It’s hard to overstate the importance of olives to the economy of the lands facing the Mediterranean Sea in ancient times. Olea europaea has been cultivated in these regions for 6,000 years. Quite possibly, olives were the source of the wealth of Minoa, the Bronze Age civilisation in Crete that provided the basis for the civilisation of Ancient Greece.
Certainly by the time of Thales of Miletus, around 600BC, life could not function without the fruit of the olive tree. Olives and more especially their oil were used as food, as heat for cooking, as a means of providing light as well as being the Mediterranean’s leading beauty product – ancient Greeks used olive oil as a moisturiser and for hair care. Such was the ubiquity and the importance of olive oil that it also became symbolic. Olive oil anointed Hebrew priests and the kings of Ancient Greece. Meanwhile, the eternal flame of the original Olympic Games was fuelled by olive oil.
Basically, if you think the modern world runs on the hydrocarbon version of oil, that’s nothing compared with the dependence of the ancient world on olive oil. So imagine the economic power that accrues to anyone who corners the market in olive oil. Effectively, that’s what Thales of Miletus did and the means by which he did it was the world’s first options contract.
Clearly, the oil has to be extracted from the olives and the way this is done has remained essentially the same since processing began. It’s a two-stage process. First, olives are ground into a paste, then the paste is spread onto fibre disks that are stacked in a press. Oil and water are then squeezed from the paste and the oil is separated from the water.
The olive mill and press are, therefore, vital pieces of capital equipment in the production process. They are olive oil’s equivalent of the modern oil refinery. Control the press and you control the whole process of getting the oil from the countryside to the consumer.
Thales was a smart guy. Like so many of the great ancient Greeks, he was multi-talented – part mathematician, part philosopher (Bertrand Russell said “western philosophy began with Thales”), part astrologer and occasional entrepreneur. It’s not so much that Thales was interested in money as he wanted to show his fellow citizens of Miletus – now part of modern-day Turkey – that esoteric learning could have useful applications. So one year, according to the tale, he used his skills in astrology to foresee a bumper olive harvest. His response was to take the limited capital he had and use it to buy from the owners of all the olive presses in the vicinity the first use of their press when the harvest came in.
Buying the right so far in advance of using it meant that Thales acquired monopoly pressing capacity on the cheap. Simultaneously, the owners of the presses were happy to sell the right for first use because they got the certainty of some cash upfront, which they preferred to the possibility, though not the certainty, of more cash some months into the future.
When the bumper harvest came in, farmers discovered that they had to pay expensively for use of the presses. Thales, who had got there first, was able to sell them the right of use, but at a price that he could dictate. Not only had he proved something that the ancient Greeks were sceptical about, but which we take for granted – that there is money to be made from the equivalent of rocket science; more to the point, he had illustrated the way that traded options work.
The contracts that Thales made behaved exactly the same way as modern traded options. In exchange for paying an upfront sum – the ‘premium’ – Thales got the use of the olive presses. Today, in exchange for paying a premium, an investor would get, say, the right but not the obligation to buy shares in GlaxoSmithKline (GSK) at £16 per share in three months’ time against a current market price for Glaxo’s shares of maybe 1,580p. If Glaxo’s shares had fallen to 1,560p when the option expired then the contract would have no value and the buyer would have lost what he had paid for it (probably about 25p per share). But no matter how far Glaxo’s share price falls before the contract’s expiry, the cost of the contract would be the limit of the holder’s losses.
However, if Glaxo’s share price rose to, say, £17, then the holder of the contract would be in much the same position as Thales – he could sell the contract at a fat profit. Common sense tells us that, if the market price of a security is £17, then an option to buy it at £16 would be worth almost £1.
Depending on how long there was before the option expired when the share price hit £17, then the option’s value might actually be worth more than £1. How much the share price was likely to bounce around in the period up to the option’s expiry would also affect the option’s value. The bouncier the price, the more valuable the option would become. That counter-intuitive piece of logic applies because a bouncy price – ‘volatile’ is the word used in investment – would give the option’s holder more opportunities to make a profit while having no effect on the possible losses, which were limited to the cost of the option. Understanding that notion, however, really did depend on a piece of rocket science. It would have been beyond even Thales and we’ll explain that in the next object.
23: Science museum rocket – black scholes options for pricing model
Here’s a nice little toy – suitable for children of all ages. Vendor branded by London’s Science Museum and retailing on Amazon for £10.99, the Science Museum Cosmic Rocket has to be a bargain, especially as it’s educative – amuse yourself and your friends while you learn about rocket science.
