OPTION: The Basics of Option and Option Trading
With the launch of options product in Malaysia, this article will attempt to describe a host of basic option-related terms, but don’t let it overwhelm you. It is important to remember that while there are a number of different option styles, this article will focus more on European option, a style used for the Kuala Lumpur Composite Index option or better known as OKLI. The OKLI is a product offered by Bursa Malaysia Derivatives Berhad.
An option is a type of financial derivative contract whose value is derived from the underlying asset. It is a contract between two parties (a buyer and a seller) to transact the right to buy (the buyer/holder of the option) and the obligation to sell (the seller/writer of the option) for a certain quantity of the underlying asset at a specified time and agreed strike price in the future.
The buyer/holder of the option has limited risk as the maximum loss for the buyer/holder is just up to the premium he has paid for the option.
The seller/writer of the option however has unlimited risk as he has the obligation to sell the underlying asset at the particular strike price to the buyer/holder if he exercise the option including the price difference between the current higher price and the lower strike price that the seller/writer has agreed to sell to the buyer.
For European option, there is no option to exercise or settle prior to expiration dates.
About Futures Option
A futures option (sometimes known as option on futures) is a financial derivative contract where the underlying asset is a futures contract. It is a unique form of derivative instrument as it is a "derivative on derivative". The OKLI is a fantastic example of a futures index option. The underlying asset of the OKLI is the Kuala Lumpur Composite Index futures (FKLI) whereas the Kuala Lumpur Composite Index itself underlies the FKLI.
Futures Contract vs. Option Contract – The Difference
A futures contract is a pledge to deliver or take delivery of the underlying asset. An option contract is a right, but not an obligation, to buy (for the buyer of the option) and an obligation to sell (for the seller of the option) of an underlying asset.
Option Contract Specifications
The option specifications define the properties of the contract. These specifications are: the underlying asset, the expiration date, the strike price and the option premium. Let’s see what each means.
(a) Underlying Asset
Underlying asset is a reference to the asset that underlie all derivatives and from which the values of derivatives are derived from.
(b) Expiration Date
Expiration date is a last use-by-date for option owner to exercise his rights. An option is no longer valid after its expiration date.
(c) Strike Price
The strike price is the specified future price, at which the underlying asset can be traded if the option is exercised. Strike price is also known as exercise price.
The price of an option is referred to as the premium. It is the price paid by an option buyer to acquire the right to buy the specified option and the price received by an option seller with the obligation to sell his underlying asset should the buyer of the option exercise his right to do so.
Types of Options
There are two types of options contract, a call option and a put option. Both are two totally separate options contracts and not the opposite side of a transaction.
(a) Call Option (Calls)
A call or call option is a type of option contract that gives the buyer the right, but not the obligation, to buy a certain quantity of the underlying asset based on the agreed strike price at the expiration date. The buyer of a call option pays a premium to acquire this right. Hence, the seller of a call option is obligated to sell the option contract if the buyer decides to exercise his right. As a call option buyer, if you don’t exercise a call option at the expiration date, you lose only the premium spent on the call option.
The buyer of a call option expects that the price of the underlying asset is going to rise hence he long the call option to gain the right to buy the respective underlying asset of the option at the specific price (also known as strike price). In simpler terms, buying a call option is like renting the underlying asset with an option to buy at the expiration date. Most of the sellers of call options own the underlying asset and they would like to lock in their target profit by selling the underlying asset at higher strike price coupled with the additional premium they can earn from selling the right to the buyer.
(b) Put Option (Puts)
A put or put option is a type of option contract that gives the buyer the right, but not the obligation, to sell a certain quantity of the underlying asset based on the agreed strike price at the expiration date. The buyer of a put option pays a premium to acquire this right. Hence, the seller of a put option is obligated to buy the option contract if the buyer decides to exercise his right. If the put option buyer does not exercise his right at the expiration date, the risk is limited to the premium paid for to acquire that right.
The buyer of a put option (long put) forecasts that the price of the underlying asset is going to fall. Apart from its flexibility and risk-limited leverage, it is also an excellent trading instrument when you’re hedging against a downward price movement in stocks, futures contracts or commodities that you already own.
Participants in the Option Market
Now that you know the two types of options, we now look at the participants. There are two sides of each options contract – a buyer and seller for each type. The buyer, sometimes known as the holder or owner, is the party who pays a price (the option premium) to acquire the right to exercise an option. The seller, or also called the writer, is the party who sell (or writes) the option and earn an income from the option premium for doing so. For every put option buyer out there, there must be a put option seller, and for every call option buyer, there must be a call option seller.
The Right to Exercise
When you own an option (as a call or put owner), you control the right to exercise. Owner acquires this right by paying a premium. By doing so, the opposite participant is required to fulfill his obligation.
According to Wikipedia, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. There are a number of existing styles, each with different elements but a vast majority of options are either European or American (style) options.
(a) American Option
American options can be exercised at any time before the expiration date.
(b) European Option
European options can be exercised only at the expiration date. European option is the style employed by Bursa Malaysia for its option product offerings: the OKLI (FKLI underlying) and the soon-to-launch OCPO (FCPO underlying) products.
You should now have a basic understanding of option trading. Keep in mind that options trading may not be suitable for all traders as it is speculative in nature. If you are keen on option trading, our advice is that you should equip yourself with sound trading knowledge. Stay tuned for the next article where we discuss further about options.
Wan Zuraiha Wan Zakaria is a staff writer at Oriental Pacific Futures (OPF) where she writes on investment and trading. OPF is a futures and options broker based in Kuala Lumpur, Malaysia and provides electronic trading, brokerage and clearing services to retail and institutional traders since 2007. OPF is licensed under the Securities Commissions of Malaysia and offers cash-settled derivatives instruments traded on Bursa Malaysia, as well as select major derivatives exchanges around the world.
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