In the previous issue, we have introduced the concept of options, some basic terminologies and the common

uses of options. In this issue, we will focus on some basic fundamentals about options trading before introducing some trading strategies. References to FTSE Bursa Malaysia KLCI Options (OKLI) and Bursa Malaysia FCPO Options (OCPO) will be drawn.

Contract SpecificationsBefore options can be traded, we first need to understand its contract specifications (available on Bursa Malaysia website). The contract specifications table states the important information required to trade the respective options.

Merely knowing what the underlying asset/assets is/are will not be sufficient in making a directional bet using options; we must understand what drives the underlying assets. Both the OKLI and OCPO are futures options and the underlying assets are futures contracts FKLI and FCPO respectively. The FKLI and FCPO

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In this second part of our options series, we go into the finer aimed at creating awareness and educating investors on derivatives trading.

By Phillip Futures

Options Essentials

BursA COlumnOptions Essentials

where C = call price; PV(E) = present value of exercise price; S = stock price; P = put price.

C + PV(E) = S + P,

themselves are derivatives of Kuala-Lumpur Composite Index (KLCI) and Crude Palm Oil (CPO) prices.

KLCI is an equity index comprised of the top 30 Malaysian companies based on market capitalisation. The price of KLCI is based on the stock price performance of these 30 company stocks. Financial, telecommunications and consumer goods companies together make up more than 64% of the index (as of 06 July 2012), of which financial companies alone make up close to 35% of the index. Hence, to speculate the directional view of OKLI, we need to closely monitor the price movements of these companies, which are heavily influenced by global economic factors.

CPO prices, on the other hand, are influenced by demand-supply fundamentals. Demand-supply factors include inventory, weather conditions, warehousing and logistics costs, availability and prices of close substitutes, global demand and new uses of the commodity, etc. Understanding these factors will help us to predict the likely directional

move of OCPO.Like most global exchanges, both

OKLI and OCPO are automatically settled if they are in-the-money (ITM). However, the two options are settled differently – OKLI is cash-settled while OCPO is physically settled. This means that when exercised, the OCPO options contract will result in a long position in FCPO for a call buyer and a short FCPO position for a put buyer. Accordingly, the call seller will be assigned the short position and the put seller will be assigned the long position.

Put-Call ParityBoth the OKLI and OCPO are European options. Since the time of exercise (upon expiry) is known, and there is no uncertainty to the timing of payout, a fairly-priced call option and put option with the same strike price of the same underlying with the same expiry should result in the same returns. Otherwise, it presents an arbitrage opportunity. This no-arbitrage relationship is called the put-call parity. In short, the put-call parity equation is:

BursA COlumnOptions Essentials 024

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According to this relationship, combinations of options can create positions that are the same as holding the stock itself, such as shown in Figure 1.

In instances where the put-call parity relationship does not hold, an arbitrageur can profit at no risk. However, arbitrage opportunities like this is rarely available and only lasts for a few seconds, so arbitrage strategies are used primarily by market makers or floor traders.

Profit Potential for Retail InvestorsThus far, we have discussed how an option buyer can enjoy unlimited profit potential if the right directional bet is made and the option is exercised (refer to payoff diagram in the first issue). In practise however, most of the options traded are never exercised. The most common way for retail investors to profit from

options trading is, in fact, by buying and selling the option before it expires.

If you bought the out-of-money (OTM) June 1,580 call at RM 11.40 on 7 June, it would have become in-the-money (ITM) by 20 June. However, the OKLI option can only be exercised upon expiry on 29 June and there is likelihood that the option may become OTM by then. If the investor speculates that FKLI prices will drop such that OKLI becomes OTM by 29 June, he can sell the call option on 20 June to lock in the RM16.60 profit (RM28.00 – RM11.40).

Figure 1: Put-Call Parity RelationshipSource: Phillip Futures

Date FKlI Jun 2012 (spot Price) OKlI June 1,580 Call

07-Jun-2012 1571.0 RM 11.40

20-Jun-2012 1607.5 RM 28.00

Table 1: OKLI and FKLI Settlement PricesSource: Bursa Malaysia / Phillip Futures

Bullish Bearish

Small move expected

Buy slightly in-the-money (ITM) call option

Buy slightly in-the-money (ITM) put option

Large move expected

Buy out-the-money (OTM) call option

Buy out-the-money (OTM) put option

Table 2: Option strategies to express directional view and expected extent of movement of underlyingSource: Bursa Malaysia / Phillip Futures

We learnt previously that investors who express a bullish view on the underlying asset of the option would generally buy a call option while investors with bearish view would buy a put option. Apart from the directional view (bullish or bearish), the extent of the expected move (large or small) also plays a pivotal role in deciding the moneyness of the option used to maximise profit potential. The table below summarises the optimal combination of option type and moneyness in relation to the market view of investors.

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Disclaimer: The article is written by Phillip Futures Sdn Bhd and is for general information purposes only. The information contained does not constitute legal, financial, trading and/or investment advice and neither does it make any recommendation or endorsement regarding the services mentioned herein. Readers are advised to seek independent advice prior to trading, listing and/or investing. Although care has been taken to ensure the accuracy of the information in this article, Phillip Futures Sdn Bhd and/or Bursa Malaysia Bhd does not warrant or represent, expressly or impliedly as to the accuracy or completeness of the information herein and in no event shall Bursa Malaysia Bhd and/or Phillip Futures Sdn Bhd be liable to the reader or to anyone else for any claim, howsoever arising, out of or in relation to this article. All applicable laws, regulations and current Bursa Malaysia Bhd rules should be referred to in conjunction with this article.

ConclusionIn essence, we have laid the foundations for basic options trading. In the next few issues, we will discuss the factors affecting options pricing and more advanced options trading strategies.

In order to crystallise the concept delineated above, let’s go through a real example where the underlying asset (FLKI) increased substantially and compare the resultant profit potential given the same capital outlay (e.g. RM20.00) between buying ITM call option and buying OTM call option. Based on the data in Table 3, FKLI increased 1.6% from 18 June 2012 to 21 June 2012. Chart 1 shows that this 1.6% change is considered a large movement in KLCI price as it falls within the top ten percentile for a 3-day period price change. The price of the 1,570 ITM call option increased 126.4% (from RM16.30 to RM36.90) while the OTM call option increased by a whopping 223.3% (from RM6.00 to RM19.40). Hence, investors may wish to factor in the expectation of the direction as well as magnitude of the move in the underlying asset when buying options.

Date FKlI Jun 2012 (spot price) OKlI June 1,570 Call OKlI June 1,590 Call

18-Jun-2012 1581.5 RM16.30(ITM as 1581.5 > 1570)

RM6.00(OTM as 1581.5 < 1590)

21-Jun-2012 1606.5 RM36.90(ITM as 1606.5 > 1570)

RM19.40(ITM as 1606.5 > 1590)

No. of lots purchasable with RM20 outlay 1 3

Potential Profit 1 x RM20.60 = RM20.60 3 x RM13.40 = RM40.20

Table 3: Profit Potential of Trading ITM and OTM OptionsSource: Bursa Malaysia / Phillip Futures

Chart 1: Distribution of fluctuation in FKLI for a rolling3-day period from 6 July 2011 to 6 July 2012Source: Bloomberg / Phillip Futures

For more info, go to phillipfutures@poems.com.my