Stock Options Definition

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
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
• 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
• 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
• Buy CALL @ RM500
• If Price increase to RM75,
– You buy the share @ RM50 x 100 shares =
RM5000 (pay)
– you sell the share @RM75 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 PUT @ RM500
• If Price decrease to RM25,
– You buy the share @ RM25 x 100 shares =
RM2,500 (pay)
– you sell the share @RM50 x 100 shares =
RM5,000 (get)
– Profit is RM2,500 (RM5,000 – RM2,500)
STRIKE PRICE
5
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