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Options are a form of derivative instrument (an instrument which derives its value from that of the underlying asset) in the financial world that provides the buyer of the option the right but not the obligation to execute the contract. Options are not a cup of tea for a regular and neither do they prove an easy cake walk for them. Hence, it is necessary to understand basic terminologies involving option trading before plunging into the trade.

Options are mainly of two types – call and put options. The call option provides the right to buy the underlying asset and puts give you the right to sell the underlying asset. Let`s understand a simple call and a put option with the help of an example.

Investment in Option Trading A Call Option: Suppose X is interested in buying 100 shares of company ABC from Y at Rs 52 at the end of the month. The shares of the company are currently trading at Rs 50. If suppose, at the end of the month, the share price of the company trades above Rs 52 then X will exercise the call option and purchase the shares from Y at Rs 52. If otherwise, the company trades at a price below Rs 52, the option expires worthless. Additionally, to stay put with the agreement, X agrees to pay Rs 2 to Y which equals Rs 200 in total.

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A Put Option: Now consider a case where X wants to sell 100 shares of the company ABC to Y at Rs 48 by the end of the month. The shares of the company are currently trading at Rs 50. X certainly agrees to pay Rs 2 for each share to Y to keep the option and expects to execute the option if the share price falls below Rs 48. This naturally would be profitable for X but not for Y.

After understanding the simple call and put options, highlighting some important key aspects in the above example will help us understand the terminologies in the better way.

a) Strike Price: In case of a call option, Rs 52 is the strike price meanwhile in case of put option; Rs 48 is the strike price.

b) Risk Premium: The Rs 2 which X has agreed to keep with Y in either of the cases is called the risk premium. This is the amount which Y is required to keep even if the option expires worthless.

As said above, option trading involves a lot of risks and one has to stick to strict guidelines and techniques while trading in the financial instrument. An important thing one has to remember is that trading in options is not a game of an amateur player. Hence, avoid getting into complex strategies like butterfly spreads and so on while engaging in options trading. Also, the knowledge of fundamentals is strictly important for trading in option strategies. Always be strong fundamentally when trading in the financial instrument.

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