Options

What is an Option?

An option is a type of derivative that gives the holder the right, but not the obligation, to buy or sell an asset at a predetermined price on a predetermined date in the future. Options are typically used to speculate on the future price of an asset or to hedge against risk.

How do Options Work?

Let’s say that you are a trader who believes that the price of gold is going to rise in the future. You can buy a call option to buy gold at a predetermined price on a predetermined date in the future. This will give you the right, but not the obligation, to buy gold at the predetermined price, even if the price of gold rises above the predetermined price.

On the other hand, let’s say that you are a jewelry manufacturer who needs to purchase gold in 3 months to make jewelry for the holiday season. You can buy a put option to sell gold at a predetermined price in 3 months. This will give you the right, but not the obligation, to sell gold at the predetermined price, even if the price of gold falls below the predetermined price.

MCQs on Options:

1. Which of the following is not a characteristic of an option?
   • It is a contract that gives the holder the right, but not the obligation, to buy or sell an asset.
   • It is traded on an exchange.
   • It has a predetermined price and a predetermined date.
   • It can be used to speculate on the future price of an asset or to hedge against risk.
   • All of the above are characteristics of an option
   • Answer: It is traded on an exchange.
2. Options are typically used to speculate on the future price of an asset or to hedge against risk.
   • True
   • False
   • Answer: True
3. Options are typically used by large institutions and sophisticated investors.
   • True
   • False
   • Answer: False
4. Options are typically more liquid than futures contracts.
   • True
   • False
   • Answer: False
5. Options are typically more expensive than futures contracts.
   • True
   • False
   • Answer: True

Conclusion

Options are a versatile tool that can be used to manage risk and generate income. However, they are also complex instruments and should only be used by experienced investors.

Here are some additional points to keep in mind about options:

• Options are contracts that give the holder the right, but not the obligation, to buy or sell an asset. This means that the holder of an option can choose not to exercise the option, even if the price of the underlying asset moves in their favor.
• Options are typically traded on an exchange. This means that they are more liquid than forward contracts and can be easier to trade.
• Options are typically more expensive than futures contracts. This is because they give the holder more flexibility and control over their investment.

It is important to understand the risks and limitations of options before using them.