PRINCIPLES

OF
OPTIONS
CONTRACT
Prepared by
Dr Fahmi Abdul Rahim
UiTM Cawangan Melaka
Definition
&
Concept
 ´ Option, by simple definition, is a contract to buy and sell
a specified asset at specified price and time.

´ Like futures, the price is agreed today but the fulfillment

of the contract will be executed later.

Definition ´ However, option does not oblige both parties to fulfill

the contract.
and
Concepts ´ As the name implies, one party will be given an "option"
of Option either to execute (exercise) or not execute his contract
(right).
 DIFFERENT FUTURES AND OPTION

BUYER OF CONTRACT SELLER OF CONTRACT

FUTURES/FOWARD OBLIGATION OBLIGATION

OPTION RIGHT OBLIGATION

 CALL OPTION VS PUT OPTION

BUYER OF CONTRACT SELLER OF CONTRACT

OPTION RIGHT OBLIGATION

CALL OPTION Right to buy underlying asset Obligation to sell underlying

asset
PUT OPTION Right to sell underlying asset Obligation to buy underlying
asset
PREMIUM (price PAY RECEIVE
of options (CASH OUTFLOW) (CASH INFLOW)
contract)
Call Option: OKLI Dec 1660 (XP) call @18 (PRM)
Today
Get right to buy shares
at price 1660 Buy Call OKLI Dec with XP = 1660.
Buyer of He needs to pay 18 as premium Seller of
Call option Call option
Contract Contract
Sell Call OKLI Dec with XP = 1660.
He receives 18 as premium Get obligation to
sell shares at price 1660

Later
Buy share at price 1660

Buyer of Decide to exercise call option Seller of

Call option Call option
Contract Contract
Must exercise call option
based on buyer of call option’s sell shares at price 1660
decision
Put Option: OKLI Dec 1700 (XP) put @20 (PRM)
Today
Get right to sell shares
at price 1700 Buy Put OKLI Dec with XP = 1700.
Buyer of He needs to pay 20 as premium Seller of
Put option Put option
Contract Contract
Sell Put OKLI Dec with XP = 1700.
He receives 20 as premium Get obligation to
buy shares at price 1700

Later
sell share at price 1700

Buyer of Decide to exercise put option Seller of

Put option Put option
Contract Contract
Must exercise put option
based on buyer of put option’s buy shares at price 1700
decision
Features of
Option
Contract
Underlying Asset

´ This is the type of asset that underlies the

option contract.

´ In the case of KLCI options, KLCI options

are the derivative instrument or contract
while the underlying asset or instrument
will be FBM KLCI.
Exercise Price

´ Exercise price or strike price is the price

that the buyer (holder) has the right to
sell or buy the underlying assets from or
to the seller (writer).

´ The term "strike" is used to indicate that

the holder will exercise his right
whenever his option strikes the price.
Current Market
Price
´ This is the price of the underlying
asset that is displayed in the cash
market.

´ Like futures contract, the price of

option is derived from the actual
price of it's underlying.

´ For instance, the price of OKLI are

dependent on the actual current
price of the FBM KLCI
 Premium is the price of option and is
determined by the bid and ask price in
the market.
In other words, the premium may go up,
down or remain unchanged throughout
the life of option contracts.
Premium As mentioned earlier, an investor who
buys an option pays premium while a
seller receives it.
Therefore, like stock prices or indices,
premiums of options will fluctuate over
time.
 Example Call Option: OKLI Dec 1660 call
@18

Investor with Call option contract Investor without Call option contract
(buyer of call option)
Today (November) Plan to buy share in December Plan to buy share in December

Buy OKLI Dec 1660 call at 18.

Pay RM18 (premium) to the seller of call option and get right to
buy share in December at price 1660.
Expiry month Investor has 2 choice: Investor need to buy share at market
(December) price in December (1800).
1) Buy share at market price. He needs to pay 1800.
Market price of share
1800 OR

2) Buy share by exercising call option contract. He needs to

pay 1660 only (exercise price of call option). (buy share at
lower price (1660) compared to current market price
(1800))
 Example Put Option: OKLI September
1900 put @ 21

Investor with put option contract Investor without put option contract
(buyer of put option)
Today (July) Plan to sell share in September Plan to sell share in September

Buy OKLI September 1900 put at 21.

Pay RM21 (premium) to the seller of put option and get right to
sell share in September at price 1900

Expiry month Investor has 2 choice: Investor need to sell share at market
(September) price in September (1600)
1) Sell share at market price in September. He received 1600.
Market price of share
1600 OR

2) Sell share by exercising put option contract. He received 1900

(exercise price of put option). (sell share at higher price (1900)
compared to current market price (1600))
Expiration date

´ This is also known as the maturity date. It

is the last day in which the option can
be exercised.

´ Since the emphasis is on the holder as

the buyer of option, if he does not
exercise until maturity date, the option
will become worthless.

´ In other words, his right to exercise lapses

beyond the expiry of the option
contracts.
 ´ Although a buyer has the right to exercise, the time
when he can exercise depends on the style of option.

´ American-style options give the holder the right to

exercise on or before the expiry date.

´ European-style options only allow the holder to exercise

at expiry date.
Time to
Exercise ´ KLCI options are European type and therefore must be
settled by cash at maturity, similar to the KLCI futures.

