Forsa Equity Options Traded on the Kuwait Stock Exchange

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1 Forsa Equity Options Traded on the Kuwait Stock Exchange Options are not suitable for everyone. In light of the risks associated with trading options, you should use them only if you are confident that you understand the nature of these products and the extent of your exposure to risk. Before you invest, you should carefully assess your experience, investment objectives, financial resources and all other relevant considerations. 1

2 What Are Equity Options? Equity Options are derivative instruments whose value and characteristics depend on the value and characteristics of the underlying equity security. Equity Options provide a high leverage approach to stock trading with limited risk and unlimited profit potential to the buyer of the Option. There are two types of Options: Call Options and Put Options. An option which gives the buyer the right to buy the shares is a Call option, and an option which gives the buyer the right to sell the shares is a Put option. Call Options were first introduced to Kuwait Stock Exchange (KSE) by Markaz in March 2005 through Forsa Financial Fund "Forsa". Forsa is an open ended fund managed by Markaz structured to write Option contracts on underlying stocks listed at the KSE. Currently, Forsa is the sole market maker for Call Options at the KSE. Put Options will be launched soon. Forsa Call Options A Forsa Call Option is an American Style Option contract between the Option Seller (Forsa) and the Option buyer whereby Forsa grants the Option buyer the right, but not the obligation to buy a specified number of shares of a certain stock at a specified price (Strike Price), on or before a specified future date (Expiration Date). To acquire this right, the Option buyer pays Forsa (Option Seller) the Option premium or the Option price. Settlement of Forsa Options The buyer of a Forsa call option has two choices of settlement during the life of the option contract: a) Cash Settlement: Sale of option contract back to Forsa at the Bid 1 price quoted by Forsa. In order to provide liquidity to all contracts, Forsa provides Bid Ask 1 prices of all the options outstanding in the market on a daily basis and always stands ready to buy back the option contract from the client. b) Physical Settlement: buy the predetermined number of shares from Forsa at the strike price on any day up to the expiration date. Example of Forsa Call Option 1 Bid and Ask The Bid is the price quoted by Forsa to purchase an option. The Ask is the price quoted by Forsa to sell an option. 2

3 Assume that on 30-April-08, the NBK is trading at KD 1.400, Forsa provides the following quote for Call Options on NBK Share: Stock Stock Strike Price Quantity Expiration Ask Bid Price Date NBK , Jun * Figures are in KD An Option buyer purchases 10,000 shares from Forsa at the strike Price of KD and the expiration of 29-June-08. The Option buyer pays the Option Premium (Ask Price) of KD per share of NBK to Forsa and thus pays KD 660 for this block of Options (10,000 shares x KD 0.066). The Option buyer will have the right to buy the 10,000 shares of NBK each at KD (Strike Price) from Forsa at any time on or before 29-June-08. Assume the on 22- May- 08 the NBK is trading at KD and the Option quote provided by Forsa is as follows: Stock Stock Price Strike Price Quantity Expiration Date NBK Jun * Figures are in KD On 22-May-08, the buyer of this contract has the following rights: a) Sell the Option back to the Forsa at the Bid Price of KD or a total of KD 1,370 (10,000 x KD 0.137). This represents a 108% profit on investment (KD 1,370 KD 660) / KD 660 b) To exercise the option and purchase 10,000 shares of NBK for KD per share from Forsa. In this case the buyer pays KD x 10,000 shares = KD 14,000. The shares have a value of KD 15,000 (10,000 shares x KD 1.500), meaning a revaluation gain of KD 1,000, less the premium paid of KD 660, meaning a net profit of KD 440. Finally, on expiration date, if the stock price remains at KD and the Option Buyer does not exercise the option contract, it will automatically be paid the cash settlement amount of KD 1,000 ((KD settlement price strike price) x 10,000 shares). The holders profit would be the KD 1,000 settlement less the premium paid of KD 660, meaning a net profit of KD 440. Ask Bid Advantages of Forsa Options Trading Favorable risk reward potential: The Option buyer has limited risk up to the amount of the Option premium paid by him to buy the Option. However, its participation in return is unlimited and not capped as the prices can go higher and higher. High leverage: Option provides a high leverage tool as the Option buyer has to pay a fraction of the underlying price to acquire the right to purchase whole lot of total shares. Time to decide: Buying a call option can give you time to decide if you want to buy the shares. You pay the premium which is only a fraction of the price of the underlying shares. The option 3

