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Understanding Options

Options are financial derivatives that allow the holder to buy (call options) or sell (put options) an underlying asset at a predetermined price before a specified date. Call options are used when expecting price increases, while put options are for anticipating price declines. Understanding key terms like strike price, premium, expiration date, and the associated risks and benefits is essential for effective options trading.

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3 views

Understanding Options

Options are financial derivatives that allow the holder to buy (call options) or sell (put options) an underlying asset at a predetermined price before a specified date. Call options are used when expecting price increases, while put options are for anticipating price declines. Understanding key terms like strike price, premium, expiration date, and the associated risks and benefits is essential for effective options trading.

Uploaded by

Simon Chen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Understanding Options: Calls and Puts

Definition:

Options are financial derivatives that give the holder the right, but not the
obligation, to buy or sell an underlying asset (like stocks, commodities, or
currencies) at a predetermined price (the strike price) on or before a
specified date (the expiration date).

Types of Options

1. Call Options:

o Definition: A call option gives the buyer the right (but not the
obligation) to buy the underlying asset at the strike price.

o Purpose: Used when you expect the price of the asset to


rise.

o Example:

 You buy a call option on Stock XYZ with a strike price of


$50 and a premium of $5.

 If the stock price rises to $60, you can buy it for $50, sell
it at $60, and pocket the $10 profit (minus the $5
premium).

 If the price stays below $50, you can choose not to


exercise the option, losing only the $5 premium.

2. Put Options:

o Definition: A put option gives the buyer the right (but not the
obligation) to sell the underlying asset at the strike price.

o Purpose: Used when you expect the price of the asset to fall.

o Example:

 You buy a put option on Stock XYZ with a strike price of


$50 and a premium of $5.

 If the stock price falls to $40, you can sell it for $50,
pocketing a $10 profit (minus the $5 premium).

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 If the price stays above $50, you can choose not to
exercise the option, losing only the $5 premium.

Key Terms to Know:

1. Strike Price: The price at which the option can be exercised.

2. Premium: The cost of purchasing the option, paid upfront.

3. Expiration Date: The date by which the option must be exercised.

4. In-the-Money (ITM): When exercising the option would result in a


profit.

o Call Option ITM: Market price > strike price.

o Put Option ITM: Market price < strike price.

5. Out-of-the-Money (OTM): When exercising the option would not


be profitable.

Benefits of Options:

1. Leverage: Control a large position with a smaller investment.

2. Flexibility: Profit from both rising and falling markets.

3. Risk Management: Use options to hedge against potential losses.

Risks of Options:

1. Limited Lifespan: Options expire, and if they’re OTM, they become


worthless.

2. Premium Loss: Buyer’s risk losing the premium paid if the market
doesn’t move as expected.

Summary:

 Call Options are for bullish investors (expect prices to rise).

 Put Options are for bearish investors (expect prices to fall).


Options provide a versatile tool for speculating, hedging, or
generating income but require a clear understanding of their
mechanics and risks.

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