´ On the other hand, stock option to be introduced by

BMDB will be an American type.
Value of
Option
Contract
 In-the-money is the option which gives the holder profit if he exercised his option.

Option holder will only exercise his option contract if it is in the money condition.

Value of
Call option is in the money when the current market price of the underlying assets is higher
than the exercise price of the option.
Options:
Call ITM = MP > XP In-the-
Put option is in the money when the current market price of the underlying assets is lower
money
than the exercise price of the option

Put ITM = MP < XP

 Out-of-the-money is the option which gives the holder loss if he exercised his option.

Option holder will not exercise his option contract if it is out of the money condition.

Value of
Call option is out of the money when the current market price of the underlying assets is
Options: lower than the exercise price of the option.

Out-of-the- Call OTM = MP < XP

money Put option is out of the money when the current market price of the underlying assets is
higher than the exercise price of the option

Put OTM = MP > XP

 The holder of option contract has
neither loss nor gain to exercise
either his call option or put option.

Value of
Options:
At-the- At the money Call and Put =
money
Market Price = Exercised Price
 Example Call Option: OKLI September 1600 call @ 18

Market
price
of share 0 1400 1600 1900
Call Option Call Option Call Option
Out of the money at the money In the money
MP<XP MP=XP MP>XP
1400<1600 1600=1600 1900>1600

Call option holder Call option holder Call option holder

makes loss if he get no profit or loss if get profit if he
exercise his call he exercise his call exercise his call
option contract. Buy option contract option contract. buy
share at higher price share at lower price
compared to market compared to market
price price
 Example Put Option: OKLI September 1900 put @ 21

Market
price
of share 0 1800 1900 2000
Put Option Put Option Put Option
In the money at the money Out of the money
MP<XP MP=XP MP>XP
1800<1900 1900=1900 2000>1900

Put option holder Put option holder Put option holder

get profit if he get no profit or loss if makes loss if he
exercise his put he exercise his put exercise his put
option contract. Sell option contract option contract. Sell
share at higher price share at lower price
compared to market compared to market
price price
Factors affecting
Option
premium/ price
Price Of The
Underlying Asset
´ If the price of the underlying asset moves
up and down, the option price is
affected.

´ In the case of call option, if price of the

underlying assets increase and deeper in
the - money, the higher the premium of
the option.

´ On the other hand, for the put option, as

the price of the underlying increases, the
put option will have a lower premium and
it has a higher premium if the price of the
underlying assets decreases
 Example Call Option: OKLI September 1600 call @ 18

Market price of share decrease Market price of share increase

Market
price
of share 0 1400 1600 1900
Call Option Current market price Call Option
Out of the money of share In the money
MP<XP MP>XP
1400>1600 Call Option 1900>1600
at the money
Market price of MP=XP Market price of
share decrease 1600=1600 share increase
↓ ↓
Call option out of Call option in the
money (make loss) money (make profit)
↓ ↓
Less demand for more demand for
call option call option
↓ ↓
Call option premium Call option premium
decrease increase
 Example Put Option: OKLI September 1900 put @ 21

Market price of share decrease Market price of share increase

Market
price
of share 0 1800 1900 2000
Put Option Current market price Put Option
In the money of share Out of the money
MP<XP MP>XP
1800<1900 Put Option 2000>1900
at the money
Market price of MP=XP Market price of
share decrease 1900=1900 share increase
↓ ↓
put option in the put option out of the
money (make profit) money (make loss)
↓ ↓
more demand for Less demand for
put option put option
↓ ↓
Put option premium Put option premium
increase decrease
Strike Price : Call option
´A call option with a higher strike price will have a lower option
price compared to a call option with a lower strike price.
´This is because the call option with a higher strike has lower
intrinsic value.
Strike Price: Put Option
´A put option with a higher strike price will have a higher option
price compared to a put option with a lower strike price.
´This is because the put option with a higher strike has higher
intrinsic value.
 Whether it is a call option or a put option,
both will have higher premium if their time to
expiration longer.

This is because these options have more time

to gain in their intrinsic value as compared to
those options with short time duration.
Expiration
Time

An option is said to be a wasting or depleting

asset as the time to expiry approaches.
 The premium of the option is also influenced by interest
rate, higher interest rate results in borrowing money to buy
underlying asset becomes expensive, and vice versa.

As such, option becomes cheaper in rising interest rates

and expensive in falling interest rates. Interest
Rate

Therefore, the level of interest rates and the price of

options have an inverse relationship.
The higher the volatility of the underlying assets, the higher
is the chance for that underlying asset to fluctuate in both
directions. This will enhance the investor opportunity to
make large gain.

Both call and put premium increase when the volatility of

the underlying asset increases and likewise if the volatility
decreases. Market
Volatility

As such, the more volatile is the market, the more will be

the current price to change, and hence the more
attractive will be the options for investment purposes.
 Usually, dividends have an impact on stock
option. After dividends are paid, the stock
price will decline for adjustment purposes.

For a call option, the decline in stock price

will result in the option becomes less valuable
Dividends and hence the option price is lower, and vice
versa for the put option.

Therefore, the put option becomes more

valuable and this leads to a higher option
price.
 Prepared by

Thank you Dr Fahmi Abdul Rahim

UiTM Cawangan Melaka