Which of the following is NOT true.
An options contract is
A. a contractual agreement between two parties.
B. is based on the value of an underlying security.
C. obliges the holder to exercise it at the expiration date.
D. gives a trader the right to buy or sell the underlying security.
The Correct Answer and Explanation is :
Correct Answer: C. obliges the holder to exercise it at the expiration date.
Explanation:
An options contract is a financial derivative that provides the holder with the right, but not the obligation, to buy or sell an underlying asset at a specified price (the strike price) before or at a particular date (the expiration date). Here’s why C is incorrect, along with an explanation of the other options:
A. A contractual agreement between two parties.
This statement is true. An options contract is indeed an agreement between two parties: the option buyer (holder) and the option seller (writer). The contract specifies the terms under which the transaction can take place, such as the strike price, expiration date, and whether it’s a call or put option.
B. Is based on the value of an underlying security.
This statement is true. Options derive their value from the price movements of an underlying asset, such as stocks, indices, commodities, or currencies. This makes them a derivative instrument. For instance, the price of a call option will increase if the price of the underlying stock rises.
C. Obliges the holder to exercise it at the expiration date.
This statement is NOT true. The holder of an options contract has the right, but not the obligation, to exercise the option. If exercising the option would not be profitable, the holder can choose to let it expire worthless. This flexibility is a key feature of options contracts.
D. Gives a trader the right to buy or sell the underlying security.
This statement is true. A call option gives the holder the right to buy the underlying asset, while a put option gives the right to sell it. The holder has the discretion to decide whether or not to exercise this right based on the prevailing market conditions.
Conclusion:
Options are versatile instruments offering potential profits with limited risk for buyers. However, unlike futures contracts, they do not oblige the holder to perform the transaction, which makes C the incorrect statement.