The Cosmic Rocket is powered by an environmentally-unfriendly combination of vinegar and bicarbonate of soda. Unfriendly, because, as any chemistry student should tell you, put these two together and you’ll get carbon dioxide. As that gas builds up in the rocket’s body, the pressure rises; soon the gas is forced out, sending the rocket skywards. The maker claims the thing will shoot 50 feet into the air, and customer reviews indicate heights a good bit more than that. It depends on the vinegar/bicarb mix; it depends on the weather, too.
If you’re really into mathematics – in particular, into differential calculus – then, with just a few key factors, you could determine the rocket’s flight – its maximum height, trajectory and distance covered. That’s what rocket science is all about. But rocket science has other applications, too – especially in finance. Indeed, it was using a bit of maths that could continuously plot the flight of a rocket that three young researchers found the formula that would transform the world of finance – the Black-Scholes model for pricing options.
In business, options aren’t exactly new. They have been around for thousands of years, as we found out with the ancient olive press. Yet until recently the difficulty with options was pricing them quickly and easily. The question is, at each and every point of an option’s life (its ‘term’), what is the theoretical value for giving the option holder the right but not the obligation to buy (or sell) an underlying asset at a specific price? Answering that question became more pressing during the early 1970s as trading of over-the-counter options expanded; and it became really acute in 1973 when the first traded options – in effect, off-the-peg options – were launched on the Chicago Board of Trade, a commodities exchange.
Two young mathematicians, Fischer Black and Myron Scholes, were trying to answer it. Modelling the theoretical value of an option at specific points in time was easy enough. It began with the law of ‘one price’, which said that if two assets – or two portfolios of assets – had the same pay-off in the future then they must have the same value in the present. This principle was extended to options pricing in what’s called ‘put-call parity’. This is a bit more complicated, but essentially says that, for an option, the value of a ‘call’ (ie, the right to buy an underlying chunk of stock) minus the value of a ‘put’ (the right to sell) for the same chunk must always be the same as the market value of the underlying stock minus the present value of the price at which the option can be taken up (or ‘exercised’). If the value of these two propositions are not the same, then market traders will seize the chance to make riskless profits.
So put-call parity could always find a theoretical value for an option, but fitting that principle into a model that would find a continuous value was beyond the mathematical skills of Black or Scholes. Luckily a colleague of Scholes at the Massachusetts Institute of Technology just happened to know about an obscure piece of calculus called Itô’s lemma, devised by a Japanese mathematician, Kiyoshi Itô. In effect, this piece of calculus can take random changes in a process – the flight of a rocket, or the movement of a stock price – and model them into such infinitesimally small packets that they become continuous.
Intuitively, it’s easy to see that what works for the trajectory of a rocket may also work for trajectory of an option’s price. And so it proved. Black and Scholes published their pricing formula in a paper, The Pricing of Options and Corporate Liabilities, in 1973 and within months Texas Instruments was making a hand-held calculator containing the model.
To use the Black-Scholes model to find the theoretical value of an option, just six bits of data are needed: the security’s price; the exercise price at which the option can be exchanged for the security; the date today; the date when the option expires; an estimate of the volatility of the security’s price; and an interest rate to reflect the value of the use of money during the term of the option. If the security pays a dividend, then it’s helpful to add the yield as a factor, too.
Of these inputs, the most contentious – and the most important – is the estimate for price volatility (which is measured by the standard deviation of the security’s price movements). It is the vital input because more than anything the Black-Scholes model puts a value on how much the security’s price will bounce around. Bouncy prices bring the potential of gains for the option holder and the fear of losses for whoever underwrites the option (ie, agrees to deliver the stock or to take delivery of it). It’s much the same with that Science Museum Cosmic Rocket – the more it bounces in flight, the better the chances that it will soar to new heights, but also the more likely that it will crash into the neighbour’s hedge. And the Black-Scholes equation can model that, too – after all, it’s rocket science.
24: Nick Leeson's trading jacket: risks with options
To say this jacket is tasteless is an understatement – it’s so gaudy it might even look out of place at the Henley Regatta. But that’s how it is with the jackets worn by traders on the diminishing numbers of financial markets that still conduct trading through so-called ‘open outcry’. True, in the hurly-burly of open-outcry trading – where traders use feverish hand signals as much as lung power to get what they want – dealers need to be noticed and identified. So a jacket takes on the function of a horse owner’s colours or a football team’s strip. Indeed, this black-and-gold-striped jacket might fit the bill as a particularly nasty away strip, although the name emblazoned on the back is a bit of a giveaway – Baring Futures.
