Question

1. Describe the key defining characteristics of a put or call option on any asset. (2 pts.)

2. Which has unlimited downside risk, a long or short position in a call option? What about a long or short position in a put option? Explain your answer. (3 pts.)

Answer 1

The key characteristic of a put or a call option is the choice it gives to the holder of the option. Unlike Futures, the buyer of the option has a choice whether to exercise the option or not. In case of Call option ,it is the option to buy the underlying asset at a fixed price called Strike price and in the case of put option, it is the option to sell the underlying asset at the strike price.

2 The Buyer of the option (One who has long position) has limited downside risk and unlimited upside potential, The opposite holds true for the seller of the option (one who has short position)

Hence, the short position of the call option has unlimited downside risk

Also, the short position of the put option has unlimited downside potential (the downside is somewhat limited as the price of the stock cannot become negative)