The Swedish Put

The Swedish Put - Intro

In finance, options are used for either speculation or hedging purposes, but always to create win-win outcomes. Due to the importance and complexity of options, universities have dedicated full length courses to just understand option basics. These classes break options down into their components including risk-free rates, time value, underlying assets, volatility and expiration dates to see how the movement in one component impacts the final price of the option. Knowledge from taking investment courses on options can be transformed into real life options. Successful entrepreneurs use options all the time when starting their companies. They pay an upfront cost in time, effort, and money to hopefully create the next unicorn and if they fail society will bail them out so they can try again. Societies with large safety nets therefore increase the entrepreneurial utility, which is great for the general economy. I call this the Swedish put. There exist many other real life options and to be successful you should seek them out because if you find one, then you have created a win-win situation.

Components making up an option

Financial Options

Why does a disproportionate amount of unicorns start their journey in Sweden? The answer to this billion dollar question is that Sweden limits risks by provide option like incentive structures for entrepreneurs. I started to understand the concept of risk in my first investment class at Boston University, which was taught by old school hedge fund legend Jim Welch. He educated us on the power of financial options contracts and how option dynamics impact entrepreneurial risk taking. As Professor Welch explained backwardation and contango of future prices in oil markets, I remember feeling in awe with how a quantitative framework can be used to create win-win situations and for this we owe a thanks to mathematicians Fisher Black and Merton Scholes. Given some underlying assumptions, they invented one single equation for knowing the future option price of oil[1]. Obviously, there are flaws in equations involving assumptions when applied practically, but by breaking up the Black and Scholes equation into six components, it is possible to get a framework for understanding both financial options and real life hidden options, which in turn explains how the Swedish Put continues to create unicorns including IKEA, Spotify, Skype and Klarna.

Merton Scholes

Decomposing Financial Options

Learning the individual components that together determines the final price of financial options can help with understanding the power of hidden options. Generally, two types of options exist: calls and puts. A call option is the right, but not the obligation to buy an underlying asset at a future time and price, while a put is the right, but not the obligation to sell at a future time and price. To avoid confusion, we can use a put option on oil as an example. The first determinant of the price of a put option is the price of the underlying cash commodity, which is the actual spot (current) price of oil. The market price of oil is in turn determined by supply and demand so if oil price increases, the price of the oil put options decrease all else equal. That is because the put option is only exercised if the price of the underlying oil commodity is below the exercise price. For example, if the put option has an exercise price of 10 USD and the price of oil increase from 11 to 12 dollars, the price of the oil put option will decrease in value as it is more unlikely to be exercised. The second determinant is a lower or higher exercise price. A higher exercise price will lead to a more expensive put option all else equal, as the option is more likely to be exercised. The third determinant is time to expiration. If the option’s exercise date is further into the future there is more uncertainty, which increases the put options price. The fourth determinant is the risk free rate. This fourth component is used to present value discount the price of the option. As the risk free rate increases, the value of a put option decreases and the value of a call option increases. The fifth and final component is the volatility of the oil price. If it swings wildly, then put options on oil are more likely to be in the money (exercised). This as the likelihood of oil prices dropping well below the exercise price increases, which means a put option’s value is positively correlated to the volatility in price of oil. By combining these five determinants in the Black and Scholes equation, the future price of oil is always known. This is an important lesson for entrepreneurs, as they want to expose themselves to ideas that make a lot of money in the future. Entrepreneurs also want to know the opportunity cost of pursuing something else, time value profitability and how to protect against company failures. The quantitative frame work for analyzing financial options can therefore be used to produce a cost-benefit analysis for startups.

