Chapter 7 Option Contracts; Specification & Trading

1. Chapter 7Option Contracts; Specification & Trading Chapter Objective: This chapter examines the trading of options and its contract specifications. The mechanics of option trading and issues related to the trading of options is examined in detail. The chapter also analyses the features of option contract specifications and discusses their rationale

2. Introduction • Malaysia’s first exchange traded option contract was introduced on 1st December, 2000. • The contract was introduced by Bursa Malaysia Derivatives Bhd’s (BMDB’s) predecessor the Kuala Lumpur Options and Financial Futures Exchange (KLOFFE). This first option contract was introduced almost five years after KLOFFE’s first product, the KLCI Futures Contract. • The KLCI Options as they are known, have both call and put options of varying exercise prices. The underlying asset is the Bursa Malaysia, Kuala Lumpur Composite Index. • As an index linked derivative, the KLCI options are heavily dependent on market sentiment and other macro factors for its performance.

3. Trading Option Contracts • As is the case with other derivative instruments, options may be used for hedging, arbitrage and speculative purposes • Unlike other derivatives, options involve no obligation on the part of the buyer. The buyer of a call option on a stock has the right to buy the underlying stock at the exercise price • On exercise, the holder of the call pays the exercise price in return for the stocks from the call writer. In the case of a Put, the holder on exercise receives the exercise price in return for his shares • While such is the case in physical settlement, stock and index options in Malaysia are cash settled. As such, there is no delivery of the underlying asset

4. Since buyers (long position) of options would only exercise if it is profitable for them to do so, fund flow at exercise can only be in one direction; i.e. from seller to buyer Unlike futures, there is no possibility of a loss on exercise for the long position in options

5. Example: Suppose, the KLCI is now 850 points and 30 day at the money index calls are being quoted as follows; 850 Call @ 4 points The index multiplier for index options is the same as that of index futures; i.e. RM100. To purchase the call (long call), the investor pays a premium of; 4 pts x RM100 = RM400

6. Scenario 1; KLCI up by 15 points Profit on Exercise For Calls: (Settlement Value – Exercise price) x Index Multiplier. (865 points – 850 points) x RM100 = (15 points) x RM100 = RM1,500 The net payoffs to the long and short call positions are as follows:

7. Scenario 2; KLCI falls 15 pointsAssuming the KLCI falls 15 points over the next 30 days, its value; will be 835 points which is 15 points lower than the original 850 points.The payoff to the long and short positions will be as follows; The maximum loss possible to the long position in options is the amount of premium paid.

8. Option Premiums and Underlying Asset Price The above example illustrated the exercise procedure and the net payoffs to the long and short positions upon exercise. The assumption was that the option position is held until maturity. However, an investor taking a position in options need not hold the position to maturity. While the KLCI options have European style exercise and so cannot be exercised before maturity, there is nothing to stop the investor from realizing or taking profit by selling off his option. If the investor’s original bullish sentiment had been correct and the underlying asset, in this case, the KLCI had gone up in value, the call option which was at the money during purchase would now be in the money. The call would now command a higher premium.

9. When the underlying assets spot price/value increases, call premiums will rise whereas put premiums will fall. When underlying asset’s price/value falls, call premiums fall in value but put premiums rise. Call premiums are positively correlated with underlying asset values whereas put premiums are inversely correlated.

10. American Style Options and Early Exercise • If the option has European style exercise, the holder has only one way to realize profits before maturity; that is by selling the option at the higher prevailing premium. • If the option is American style, the holder of an in the money option has two choices. the holder can choose to exercise immediately in order to realize profits, or he can choose not to exercise but sell the option at the higher prevailing premium.

11. Would the two choices provide the holder of the American style the same profit payoff?The answer is no Early exercise of an option would be inferior to selling the option since exercise captures only the intrinsic value. Selling the option would provide a premium that includes both intrinsic and time value.

