Stock Options. Definition
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1 Stock Options Definition Contractual instruments whereby two parties enter into an agreement To give something of value to each other Option contract gives the holder the right to buy/ sell a certain amount of underlying financial asset at a specified price for a specified time period Not only restricted to shares, it can include foreign currencies, debt instruments, commodities and financial futures Owner of option : option purchaser/ holder Option seller : option writer Price of option : premium Option contract has expiry date 1
2 Types of Option CALL OPTION Negotiable instrument that gives the holder the right but not obligation to BUY an underlying financial asset (a specific number of common shares) at a specified price and within a specified time period Valid for less than a year Issued by investor who is willing to stand behind it An option to BUY SHARES when price is low with an expectation that the price will be high and sell when the price is high PUT OPTION Negotiable instrument that enables the holder to sell the common stocks a specified price over a specified time period Used by investors who expect the stock price to decline during the period, Option to sell the shares when the price is high and buy back when the price is low Terminology in Options Exercise (strike) price The price-per-share at which the stock can be bought or sold between the buyer of the option and the writer of the option CAL OPTION : represents the price at which the stock can be bought PUT OPTION : represents the price at which the stock can be sold to the writer 2
3 Option premium The price paid for the option itself by the option buyer to the writer (seller) of the option It is what the call buyer must pay for RIGHT to BUY at a given price in the future It is what the put buyer must pay for RIGHT to SELL at a given price in the future Expiration date The date on which the option expires or the last date on which option can be exercised It specifies the length of the contract between the holder and the writer of the option Option Maker (Writer) The individual/ institution that writes or creates put and call options In-the-Money CALL OPTION : means that the stock price is higher than the exercise price PUT OPTION : means that the stock price is lower than the exercise price 3
4 Out-of-the-money CALL OPTION : means that the stock price is lower than the exercise price PUT OPTION : means that the stock price is higher than the exercise price At-the-money CALL & PUT OPTIONS : means that the stock price is approximately equal to the exercise price American Option Option which permits the holder to exercise the option any time up to and including the expiration day European Option Option which permits the holder to exercise option only on the expiration day HOW PUTS AND CALL WORK CALLS Example: A stock is currently selling at RM50/ share. Assume you buy a CALL on the stock, which enables you to purchase 100 shares at a fixed price of RM50 each. CALL option is bought with a hope that the price of C/S will RISE. What profit is made is the stock price increases to say, RM75? 4
5 Buy RM500 If Price increase to RM75, You buy the RM50 x 100 shares = RM5000 (pay) you sell the x 100 shares = RM7500 (get) Profit is RM2,500 (RM7,500 RM5,000) Assume the stock sells at RM50 and you buy a PUT (right to sell) for RM500. The put option is to buy 100 shares at strike price of RM50. You want the price to decrease. What profit is made is price of share drops to RM25? Buy RM500 If Price decrease to RM25, You buy the RM25 x 100 shares = RM2,500 (pay) you sell the x 100 shares = RM5,000 (get) Profit is RM2,500 (RM5,000 RM2,500) STRIKE PRICE 5
6 KLOFFE The Kuala Lumpur Options and Financial Futures Stock options and futures contracts are traded at the KLOFFE and the Malaysia Monetary Exchange KLOFFE began its operations on December 15, 1995 It offers derivative instruments such as stock options and stock index futures to both domestic and foreign investors Operations are under supervision of Ministry of Finance and Securities Commission A fully electronic exchange which operates an integrated trading and clearing/ registration system KLOFFE has rules, which includes: Membership to the KLOFFE Administration of the KLOFFE Member-customer relationship Trading practices Definition of products 6
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