How Financial Options Relates to Real Life Options

Market participants including both investors and large institutions often use financial options to profit from or hedge against large price swings in the market. For example, airline revenues tend to decline as oil prices increase so airlines are likely to purchase call options on oil to protect against unexpected price spikes. On the other side of the trade are oil speculators that sell these call options to profit rather than to hedge. Both hedgers and speculators sometimes purchase options rather than the underlying cash commodity, as options allow for implicit leverage, another way of saying more exposure to oil for the same amount money. For instance, if a trader has 100$ and want to maximize exposure to the oil market, he can at most buy oil worth 100$. However, with an options contract worth 10$, the trader is able to buy 10 contracts and perhaps have exposure of more than 1000$ to oil. Option features like leverage can be found in real life as well and this is attractive for entrepreneurs, especially if the premium/insurance is paid by someone else. For example, bankers use the power of optionality when providing investment research, entrepreneurs when starting companies and movie companies when producing movies. Putting yourself in a position to benefit from optionality is a smart tactic for both earning profits and career advancement.

2018

The Swedish Put

Although entrepreneurs found companies for different reasons, they improve the job market, economy, and welfare system for their countries. Some start companies for huge rewards and glory, while others enjoy improving the life of others. If these entrepreneurs successfully create a billion dollar unicorn, then they are set for life, which is reasonable given the added benefit to society. However, for every unicorn company that makes it there are hundreds of entrepreneurs and companies that fail. According to Investopedia, only 25% of companies survive more than 15 years in the US and only a special few of them become unicorns. Young people and students learn about high failure rates in school or through other channels and might therefore be discouraged to start new companies, especially if there is no social safety net in their country. It is precisely the social safety net that makes countries like Sweden special, as these countries have created a system that includes free healthcare, education and high unemployment benefits. As a result, founders know that if they fail, the Swedish tax payer provides insurance, which means the Swedish society directly promotes entrepreneurial risk taking. Worth noting is that the Swedish people not only provide insurance against failure, but they also invest in infrastructure that support entrepreneurs. For example, Stockholm was one of earliest adopters of fiber optic networks and currently there is almost 100% internet access from home. Finally, free education is provided all the way up to the Phd level, which means that most Swedish students are able to attain higher level of education for no cost. As a result, there are plenty of well-known billion dollar unicorns that originated from Sweden including Spotify, King, Skype, Evolution Gaming, Klarna and Mojang. In a 2016 article based on 2014 and 2015 data by USC professor Gerard J Tellis, Sweden accounted for a 2% market share of private unicorn companies with a market capitalization greater than 1 billion. Sweden lagged behind only U.S (65% market share), China(14%), India(4%), UK(3%) and Singapore(2%). Another article published by Wharton Business School concludes that Stockholm had the second highest unicorn per capita in 2015, which is only second to Silicon Valley. There is something special driving Swedish innovation and other countries should take note.

The Powell Put

Savvy investors must possess an edge to outperform the market. Some investors have greater computing power, while others are experts within a field or niche asset class. An example of the latter is being an expert on market rules and regulatory changes, as governments around the world continuously update them to maintain economic growth and protect against bad stuff such as unemployment and inflation. Countries can have plenty of regulation and high taxes or a mix. Generally, rules and regulations ebb and flow adaptively with each countries’ election cycle, as new governments often tweak policy to appease their political base after an election. However, monetary and fiscal policy easing has been a constant across the world for the first twenty years of the 21st century. In terms of monetary policy, central banks have decided to use every stimulus tool in the toolbox to prevent markets from a long 1929 type of depression and on the fiscal side, governments have handed out large stimulus packages to generate economic growth. These monetary injections are paid for by a depreciation in domestic currency value all else equal, meaning that people holding lots of currency will in the future purchase less goods and services for the same amount of money. In the beginning, it is hard to notice a depreciation in the currency, but at some point, the diminishing value of currency could create an economic catastrophe. In a worst case scenario, people could lose faith in institutions responsible for overseeing our monetary system, which might lead to hyperinflation. The parts of our society that are being especially protected by the Powell put are zombie companies and rich people that own equities.

