bill Spight says

    A couple of points. First, IMX, financial risk management is often not a way of reducing overall risk, but a way of shifting risk to someone else. That’s why financial innovation is usually harmful. As we saw 10 years ago.

    Second, intellectual property rights are not socialistic. They follow the basic capitalistic paradigm: Privatize profits, socialize costs. In the late 18th century and the 19th century they helped the middle class at the expense of the aristocracy. (They also helped end the long period of esoteric knowledge and usher in the modern period of exoteric knowledge, which has been a general benefit to society. We hardly know what the era of esoteric knowledge was like.)

    Third, mature capitalism starts to look like feudalism. Walmart has spawned a dynasty. Instead of elevating the middle class, for the past several decades capitalism has crushed the middle class. And intellectual property rights have been one of its tools in doing so.

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