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Stock Options – Financial Instrument

Stock Options – Financial Instrument

a) A Stock Option may be understood as a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed upon price within a certain period or on a specific date regardless of changes in its market price during that period.

b) The various kinds of stock options include put and call options, which may be purchased in anticipation of changes in stock prices, as a means of speculation or hedging. A put gives its holder an option to sell, or put, shares to another party at a fixed price even if the market price declines. A call gives the holder an option to buy, or call for, shares at a fixed price even if the market price rises.

Stock Options – Financial Instrument

c) Stock options involve no commitments on the part of the buyers of the option contracts individual to purchase or sell the stock and the option is usually exercised only if the price of the stock has risen(in case of call option) or fallen (in case of put option) above the price specified at the time the option was given.One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date.Investing in options provide limited risk , high potential reward and smaller amount of capital required to to control the same number of shares which can be done via investing through cash market.

d) There are always two types of entities for an option transactionI buyer and a seller (also known as writer of the option) . So, for every call or put option purchased, there is always someone else selling/buying it. When individuals sell options, they effectively create a security that didn’t exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration. The price of an option is called its premium. The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited

Stock Options – Financial Instrument

e) In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock (opposite to the position taken via selling the option contracts), the seller’s loss can be unlimited , meaning the seller can lose much more than the original premium received.

f) You should be aware that there are two basic styles of options: American and European. An American, or American-style, option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style and all stock options are American style. A European, or European-style, option can only be exercised on the expiration date.In Indian Market options are European style options.

Stock Options – Financial Instrument

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