Our weekly explainer on economics using lessons from popular culture. In Installment 64, James Bond learns about Options Theory.
Casino Royale is probably my favorite James Bond movie (although I’ll be the first to say that it’s a close run thing!). Of the many things to like about that movie, though, there’s one aspect that tickles me like no other: it’s a great way to learn options theory.
As M explains to (and let’s be frank here) a rather befuddled Bond, there is a way to make a whole lot of money by giving financial markets some unexpected bad news. And if you, like me, are a fan of the movie, you know what the unexpected bad news was supposed to have been.
A Very Bad Man is hired to go put a bomb on the maiden flight of a brand new aeroplane, due to fly out of Miami airport. If that bomb had gone off as per plan, it’s safe to assume that the stock price of the airline in question would nosedive whenever markets opened next. So what, you ask? Here’s a simple example.
Say pre-successful-explosion, the stock price of the airline in question was a hundred dollars. Le Chiffre, the villain in Casino Royale, would buy an option today to sell a share of the firm tomorrow at maybe ninety-nine dollars. What Le Chiffre has purchased is known as a long put. Translated into English, it is the purchase of an option to sell something at a predetermined price. Let’s say that this purchase of the option happens for the price of one dollar.
If the plane blows up, the price of that same share tomorrow may well be fifty. Le Chiffre, because he has the option to sell at ninety-nine, can make a whole lot of money by buying the share in the spot market at fifty, and selling it at ninety-nine, pocketing a cool forty-nine dollars in the process. And if forty-nine seems like a very non-Bond-villain number to you, buy one hundred million long puts.
Having purchased a hundred million such options, Le Chiffre did what Bond villains do, and tried to get the plane to blow up. Bond did what Bond does, and stopped the plane from blowing up. Long story short, on the morrow, the stock price of the airline in questions opened at a price higher that ninety nine.
The puts, which Le Chiffre had purchased for a dollar apiece, expire worthless, and Le Chiffre is short a cool hundred million. Which is why he decides to play that high stakes poker game — and well, we know the rest of it.
Now, this might leave you with the impression that options are the work of the devil, but that’s a little bit like blaming the knife for the stabbing. Options in the world of finance have been used literally for centuries, sometimes to speculate and make profits, but also to provide insurance. These same long puts, for example, also provide a cotton farmer with the option to sell her cotton at a high price, irrespective of how low it gets in the market come harvest day. Calls, puts and other, more exotic types of options are just instruments in financial markets — what creates problems is not these instruments themselves, but how you use them.
Options are great arrows to have in your quiver where life is concerned (and not just in financial markets.) For as the name suggests, they give you an option, in return for what is often a low payment upfront. Getting an additional degree, reading books that you don’t have to, buying health insurance — all of these and much more are really just small upfront payments of time, money or both. They leave you with the option of using them whenever necessary, often to make a large profit, or avert a large loss. They’ve been around for about as long as humans have been around, and have proven to be extremely useful in practice.
Yes, governments all over the world, and India’s in particular, have been rather trigger happy at shutting them down every now and then, but that’s a topic for another day. The bottom-line is, options are truly useful — and who better to teach you about this than 007?