So I want to go right to the question, why do we have options? Why do they matter? And there's both a theoretical approach to that and there's a behavioral approach to that. The theoretical reason goes back to Kenneth Arrow who is a highly esteemed mathematical economist, who talked about economic efficiency. Meaning, efficiency in our economic system requiring that all risks are traded. And the risk that a stock will go up above the strike price, will go above another strike price, are all risks that might matter to some person who needs help, who has risk that somehow focus on that risk and would like to trade the risk in order to reduce the risk or maybe to do some kind of business. So Arrow gave the sense that a major source of economic inefficiency is cured by options market. And Stephen Ross who used to be here at Yale, he's still living here in New Haven, has a famous paper in 1976 called "Options and Efficiency" arguing that, if you have a complete set of options, you've in a sense completed the market. You've dissected the risk by the different strike prices and exercise dates into many risk. Each stock is really many risk, not just one and they matter differently to different people. That's the pure theory, our justification of options. And there is much truth in that but I want to add to that also, a behavioral approach to options pricing. So behavioral finance looks at how people really think or how they sometimes they don't act logically. One thing we pointed out already about behavioral finance is that people pay attention to salient things. That's a cycle. Maybe it's a psych term saying something that grabs your attention. And so, it seems like people overreact to the news. For example, after a flood, lots of people buy flood insurance for their homes. Why didn't they buy it before that? They should have known right, that there is a possibility of a flood. But they don't. People are human and they forget. So they all of a sudden want flood insurance. A put option is like insurance on a stock. Suppose you're owning a stock and you think, "I have big hopes for this stock." But suddenly, something scares me and I think that the stock price might fall. So, I would then buy a put option on the shares I own with an out of the money strike way below the current price of the stock and that puts a floor on my investment because if the stock falls below that, I can always exercise the option and sell it at this option price. Shefrin and Meyer Statman are two behavioral finance people who describe what they call "A Silver Lining Theory". A theory that find that the people in their emotions don't look only at the bottom line, they look at different aspects of their portfolio. And suppose the stock market has gone way down, and you've lost a lot of money, and you're feeling bad, "Why did I put all this money in the stock market?" But then you look that you also put a put on some of your shares and then you feel better. You feel, "I'm kicking myself for having put so much in the stock market, but at least I had the good sense to buy some puts on some of my shares so that I have the right to sell them and I didn't lose so much money." And so, you just feel better. The theory here is that, people don't focus appropriately, as the financial theory says, on their total portfolio. They look at little details and they think, "Well, I lost a lot of money but there's a silver lining here. On my action, I put some of it in the puts and boy, am I glad I did that." So if people think that way, it opens up the possibility for sales people to kind of manipulate you and deceive you into buying options. So Shefrin and Statman in their famous paper on Silver lining, quote a investment. This is a book I'm quoting, I'm taking their quote from it. A book by Mr. Gross who writes about how to be a stockbroker. So the title of his book is, "The Art of Selling Intangibles, How To Make Your Millions by Investing Other People's Money". Now you can tell from the title of the book that Mr. Gross is not highly committed to serving his clients well. In fact, it's quite the opposite. Mr. Gross is telling you how to make a lot of money off of ignorant people. And what we like about this book is that, Mr. Gross really comes out and says it. In fact, he gives you scripts for what to do on the phone with your clients. So now suppose you're a stockbroker and you deal in stocks and options, and you recommended some stocks to somebody and they have done badly, so you are Joe salesmen. You have told me that you have not, now he's on the phone with John prospect. Maybe he's a prospect for him to sell an option to. You've told me you've not been too pleased with your stock market investments and John prospect says, "That's right. I'm dissatisfied with the return." So now Joe salesman swings into action trying to give him a point of view that makes him vulnerable to a sale of an options. Starting tomorrow, how would you like to have three sources of profit every time you buy a common stock? Now,this is really phishing as Akerlof and I call it. You're supposed to be focused on the bottom line not on three separate sources, but he wants you to think of it that way so you'll feel better about yourself having done it this way. So predictably, Mr. Prospect responds three sources of profit what are they? And the sale? Now what he's trying to get this guy to do, who has bought a stock that's gone down and maybe he's worried about it but he's hoping it will still go up. So he's saying, "Why don't you write a call on your option? I'll arrange it. You'll write a call and sell with an out of the money strike price." That means, at a price higher than the stock is right now. So the salesman explain, first, you could collect a lot of dollars, maybe hundreds sometimes thousands for simply agreeing to sell your just bought stock at a higher price than you paid. And that's your money to keep forever. Your second source of profit would be the dividends as the owner of the stock. You'll still collect dividends on the stock, go directly, you're the owner. You still get them. The third source of profit would be the increase in the price from what you paid to the agreed selling price. All you're giving up is the up the possibility that the price goes up even more than what the selling the strike price. And then he says, "Don't think about that." It says, "You are only giving up the unknown unknowable profit possibility above the agreed price." These words are all carefully chosen to deceive you. So he's right. There are three sources of profit but you as a logical rational economic human being should be asking, "Well, I don't care about the three separate sources, I want to add them up and look if it's a profit." In fact, he doesn't quote any numbers except three. He tells you there's three sources of profit, he doesn't tell you how big they are. So all you're doing is giving up the unknown profit possibility beyond the strike price as if that's nothing but that could be a lot. And so, this argument to sell and call option, makes no sense. It can only make sense if he puts numbers on those three sources of profit and then you add them up. You're supposed to do that but apparently, a lot of people don't think that way. So that's another reason why we have options.
