Rights, Obligations, and Swimming Pools

Today I hosted the second of three webcasts for what is collectively known as Money Smart Week in Chicago.  CBOE participates in Money Smart Week in two ways.  First we open up the exchange for tours each morning of the week and second we introduce the uses of options through three webcasts.

As I stumbled through answering a question about the difference between a buyer of an option obtaining a right and a seller taking on an obligation I pulled a pretty cool analogy out of the air.  Since it is late April and eventually the weather will turn warm in Chicago I demonstrated rights versus obligations using a swimming pool.

Let’s say your neighbor, Jim, owns the very best pool in the whole Midwestern United States.  He offers to let you swim in it on a day of your choice between today and Labor Day.  However Jim is a trader and a capitalist at heart.  He offers this opportunity to swim in his pool on a single day for a cost of $50.  Knowing how great Jim’s pool is you take him up on this offer.  The result is you and Jim have entered into an option contract.

You have the right to go swimming in Jim’s pool one time between now and Labor Day.  He has the obligation to let you swim whenever you please.  As the seller of the option Jim has taken on an obligation.  As the buyer you have obtained a right.

Option contracts represent a right for a buyer as well.  If you buy a call option you now have the right to buy a stock at a certain price up to a certain date.  The seller of that call option has taken on an obligation to sell you that stock up to the same date.  As a buyer of a put option you now have right to sell a stock at a certain price.  The seller of that put has taken on the obligation to buy a stock from you.  Just substitute stocks for swimming pools and it works.

Finally, if you do enough profitable buying and selling of options maybe you can out do your neighbor Jim and build what will then be the greatest swimming pool in the Chicago area.  Then you don’t have to deal with Jim anymore.  Who would want to if he’s going to charge you $50 to use his pool.

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