‘The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what's going to happen contradicts my way of looking at the market.’ George Soros

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OPTIONS

An option is a type of derivative, which, like shares, bonds and warrants, is a financial instrument. Being a type of derivative, it is therefore linked to, or derived from, an underlying asset. This is where the term derivative comes from.

The main reason for the creation and widespread use of options lies in their leverage. The flexibility of options allows them to be used as high risk trading instruments, insurance and hedging or as fine-tuning tools for a large portfolio.

WHAT IS AN OPTION?

An option is an agreement, or contract, between two parties giving the buyer the right, but not the obligation, to buy or sell a parcel of shares (or any other thing) at a pre-determined price either on, or before, a set date. To acquire this right, the buyer pays a premium to the seller (or writer) of the contract. The contract is then called an option.

Equity options are options over parcels of ASX traded fully paid ordinary shares. An options contract is usually (but not always) over a parcel of 1000 shares. Options are traded on about 100 of the ASX’s largest and most liquid companies.

There are two different types of exchange traded equity options:

CALL OPTIONS (CALLS)

A call option gives the holder (or buyer) the right, but not the obligation, to buy the underlying parcel of shares at a set price, on or before a pre-determined date.

If you are the holder of a BHP May 2008 $45 call option, you have the right, but not the obligation, to buy a parcel of 1000 BHP shares at $45 on or before the expiry in May 2008.

If you are the seller (or writer) of this call option, you must sell 1000 BHP shares at $45 to the buyer of the option if they choose to exercise the option.

PUT OPTIONS (PUTS)

A put option gives the holder or buyer the right, but not the obligation, to sell the underlying parcel of shares at a set price, on or before a pre-determined date.

If you are the holder of a NAB May 2008 $40 put option, you have the right, but not the obligation, to sell a parcel of 1000 NAB shares at $40 on or before the expiry in May 2008.

If you are the seller or writer of this put option, you must buy 1000 NAB shares at $40 from the buyer of the option if they choose to exercise the option.

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