Options

All of us know that the dating world is full of options, but few people are aware of the methodology used to actually value and compare these options. In the world of finance, options are contracts between an issuer and a buyer that gives the buyer the right to either buy or sell a particular security (like a stock) at an agreed-upon price (strike price) on or before an agreed-upon date (exercise date) from the issuer. The value of these options is determined using what's called the Black-Scholes option pricing formula. The actual formula involves a lot of statistics and calculus, but we can supplement our understanding of relationship options by applying the Black-Scholes logic to the dating world.

The Analogy
Suppose all of your dating prospects are like stocks that you are interested in buying. Some seem more promising than others, but you can never be sure which investment will bring the biggest payoff. So rather than putting all your eggs in one basket, you invest in options that give you the ability to enter into a relationship at a lower-than-market-price should the value of dating a particular person increase over time.

For example, you’re thinking of pursuing a relationship with one of two girls. The first girl is drop-dead gorgeous, bodacious blonde girl with all the right dimensions. She’s fun with a great personality, but she’s also really high maintenance. Investing in a relationship with her is inherently risky because if she gains weight, she loses much of her appeal along with the basis of her self-esteem. Should this happen, you’ll have to deal with a host of emotional problems and you could lose a great deal on your investment. Alternatively, however, if she maintains her good looks over time and grows in character, the value of the relationship increases dramatically and your investment pays off big time. Thus, the volatility of this “underlying security” is quite high – meaning that her value can fluctuate dramatically, either up or down, within the specified time period. Accordingly, the value of an option for this relationship is relatively high and requires more of an investment – more time, more money, more commitment, etc. – because you’re probably not the only one who wants this option (bringing into play the principles of supply and demand). But should the value of pursuing a relationship increase, you’ve already got an in, so you won’t have to start from scratch; hence, the “lower-than-market-price.”

On the other hand, the second girl you’re considering is only moderately attractive, but much more stable in terms of character and emotional demeanor. Plus, if she gains weight or loses physical appeal for one reason or another, the value of the relationship won’t change much and she’ll maintain her self esteem because your relationship is based on more fundamental qualities. In essence, the value of a relationship with her is much less volatile, but at the same time, the probability of a huge payoff is not as high either. Subsequently, the value of an option for this relationship is less and thus requires less of an investment on your part (partially because she probably doesn’t get asked out as much as the other girl, therefore she’d be more willing to enter into a relationship). But since you’ve invested in the option to date (time, money, attention, etc.) and established the basis for a relationship, you still get a “lower-than-market-price” should you choose to date her.

If we wanted to get more technical about the pricing of these options, we could factor in the current price of each relationship, the strike price that your option gives you, and the risk-free relationship (i.e., the unconditional love of your mom). But that would complicate the analysis, and I think we’ve hashed out the basic logic of options with our simple example.

The Benefits
Options are an attractive investment alternative for many reasons, one of the most significant being the limited downside. Should either of these options prove worthless, all you’ve lost is whatever you paid for the option, rather than investing entirely in the relationship only to lose it all when you decide she’s not worth it anymore. Additionally, even if most of your assets are tied up in an existing relationship, you can still make small investments in options that will hedge against the risk of your exposure to this one relationship (somewhat similar to a credit default swap, i.e. rebound boyfriend/girlfriend).

The Real World
In reality, options are derivative financial securities, in that their value is derived from the price of an underlying security, such as a stock. To illustrate the basic logic behind an option, we will examine a theoretical call option. Suppose you believe that the price of IBM’s stock will rise from its current price of $80 a share to $100 a share within the next six months. So you call up Goldman Sachs and by a call option on IBM’s stock with a strike price of $90 and an exercise date six months from now. Also suppose that the option cost you $5 to purchase. If IBM’s stock does in fact rise to $100 a share within the next six months, the option gives you the right to buy the stock from Goldman Sachs at $90 a share. If you exercise that option, you can then take that share of IBM stock you bought for $90 from Goldman Sachs and sell it in the open market for $100. You instantly make $10 on the transaction; however, after subtracting the $5 you spent to buy the option, your net gain is $5. A put option follows the same logic, but in the opposite direction (you have the option to sell high and then turn around and buy low). As mentioned before, the great thing about options is that the upside is unlimited, while the downside is limited to the amount you paid for the option in the first place.

(I actually had an assignment for one of my classes to explain a complex idea from my major in terms everyone could understand. So I thought, what a perfect blog entry!)