trade stock options. The most basic definition of a stock option is a contract
that enables its owner to buy and/or sell stock under certain, specified
conditions. As an option investor, you would purchase or sell this
right (or option) in order to buy or sell stock; although importantly, this
technique is not the same thing as actually purchasing or selling the
stock itself Rather, you are purchasing the right to benefit from movement
in the market related to the underlying stock, which will (in turn)
influence the public's potential demand for that security: Because an
option is defined in terms of its relationship to an underlying security,
options are known as derivative products. Now, however, we will focus on
familiarizing the reader with options in general.
Options, in their traditional form, evolved as a type transaction
between the owner of certain property and a non-owner. The landlordtenant
and lender-borrower relationships, with which the reader is likely
much more familiar, are similar types of transactions. In the landlordtenant
situation, the landlord exchanges his or her right to use a portion
of his or her property to the tenant for a rental fee. The lender allows the
borrower to use the lender's money in exchange for an interest charge
and the borrower's pledge to return the borrowed funds pursuant to a
schedule of payments.
Owning property brings with it certain consequences that people
sometimes refer to as the benefits and burdens of ownership. These consequences
include the following:
• The right to benefit from appreciation in the value of the property
• The right to use the property as you see fit
• The risk that the value of the property will decline
• The right to determine when, and at what price, to sell the property
Options are contracts in which specific attributes of ownership are
transferred from the owner of the asset to another party in exchange for
compensation. Where a benefit of ownership is involved, the owner
receives the compensation. Where a risk of ownership is transferred, the
owner pays the consideration. Later in this book, we will look in detail at
the technical aspects of publicly traded stock. For now, though, let's consider
several common examples.
Example: Undeveloped Land
A real estate developer has a problem. He wants to build an apartment
complex on a vacant lot that he does not own. In addition to obtaining rights
to develop the vacant lot, he will need to obtain certain land-use approvals
and a loan commitment from a lender in order to finance construction costs.
Additionally; he must raise money from investors. The developer does not
want to purchase the vacant lot until he knows that the project will go forward,
but he cannot get investors until he has obtained rights to the property.
He also cannot get financing until he obtains the land-use approvals.
The solution is to purchase the right, but not the obligation (option), to purchase
the lot from the owner of the vacant lotby a certain date for an
agreed-upon price. With this right, the developer can attempt to put all of
the pieces together. Ifhe is successful, he has the resources to exercise his
right (option) to buy the property and move forward with the project. Ifhis
efforts fail, he just walks away from the project-losing only the amount
paid for the option. The motivation of the developer to purchase the option
is clear. What can we say about the motivation of the owner of the vacant
lot? Why would he sell the option to the developer? There could be two reasons:
first, the owner gets to keep the compensation paid for the option; second,
the agreed-upon purchase price is likely to be higher than the owner
could obtain if he sold the property without first obtaining the land-use
approvals. These factors might be sufficient incentive to the owner of the
vacant lot to sell the option to the developer. We refer to this type of option
as a call option. The purchaser ofthe option has the right, but not the obligation,
to acquire the property for a specific price (prior to a specified date).
After that date, the holder ofthe option no longer has the right to purchase
the property: The option is said to expire at that point.
Example: Property/Health Insurance
Auto insurance, health insurance, and homeowner's insurance are all
examples of put options. These options transfer the risk of loss from the
owner to the seller of the put (the insurance company).
We hope that we have made several important points in this general
introduction to options:
• Options have legitimate commercial applications.
• They are similar to other more common transactions such as landlordtenant
and lender-borrower relationships.
• They are not some new casino game designed to suck in the unwary.
With this background in place, we will now focus on how exchangetraded
stock options can be intelligently and prudently used to reduce
investment risk and increase investment and/or trading profitability.
Read More: Options: A Conceptual Overview