4 then locks in a buying price for the shares if you decide to exercise. You then have until the expiry day of the option to decide if you want to buy the underlying shares. Risks of Forsa Options Trading Market risks: The market value of options is affected by a range of factors (see the section Option pricing fundamentals ). They may fall in price or become worthless at or before expiry. Options are a wasting asset: Options have an expiry date and therefore a limited life. An option s time value erodes over its life and this accelerates as an option nears expiry. Effect of Leverage or Gearing : A relatively small market movement may have a proportionately larger impact on the value of the contract. This may work against you as well as for you. The use of leverage can lead to large losses as well as large gains. Forsa Options Contract Specifications Underlying Stock: Shortlist of 56 Stocks traded on the Kuwait Stock Exchange (KSE) Option Symbol: For each Option there is a unique ISIN number by which it is identified (e.g. KW ) Contract Size: Minimum of 1000 shares and Maximum of 100,000 shares. Contracts are in multiples of 1000 shares. Strike (Exercise) Price: One at-the-money and two out-of-the-money strike prices are initially listed with a difference of two price units (ticks). Expiration Cycle: Forsa Option contracts have a minimum term of 1 month and a maximum term of 12 months with March, June, September and December as the fixed expiration months. One month Option Contracts are issued every month. 3 months (March), 6 months (June), 9 months (September) and 12 months (December) contracts are issued only once on the first trading day of the year. Expiration Day: Last Thursday of the Month. This may change due to public holidays. Settlement of Exercise: The settlement cycle will be according to what is followed by Kuwait Clearing Company (KCC). Brokers' Commission: 1.25% on the contract Value + K.D. 1 per contract Trading Hours: PM to 1.15 PM (Kuwait Time) Forsa Options Pricing Mechanism 4

5 Forsa Options are priced using the Cox Ross Rubinstein Binomial Pricing model which is widely used to price American Style Options. The option price (Premium) depends on the following: underlying Price, strike price, time left to expiry, stock وvolatility Cost of funding, dividends. Under normal market conditions, and to minimize the effect of price manipulation, Forsa considers the underlying price to be equal to Weighted Average Trading Price "WATP" computed by dividing the sum of the value of each trade over the total volume of trades of the underlying share during the day. In case the stock is trading at a limit up/down, the market maker (Forsa) has the right (as per the KSE options trading rules and regulations) to: Price the option using an underlying price equal to or higher than the limit up price at the day plus five pricing units (a one day limit up). Price the option using an underlying price equal to or lower than the limit down price at the day minus five pricing units (a one day limit down). Prior to expiry the Bid price for all options quoted by Forsa will be equal to its intrinsic (WATP Strike Price) + Time value, if there is any. On expiration date, the bid value will be exactly equal to the intrinsic value of the option as the time value of the Option will be zero. For more information on Option pricing, please refer to Option Manual. Corporate Action Adjustments To minimize the effect of corporate actions on the value of the contract, the strike price and number of shares in Option contract are adjusted on the ex-date of the corporate action to minimize the loss, as far as practical, of any such event on the Option buyer. How to Trade Forsa Options Any Investor registered with KCC can trade Forsa Options provided it is not blacklisted by the KSE. Forsa displays daily the details (bid ask prices and quantities offered) of all Options listed on: 1) The Brokers' terminals 2) LCD screens located at the trading floor inside the KSE 3) Markaz and KSE websites. Forsa Option trades are only executed through the registered brokers inside the KSE. To initiate a trade, the investor has to approach its broker who will enter the order in the Option trading system and on execution of the trade will provide the investor with a contract confirmation. When the investor decides to settle his option contract (whether physically or cash), it has to approach the same broker who has initiated the contract and place the settlement order. On the expiration date and in case the investor did not settle its option contract then Forsa will automatically settle it in cash at its intrinsic value (WATP Strike). If the contract is out of the money (i.e. WATP less than Strike), the option contract will expire worthless. For More Information please visit or Visit: The client relationship desk 5

6 Markaz Ground Floor Al Duaij Building, Opp. Kuwait Stock Exchange Kuwait City. 6