Nothing to do with football then, and all about the British merchant bank that collapsed so spectacularly in early 1995. At one moment Barings – once the mightiest merchant bank in the world – was all set to announce that it had made £100m of profits in 1994, and that was after it had set aside £100m in bonuses for its marvellously talented staff. The next moment it realised it had £827m-worth of losses on its books. That was enough to wipe out its capital more than twice over and Barings duly went to the wall. As to why it disappeared so quickly, that had everything to do with one of the young men who wore such a jacket when he traded on behalf of Barings – much of the time fraudulently – on Singapore’s Simex futures and options exchange. Enter Nick Leeson, the 27-year-old whose clueless and catastrophic trading brought down Barings in next to no time.
Such is Mr Leeson’s notoriety that the Barings trading jacket he wore – apparently with the logo “Nick” embroidered into its inside pocket – was sold by the liquidator of Barings for £21,000 in 2007. However, what chiefly interests us is the trading strategy that Mr Leeson used so ineptly that it brought the bank down. As such, it beautifully illustrates the dangers of traded options. While options can be a tool for reducing risk – even eliminating it – they can also be devastating.
The point is that options work much like an insurance contract – they transfer risk. Take out household insurance and you pay an insurance company a premium. In return, the insurer agrees to pay claims for damage, theft, whatever, subject to the small print in the contract. Traded options work in much the same way.
For example, buy a ‘put’ contract that gives the option to sell Tesco shares at 180p and you would pay a small premium, let’s say 10p per share. So upfront you have paid out 10p and have reduced your risk against Tesco’s share price falling much. Simultaneously, your counterparty – the ‘writer’ of the contract – is 10p per share to the good but is committed to buying shares at 180p each even if their value plummets well below that level. At a stroke, risk has been transferred from the buyer of the contract to the seller.
Let’s play that through. Imagine that Tesco’s share price falls to 160p. Your put option is now worth almost 20p per share. It must be since it comes with the right to sell shares at 20p above their market value – at 180p against a market price of 160p. Meanwhile, your counterparty is now losing money. He has to buy shares at 180p even though he could only sell them for 160p. That 20p loss more than wipes out his 10p premium. The more that Tesco’s price falls, the worse his losses become – assuming, that is, he does not have the protection of owning Tesco shares of his own. If he doesn’t, then, in the jargon of the trade, he has written a ‘naked put’.
In traded options, there is only one thing potentially more dangerous than writing a naked put. That’s simultaneously writing a naked put and a ‘naked call’ – committing to buy a security at a specific price even when the writer does not own the security. Trade jargon for this simultaneous buy-and-sell strategy is a ‘straddle’. As the Bank of England’s report into the demise of Barings said back in 1995: “The straddle is one of the most aggressive techniques used for shorting volatility and exposes the writer to considerable risk where markets move in a sudden and unexpected fashion.”
We should explain that “shorting volatility” is more jargon, best translated as “betting that markets will stay calm”. Basically, it’s what young Nick Leeson did in bucket loads. He did it without attempting to ‘hedge’ – ie, to insure – his portfolio and in the process he broke the bank in record time.
True, of the £827m of losses that Mr Leeson left behind in February 1995, most were in his futures dealings. Even so, he managed to notch up £118m of losses in two months on his options trading. Mostly, he was writing straddles on a futures contract in the Nikkei 225 index of Japanese shares. In so doing he was betting that share prices would stay calm. That way, he would pick up two lots of options premium – both for the calls and the puts – without having losses to realise.
As the Bank of England’s report also said: “The strategy Leeson followed is not inherently complex and is one with which any options professional would be very familiar. However...Leeson did not apparently use a pricing model and did not have a risk management system capable of calculating the sensibilities (to losses).” In other words, he was cluelessly inept.
What finally did for him – and Barings – was the effects of an earthquake in Japan in January. That caused Japanese securities prices to bounce wildly, meaning that Mr Leeson lost money on both sides of his straddle. The worst came on 23 February when his losses for the day (including those on the futures market) totalled £144m. He fled Singapore, leaving the note that just read “I’m sorry”.
