Options

Chapter outline

 What is an option?
 Type of option contact
 Strike price
 Expiration date
 Exercise type
 Option terminology
 Illustration 1
 Why trade options?
 Seller of an option
 Illustration 2
What is an option?

 A contract that gives you a right (but not the obligation)

to buy or sell stock (or any underlying) at an agreed price
on or before a particular date.
Type of option contact

Call option
Type
Put Option
Call option

• Gives option holder the

Call right (but not the obligation)

to BUY stock at an agreed
price, on or before a
option particular date.
Put option

• Gives option holder the right

Put (but not the obligation) to

SELL stock at an agreed
price, on or before a
option particular date.
Strike price

 The “agreed upon price” at which the underlying

of the option will be bought and sold
Expiration date

 The “particular date” at which the option contract

will expire
Exercise type

• Allows the options buyer to

American exercise at ANYTIME before
Style Options the expiration date

• Allows the options buyer to

European Style exercise AT the expiration date
Options
Option terminologies

CALL PUT
In the money Market > Strike Market < Strike 1588
1620 > 1600 < 1600
At the money Market = Strike Market = Strike 1600
1600 1600 1600
Out the money Market < Strike Market > Strike 1620
1588 < 1600 > 1600
When you bought option

Bought
option

Call Put
 Bought a Call Option

Type Strike Expiration

• Call • 120 • 30 days

from
now

Owning this Call option will allow you to purchase the stock
at 120 per share (strike price) anytime within the next 30 days
(expiration date) no matter where the stock price is at.
Bought Option (Call)

 Ifthe stock goes up to 135

within the next 30 days, you
own a call options that allow
you to buy the stock at 120,
even though the stock
currently trading at 135/stock
 Bought a Put Option

Type Strike Expiration

• Put • 120 • 30 days

from
now

Owning this Put option will allow you to sell the stock at 120
per share (strike price) anytime within the next 30 days
(expiration date) no matter where the stock price is at.
Bought Option (Put)

 If the stock goes down to

100 within the next 30 days,
you own a call options that
allow you to sell the stock at
120, even though the market
value is 100/stock
Illustration 1: Why trade options?

 Option is like an insurance

 Assume you purchase 100 units of XYZ Stock @ RM125 per stock
 Total cost is RM12,500
 Since
stock price fluctuate, you’re risking your total investment of
RM12,500
 To hedge the above investment, you’re buying an insurance = an option
Illustration 1: Why trade options?

To insure (hedge):
 BUY a PUT Option at strike price of RM125/share
 Gives option holder the right (but not the obligation) to SELL
stock at an agreed price, on or before a particular date.
 Price of the PUT Option is RM500 (full coverage insurance for the
next 30 days) = the premium.
Why trade options?

Price of the stock

goes up to RM132 /
shares
2 scenarios
Price of the stock
goes down to
RM113 / shares
How to decide?

Option: PUT (SELL)

Option Market
RM125 RM132 √
Price goes up

 Price of the stock goes up to RM132 / shares

 Profit:
Gain = RM7 x 100 units = RM700
Cost of option = (RM500)
Net profit = RM200
How to decide?

Option: PUT (SELL)

Option Market
√ RM125 RM113
Price goes down

 Price of the stock goes down to RM113 / shares

 Loss = RM12 x 100 units = (RM1,200)
 But, you have an insurance = the PUT option
 You’re going to EXERCISE your option at RM125 / share
 Loss on stock = RM0
 Cost of option = (RM500)
 Seller of an option

 Call as the Writer

 Obliged to purchased an Option should the Buyer of Put Option decide to
exercise
 Obliged to purchase the share at RM125 / share
 Assume the risk
 If
the Buyer did not exercised, maximum seller earned is the premium of
RM500
To Ponder

 Do you have to own a stock before you can trade

option?
To Ponder

 Do you have to own a stock before you can trade option?

 NO
 You don’t have to own a stock before you can trade option.
 You can just trade the fluctuating OPTION just like you
trade stock
Illustration 2

 Assume you now don’t own any stock yet, but, there is one
particular stock that you really like. The problem is the stock is
really expensive. If you buying that shares, it requires a lot of
capital and putting yourself in high risk.
 Instead of buying that shares, you can purchased a call option.
You’re going to pay a small premium for the right to buy the stock
at a later date.
Illustration 2

 Stock XYZ is currently trading at RM125 per share.

 If
you want to buy 100 unit of the stock, you have to pay
RM12,500.
 Insteadyou buy RM125 strike call option, 30 days until expiration
paying RM500 premium.
 The options gives you the right to buy 100 shares at RM125/share
anytime during the next 30 days.
Illustration 2

Price of the stock

goes up to RM137 /
shares
2 scenarios
Price of the stock
goes down to
RM100 / shares
Illustration 2: Price goes up to 137/share

 Decision: To exercise the call option

 Owned 100 shares at RM125/share
 Profit:

Gain = RM12 x 100 units = RM1,200

Cost of option = (RM500)
Net profit = RM700
 Illustration 2: Price goes down to 100/share

 Price of the stock goes down to RM100 / shares

 You’re NOT going to EXERCISE your option at RM125 / share
 Loss on option premium = (RM500)
 Ifyou have previously bought your stock at RM125/share, you loss
now would already be RM2,500.
Illustration 2: Benefit

 Benefit of buying the option instead of directly buying the

stock:

Put much less capital Less risk

 But, in exchange you must pay a premium.