In order to understand what options are, let’s
start with an example.
Meet Zoey.
Zoey has a car.
This is Bill.
Bill requests from Zoey to give him the right
to buy the car from her at 15K in cash anytime
during the next month.
Zoe might agree on the condition that Bill
pays her 2% of the value of the car, which
is 300 dollars, for waiting out the month
without a transaction.
Zoe cannot sell her car to anyone else during
this waiting period.
Bill does not have to buy the car in this
time frame, but he does have the right to
do so.
Let’s look at the definition:
An Option is a contract allowing the recipient
the right, but not the obligation to transact
a known transaction (buy or sell) of a known
Asset at a known price in a known pre-defined
time frame.
A contract - The Option agreement between
two parties.
A recipient (of the Option right) - in our
case it’s Bill - also called “option buyer”
or “the option holder.”
A known Asset - The core of the option - in
our case, it’s Bill’s opportunity to buy
a car from Zoe.
The person giving the right and taking upon
himself the obligation (in our case Zoe) is
sometimes called the “originator” or “option
writer” or “option seller.”
At a known price - $15,000, also called “strike,”
and $300, which is the price of the option.
In a known pre-defined time frame - in our
case - One month, after that time, the option
has no value.
This pre-defined time frame in which the option
will be exercisable is called the option’s
Term or Duration.
Options that can be exercisable at any time
during the time period are called American
Options.
Options that can be exercised only at the
end of the period are 
called European.
The technical name of an Option that involves
the right to BUY an asset at a price is a
CALL Option.
In our case, Zoe sold a Call Option to Bill.
Options are very useful tools in business
and are indeed used to help execute all sorts
of transactions and help reach all sorts of
business goals.
Here are few examples:
a.
Sara is a real estate entrepreneur.
She meets Phillip, the owner of some land
close to the beach, who wants to sell his
property.
Sara knows of some friends who would love
to buy luxury apartments in this location,
which is a high demand zone and characterized
by limited supply.
Sara approaches Phillip and proposes a deal:
The owner will award Sara with the right,
but not the obligation, to buy the land for
three million dollars any time within a 24-month
period.
Within this time, Phillip’s Property is
off the market, and Sara will have time to
proceed.
Sara has high conviction in the project and
pays Phillip $50,000 for the option on the
land.
Sara then prepares the plans and finds out
she can build 30 condominiums.
She approaches ten friends and offers them
to buy a condominium from her at $750,000.
Eight agree to the transaction and are willing
to commit half the proceeds up front to secure
the property.
Sara has sufficient capital to secure the
deal and now Exercises the option to buy the
land.
In this case, Phillip sold a Call Option to
Sara.
b.
Margaret owns a coffee shop chain.
One day, a competitor approaches her with
a proposal to purchase 50% of her business.
Margaret is happy to accept the cash offer
and negotiates a two million dollar company
valuation.
For some reason, the buyer doesn't want to
buy the whole company, and Margaret worries
that differences in business approaches and
management styles might pose a problem.
Jeff, Margaret’s friend, comes up with an
Idea:
The Buyer will purchase half the business
for 1,000,000 dollars but will also Grant
Margaret the right but not the obligation
to SELL her full remaining stake in the business
for 1,000,000 dollars (based on the existing
valuation times 50% remaining stake) for a
term of five years.
Margaret had the option to SELL her share
at a price they agreed to before; this option’s
technical name is a PUT option.
Think of the Option recipient (Margaret in
our case) putting the now worthless remaining
shares in her partner’s hands and taking
the money from his pocket.
If Margaret executes the Option, the buyer
must comply.
The buyer awards Margaret the Option and the
deal is executed.
The competitor buys 50% from Moonbucks Coffee
Shop.
Margaret is 1,000,000 dollars richer.
The new partner demands to improve profitability
and takes drastic measures such as firing
two critical high-cost employees.
Profits promptly plummet resulting in an operational
loss.
Margaret is devastated, but Jeff reminds her
of her Option to sell the remaining stake
in the company so Margaret promptly exercises
the Option to sell.
The Partner competitor finds to his dismay
that now he can’t back out from the deal,
and must shell out an additional 1,000,000
dollars to buy a now worthless, loss-generating
business.
Now Margaret can take her dream vacation and
sip margaritas with Jeff.
