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Options and Derivatives: an Introduction

The holder of an option has the right to buy or sell a specified commodity, at a predetermined price, on a specified date (European option) or throughout a specified period (American Option). A key word in the definition is ‘right’. The buyer, or holder, of the option has no obligation to exercise the option. The element of choice, or option, overcomes one of the disadvantages of hedging in the futures market wherein, if a ‘profit’ is made in the physical market, a roughly offsetting loss will be made on closing out the futures market hedge position.

Options can be distinguished on the basis of whether they provide the holder, or long party, with the right to buy (call) or sell (put) the specified commodity at the predetermined exercise or strike price. The party that sells or writes the option is identified as the short party. Short calls can further be divided into covered and uncovered, or naked, options.  With a covered option, the writer must lodge the underlying stock or securities with an approved trust. In the case of naked calls, the writer must deposit an initial margin with the options clearing house and may be required to make maintenance margins.