In this lesson, we will look at how a company might use a "Right to Buy" ticket to guarantee their business costs stay safely under control.
Suppose a company, let’s call it ABC, is building a massive new facility. This project requires oil to operate, but they won't be ready to purchase it until the 20th of June next year.
The entire survival of ABC's project depends on the price of that oil. Currently, oil costs $40 a barrel. At that price, the project is highly profitable. In fact, the business will survive if the price of oil stays anywhere under $60 a barrel. But if oil spikes above $60, the project becomes a total disaster.
ABC needs a guarantee. They need to know they won't have to pay more than $60 a barrel by June.
To solve this, ABC agrees with an oil supplier, XYZ. XYZ agrees to sell ABC oil at a maximum of $55 a barrel on June 20th, even if the actual market price skyrockets to $100.
Why would XYZ do this? Because ABC pays them a small, upfront fee today. Let's say the fee is $2 per barrel. XYZ gets to keep that $2 no matter what happens.
This agreement is exactly how an option works. ABC has paid a small fee for the option to buy oil safely in the future.
The 5 Main Parameters in Action In our previous lesson, we listed the 5 main parameters of an option contract. Here is how they fit into ABC's story:
- The underlying asset: Oil
- The option type: A "Right to Buy" ticket
- The expiry date: June 20th next year
- The strike price: $55
- The option price: $2 per barrel
ABC has used this contract as insurance against disaster. Let’s look at what happens to ABC on June 20th in three different market scenarios.
- Scenario 1: The market drops. The price of oil crashes to $20. ABC simply ignores their ticket and buys oil on the open market for $20. Their total cost is $22 ($20 market price + $2 ticket fee). The project is highly profitable.
- Scenario 2: The market does nothing. The price of oil stays at $40. ABC again ignores their ticket and buys on the open market for $40. Their total cost is $42 ($40 market price + $2 ticket fee). The project is highly profitable.
- Scenario 3: The market explodes. The price of oil skyrockets to $100. If ABC didn't have their ticket, its business would be ruined. Instead, they use their ticket to force XYZ to sell them the oil at $55. Their total cost is $57 ($55 locked-in price + $2 ticket fee). Despite a massive market crash, the project is saved.
In all three scenarios, the ticket only added a tiny $2 cost. But in Scenario 3, it saved the business from a total catastrophe. This superpower, having a tiny, fixed cost but massive protection, is exactly why trading options is so powerful.