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The Underlying Security

Options are sometimes referred to as derivatives because they derive their value from the price characteristics of other financial assets. In the case of stock options price movements for the underlying security, the common stock are most important.

In our example the underlying security is IBM and the unit of trade is the standard 100 shares. One option contract controls 100 shares. Obviously, a large increase in the price of IBM common stock would have a dramatic impact on the IBM November 100 calls. For example, if IBM rallied $10 to $110 the right to buy IBM common stock at $100 would be worth at least $10, thus the IBM November 100 calls would rally to a minimum price of $10. In this case an eleven percent increase in the price of the common stock would lead to an increase of at least four hundred percent for the option. As you might expect it is this type of leverage that makes options very attractive for speculators.

Of course leverage can be a double-edged sword and we should not forget that even small movements in the opposite direction for the underlying stock price can lead to substantial losses.

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