And an option is:
An option is a "right" that you buy for a small fee; then, you have the option to exercise your right at a later time. You can buy the right to buy a security at a specific price not later than a specific date, or you can buy the right to sell a security at a specific time at a specific price.
If you don't exercise the right you paid for, you lose the money you paid for the option. Obviously, you would only exercise your option if the transaction is profitable for you.
Option risk management features:
There are a couple of interesting features embedded in the option transaction that are attractive from a risk management perspective:
- Time displacement (the distance between present and future) is usually a risk nemesis, but in options, time is on your side. Lemons become lemonade, as it where. In order for an option to become profitable, some time must pass during which the security changes value, hopefully in your favor. (Most securities trading works this way)
- Downside risk is protected. The most you can lose (if you act rationally) is your fee for the right to the option, thus protecting you from the actual loss of the value of the security
- Upside opportunity is amplified. Options leverage the value of the fee you paid. For your small fee, you may be able to participate in a very large gain, which on a percentage basis, is far greater than just trading the security.
Let's say you anticipate a make/buy juncture in the project 2-4 months out (we never use single point estimates here at Musings). Two chains of project activities radiate from this decision event: one chain supports a 'buy' decision (essentially, outsource to a supplier) and one chain supports a 'make' decision (do all the work in-house).
An option scenario is that you do something now to protect your right to go either way at the decision event. You make a small investment now in order that 'no options are off the table'.
Done right, you make a friend of time: time can be used to set up the conditions for a decision that might not otherwise be available. By protecting both eventualities, you protect agains the downside of poor alternative, or an alternative foregone because of no preparation. And, of course, your small investment may be highly leveraged: a great outcome made more likely by a small fee for preparation.
So, what are some things you might do? A few prototypes to test your in house capability; some training of staff in skills that might be needed; some due-diligence and benchmarking on the supply chain; and some research into the various vehicles for outsourcing, like incentive contracts, etc.
If you are portfolio manager, then options in the form of independent R&D (IR&D, or IRaD) is a good way to invest a small amount now in order to have project options in the future. And, of course, investing in your customer (things you know your customer wants to do is perhaps the best use of internal investment)
Oh, and how big is "small" in the investment we are talking about? No right answer of course, but a few percent of the value of the opportunity you are protecting is not a bad figure.
To learn more
If you want to see some numerical examples worked through, go to the Khan Academy and search for the short videos on options.