Living life like a call option

One thing I have sort of contemplated about after recently joining finance and learning about Options (a derivative financial instrument) is how lot of our decisions in life, esp. the more difficult and “riskier” ones, can be modeled by options calls and puts, or a combination of both.

Why is this important ? Understanding  this can actually lead to a very different kind of decision making process in our lives, and a way that can help us prevent those self-defeating attitudes that ruin lot of great stuff people want to do in life but don’t muster the courage or are too afraid of getting into.

A quick introduction to calls and puts:

Before explaining the model let me first briefly describe what call and put options are.But you don’t need to understand exactly how they work. Just a very basic intuition and the philosophy behind them is enough,  which I try to summarize here.

Options are “derivative instruments” for an underlying fundamental instrument like stocks. Their value is derived from various parameters related to the underlying instrument and other market parameters like interest rate.

Every option is characterized by a strike price (a property of the option alone).  It is a way to speculate about the future price of the underlying instrument like a stock. A call option‘s payback is equivalent to the price that the underlying exceeds the strike by. For example, if the strike is $100, and the stock price is $110, the profit from the call option is 10. The most important fact to note here is that there is no loss if the price is below $100. The option only needs to be “exercised” if the price exceeds the strike, and not otherwise. So in a sense it helps one speculate about the increase in the price of the underlying instrument and benefit from it, while insulating one from any rapid decline in its value.

To summarize, a call option allows you to benefit from the upside, with no loss from a downside. The losses are “de-magnified”.

A put option is the opposite of call: you reap benefit if the underlying falls below the strike. So in the above case, if the strike for the put is 100, you make $10 is the underlying is at $90. Nada if its $110.  So it magnifies the value of  the downside, and de-magnifies the upside.

How this ties to our decision making process:

Some of you might have noticed me talking about “magnifying” the upside and “de-magnifying” the downside. A worthy decision which involves a quantum change in our comfort levels and amount of effort we put in, can be compared to buying an option. Now many of us can over-emphasize the downside of such decisions and efforts, when there isn’t any really. Starting to train in a new sport, or competing in a challenging contest can intimidate us regarding the time or effort we put in. “What if after all the effort nothing comes out of it ?”. “Is it really worth putting in all the time and energy when I have no clue if this will actually prove to be beneficial ?” . That’s the “put” mentality. If you look carefully there is really no loss here. What is wasted effort compare to no effort at all ? Not much of a difference there. If nothing comes out if it, probably we would be in the same state as before, maybe wiser from the experience. (as they say “If you lose, don’t lose the lesson”).  So I argue the downside loss is actually zero for most worthwhile stuff in life.

Now the benefit side is obvious. If you can actually get really good in a sport and maybe even compete at a certain level, that’s only an added bonus in your life. You have grown as a person.  If the value of your endeavor exceeds the strike (the strike being your present state of life), you reap all the benefit.  There is only upside to it! That’s the “call” mentality. It recognizes that putting in serious effort in any worthwhile endeavor has a non-negative payoff. You only stand to gain from it. There is really no loss involved in comparison to your current state of life.

Probably many of us (including me) can put off many great things in life we are capable of by living in the “put” mentality…what if it doesn’t work out ? What if I am not good enough ? The answer to these questions is: so what ? There is nothing to lose. You only stand to gain. You are buying yourself a call option. And the very fact that life grants us this amazing ability to buy so many different call options is a marvelous privilege. Hopefully we don’t let these go.

I was talking in  the context of sports above, but of course this can be applied to most developmental activities that transform us as a person. Taking on a new hobby, taking a singing class, learning a musical instrument late in life, trying to get serious training in martial arts, or writing that book you thought you had some ideas about. These are all call options.

Effect of time

I have a sense that as many grow up, the “put” mentality actually grows as well. From a personal example, I remember when younger I would be way more excited about the various possibilities life had to offer. For example, I participated in many programming contests in my high school and undergrad without thinking twice. I prepared very hard for them but I was so excited about the possibility of greatly improving my skills and even winning, the thought of effort didn’t even cross my mind back then. And results were not bad at all. Today I cannot say with confidence that I can make a go for any serious goal requiring dedicated effort with the same “call option” attitude.

But hopefully I can be more like a child in that respect. Not afraid of effort.  There is nothing to lose after all. And its never too late.

A side point

I would like to point out this is not the same as being optimistic vs pessimistic. Optimism is an essential quality for any serious endeavor but its a “rosy prediction” of a future outcome…something that we hope for. The discussion above is more about how much weight we assign to the upside vs the downside when our mind is contemplating taking on a new goal or effort, and how too much weight on the latter can prevent us  from buying the option in the first place.

Conclusion

Recognize that many amazing states in life that we are capable of reaching are simply call options…there is no real downside, only imaginary ones created by the lazy and fearful parts of our psyche. Not buying them is  wasting all the wealth we have just by the act of living.