12. Intermediation and Margining When options are listed on an exchange for trading, anyone with an account with a broker can choose to either buy or sell the listed options As an exchange traded contract, parties to a transaction need not worry about the integrity of their counterparty As the intermediary, the Exchange, by means of novation guarantees all transactions registered through its clearinghouse receive premium Pay premium Option Buyer Exchange Option Seller Right to exercise Is obliged to buy or sell

13. It is obvious that in guaranteeing transactions, the exchange is taking on the default risk of participants. As we saw in Chapter 3, derivative exchanges manage this risk by means of margining and the daily marking to market process • Unlike futures contracts where both the long and short positions have to post margins, margining for option contracts are somewhat different. In the case of futures, recall that both the long and short futures positions had risk profiles that had unlimited profit and loss potential

14. Depending on which way prices moved, the long or short futures position could lose, thus the need for margins on both parties. In the case of options however, the long and short positions do no have the same risk profile Figure 7.1 (page164),7.2(page165) show the payoff diagrams

15. Option Classes and Series When options are made available for trading, an exchange typically lists a series of options of the same maturity but at different exercise prices The idea behind having such a series is to have at least one in the money, one at the money and one out of the money option on the same underlying asset Example, suppose the KLCI is currently at 830 points the class of index options listed for trading might look as follows

16. 30 day Index Options Calls Puts 810 Call @ 45 pts 810 Put @ 2 pts 830 Call @ 24 pts 830 Put @ 23 pts 850 Call @ 3 pts 850 Put @ 44 pts Since the KLCI is currently assumed to be at 830, the 830 Call and Put are both at the money. The 850 Call is out of the money but the 850 Put is in the money. Finally, the 810 Call is in the money while the Put of the same exercise price is out of the money. The entire set of options on an underlying asset (both calls and puts) of various maturities and exercise prices are together known as a class of options. Options on the underlying asset with the same maturity and exercise price is known as an option series.

17. Option moneyness as we know changes as the underlying asset changes in value. For example, suppose in the illustration above, the KLCI is at 880 points a week later, all the option series would have changed in moneyness. All three of the above calls would now be in the money whereas all the puts out of the money In the money options have much higher premiums than out of the money options. In efficient markets, premiums would adjust to reflect the different exercise prices In the absence of such adjustment the options would be mispriced relative to one another, giving rise to arbitrage opportunity

18. KLCI Options: Contract Specifications Contract specifications as we know are a key feature of exchange traded contracts. Contract specifications outline the features and the rules by which trading in the contract is carried out Chart 7.1 below, is a reproduction of Bursa Malaysia’s contract specifications for the KLCI Option

19. KLCI Options : Contract Specifications

20. Continued’ (Source : Bursa Malaysia Derivatives Bhd. Website)

21. the underlying asset is the KL Composite Index and as in the case of index futures, the index multiplier is RM100. The minimum price fluctuation is also 0.1 index points or RM10.00 • In the case of options however, the minimum price fluctuation refers to the premium tick size • Exercise price interval refers to the option series we had discussed earlier. Recall that exchanges typically list at least 3 Call and Put options of the same maturity but at different exercise prices • The exercise style is European while final settlement value is determined by averaging the index values that prevail in the last 30 minutes of the final trading day

22. The position limit is 5,000 contracts on either the long or short side and the reportable position is 100 contracts • The transaction costs per option contract is as follows: KLCI Index Options : Transaction Costs Broker’s Commission = RM50 per contract Trading & Exchange Fee = RM10 per contract ------------------------- Total = RM60 per contract

23. Stock Options Stock options or equity options as they are commonly known are a popularly traded option contract in many markets Stock options however are yet to be introduced in Malaysia though there appears to be definite plans to introduce them Stock options have as their underlying asset individual listed stocks

24. Given that stocks are traded in Malaysia in lots of 1,000 each, it is likely that stock options when introduced would also be based on 1,000 of the underlying stocks (Since 2004, smaller lot size of 100 stocks are also applicable) For example, a call option on Maybank Stock could be quoted as follows: RM14.00, Maybank Call @ .48

25. Since each contract is for one lot of 1,000 stocks, the premium amount would: RM0.48 x 1,000 = RM480 per contract Exercise price intervals are likely to be small for low priced stocks while the intervals could be larger for higher valued stocks The exercise style convention has generally been that stock options have an American style exercise

26. Contract Performance Since its introduction in December 2000, the KLCI option contracts have had a very slow start. As of end 2005, performance in the first five years of the contract have been somewhat lack lustre. Trading volume does not appear to exceed 20 contracts per day with several days of zero volume. Open interest too remains small with the highest level barely reaching 70 contracts

27. The introduction of index options constitutes an important milestone in the development of Malaysian financial markets. • From a theoretical viewpoint, with futures available, options are needed for “completing the markets”. That is with an asset traded in the spot, futures and option markets, arbitrage and other linkages will ensure that pricing is efficient • It will also enable players in one market to use the other in hedging and risk management

28. Key Terms

29. The End