The Terminator

The Movie Put

Most movies are unprofitable, but successful movies can bring in billions in revenue. Traditionally, Hollywood movies are funded by famous production companies or wealthy financiers. These players therefore pay all costs relating to the movie production including actor salaries. In return, the financiers receive a certain percentage of the movie revenue. However, as most movies are unprofitable, the movie payoff structure is similar to the purchase of a call option. Even if the movie is successful, the production cost will never be returned to the production company. In a podcast with one of the greatest podcast hosts of all time, Tim Ferris, famous polymath Arnold Schwarzenegger explains that when he created the comedy Twins together with Tommy DeVito, he did not receive a traditional salary, but rather a percentage of the movie revenue as compensation for his acting. This incentive structure is a perfect example of a put option, as the only cost is time, and in return Arnold either receives a large payoff for a successful movie or at minimum, he gets exposure to the public as an actor. In the podcast with Tim, Arnold mentions that he still gets paid for his acting role in Twins created in 1988. Setting up this put like incentive structure is the best business decision Arnold has ever made other than investing in his biceps.

Bob Rubin

The Political Put (Going from a public to private company)

Politicians are entrusted with the power to carry out the duties of the government. As civil servants, these politicians are paid less than private sector professionals. The average salary for top positions in US politics including Senator and Congressman is around USD 180K, while the average Goldman Sachs managing director earns close to USD 400k per annum. Combining lots of power with a relatively low salary creates public servant moral hazard. After creating rules and regulations when working for the government, these politicians are able to take private sector jobs. They can therefore create policy that benefits the private sector under the cover of carrying out the duties of the government. Former Wall Street trader and famous author Nassim Taleb depicts a great example of the political put when describing the Bob Rubin trade in his 2017 book “Skin in the Game”. Bob Rubin served as the 70th US Treasury Secretary from 1995 until 1999 under President Clinton and was responsible for regulation cuts in the financial sector. Regulation cuts are not necessarily something bad, but it is worth noting that in the 10 years leading up to the Great Recession in 2008, Bob Rubin collected more than 120 million dollars in compensation from Citibank. Much of that compensation was indirectly tied to the Clinton administration’s repeal of the 1932 Glass Steagall act. This particular regulation cut allowed insurance companies and investment houses to merge and institutions like Citibank to hold enormous amount of risky derivative positions on their books. In 2008, large banks like Citibank were bailed out by the American tax payer so one can argue that Bob Rubin was indirectly compensated 120 million by the US tax payer. Bob Rubin thus created policy as US Treasury Secretary that allowed him to make a lot of money no matter the consequence of his policy. Other than reputation, Bob Rubin had no skin in the game and benefitted heavily from the political put.

Davey Day Trader

The marketing trading option (The Portnoy Put)

The financial market is always open somewhere in the world and it is the job of financial commentators to inform their viewers about the latest happenings. Financial market professionals take what the financial commentators say with a heavy dose of salt, as a commentator’s main agenda is to create good content not great advice. The best content is usually news about pending disaster, but other popular content are segments such as providing the viewers with the top stock picks of the day. Historically, financial content has been distributed through recognized gatekeepers controlling the narrative such as Bloomberg, CNBC and MSNBC, which is a system limiting financial commentators from benefitting from advice in a put option fashion. With the growth of social media, however, influencers have emerged as a new type of financial commentator. These influencers create implicit put options by marketing the investments that they own. A pioneer of the marketing put is Barstool Sports founder David Portnoy. He is a self-proclaimed gambling addict and when the gambling markets shut down, he turned to the world of day trading. Under the pseudonym Dave Day Trader, he started investing in stocks. If the stocks went up, then his army of day traders including Portnoy was making money, but if stocks went down, then Portnoy was making money from content, while his army lost their savings. In the end, everyone is responsible for their own stock picks and if they think that Portnoy is a better investor than Warren Buffet, then they should invest based on Portnoy’s advice as long as they don’t come crying when they have no money left.

//Stay Adaptive

1. Assuming that the option is exercised at expiration, no dividend distributions, efficient markets, no transaction costs, normally distributed returns and a constant and known risk-free rate and volatility of the underlying (oil cash commodity). If we use oil as an example, the price of an oil options contract can always be calculated based on a few components such as the underlying price of the cash commodity (oil), exercise price, time to expiration, risk-free rate, volatility, interim cash flows and costs.

2. https://knowledge.wharton.upenn.edu/article/how-stockholm-became-a-unicorn-factory/

3. https://knowledge.wharton.upenn.edu/article/how-stockholm-became-a-unicorn-factory/