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INTRODUCTION TO OPTIONS

What is an Option?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).

The key components of an option are:

The right, not the obligation
To buy or sell an asset
At a fixed price
Before a predetermined date

These are important as they determine the valuation of an option.

The Right, Not the Obligation

Buying gives you the right

Buying an option (call or put) conveys the right, not the obligation, to buy (call) or sell (put) an underlying instrument (for example, a share).
When you buy an option, you are NOT obligated to buy or sell the underlying instrument - you simply have the right to do so at the fixed (exercise or strike) price.
The risk that you face when you buy an option is simply the price you paid for it.

Selling (Naked) Imposes the Obligation

Selling an option (call or put) obliges you to buy from (with sold puts) or deliver (with sold calls) to the option buyer if he or she exercises the option.
Selling options naked (for example, when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile.

Options vs. Stocks

In order for you to better understand the benefits of trading options, you must first understand some of the similarities and differences between options and stocks.

Similarities:

Listed Options are securities, just like stocks.
Options trade like stocks, with buyers making bids and sellers making offers.
Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.

Differences:

Options are derivatives, unlike stocks (i.e., options derive their value from something else, the underlying security).
Options have expiration dates, while stocks do not.
There are not a fixed number of options, as there are with stock shares available.
Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.

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