Options trading is relatively new in Malaysia. However, did you know that Bursa Malaysia Derivatives offers the trading of options contracts?

Before you read on, you might be asking: “I’m an investor, but what does options trading, have to do with me anyway?” Well, options trading provides investors an alternative way of investing and can also be used as an effective risk management tool in an investment portfolio. More recently, the demand for courses teaching the basics of trade options has increased. In this article, we will discuss the simple basics of options trading in Malaysia. By the end of this article, you will be able to describe an option contract, the trading process of an option contract and identify the benefits of options trading.

What is an option contract?

An option is a financial derivative that derives its value from its underlying instrument. This could be in the form of a stock, stock indices, commodities, debt instruments or futures contracts. For example, the options being offered by Bursa Malaysia Derivatives is an index option with the FBM KLCI as its underlying instrument.

By paying a premium, the buyer of the option receives the right to buy or sell the underlying asset. In return, the seller or the writer of the option, who receives the premium, has the obligation to honour the contract to deliver the underlying security if the call is exercised or buy the underlying security if the put is exercised. The writer keeps the premium whether or not the option is exercised.

There are two basic types of options:

• Put option, which gives its owner the right to sell the underlying asset at a specified price for a specified time period; and
• Call option, which gives its owner the right to buy the underlying asset at a specified price for a specified time period.

There are two components to the option price, which are the intrinsic value and the time value of the option. The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option, which reflects the effective financial advantage if the option is being exercised immediately; whereas the time value of the option is determined by the remaining lifespan of the option.

The table below summarizes the intrinsic value of an option under different conditions:

Trading of Options

In Malaysia, FBM KLCl options is the only option being traded on Bursa Malaysia Derivatives and it is an option on FBM KLCI index, which can be thought of as the trading of a portfolio of shares that tracks our local share market. However, as index options usually exclude dividend payments and voting rights, they are not considered an exact substitute for actual ownership of the shares.

The FBM KLCl, the underlying asset for the FBM KLCl options, is the weighted average market capitalisation of 30 largest Malaysian companies listed on the Bursa Malaysia by full market capitalisation. To trade the option, bids and offers are entered into the automated system by exchange members and the transaction is executed when a match is made.

Why trade options?

The main reason for individual investors or institutional investors to trade options is because appropriate option strategies can be use as effective risk management tools to hedge the risk of their investment portfolios. This will allow them to reallocate the risk to other investors who are willing to accept that risk, but at a premium. For example, owners of a portfolio of blue chips stocks can choose to hedge against the drop in the stock prices by purchasing put options on FBM KLCI.

In the event that the stock prices drop, the put option owners can exercise the put options to offset the losses in their investment portfolios. In addition, the cost of trading options is much lower compared to its underlying instruments. This enables those who want to speculate the price movement of the underlying instrument to carry out their transactions at a lower cost as they are only paying the option premium instead of the price of the underlying instrument.

In conclusion, options – while relatively new, are a useful investment tool because they help you leverage on the upside (the estimated “attractiveness” of an investment), but it does involve risks. Sometimes, you may end up with a big loss or even total loss. As an investor, remember to be disciplined when trading in options, especially if you use speculative methods. Regardless of how brave or cautious you are as an investor, you have to stick with your money-management skills and not invest more than your limit when investing in options.

© Securities Industry Development Corporation 2010.

 

*Note: This article was written by Mr Ooi Kok Hwa, holder of the Capital Markets Services Representative’s License to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is only for educational purposes and reflects the market conditions at a specified point in time, which may lapse and affect the relevance of this article. This article does not necessarily represent the official view of Securities Industry Development Corporation and should not be used as a substitute for legal or other professional advice.

FOOTNOTES:

[A] The price at which a specific derivative contract can be exercised. Strike prices is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold.  

The difference between the underlying security's current market price and the option's strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid.

Also known as the "exercise price".  ( www.investopedia.com)

 

[B] Basically, an option that would be worthless if it expired today. (www.investopedia.com)

 

[C] In the money means that your stock option is worth money and you can turn around and sell or exercise it. For example, if Johan buys a call option on ABC stock with a strike price of RM12, and the price of the stock is sitting at RM15, the option is considered to be in the money. This is because the option gives John the right to buy the stock for RM12 but he could immediately sell the stock for RM15, a gain of RM3.  If John paid RM3.50 for the call, then he wouldn't actually profit from the total trade, but it is still considered in the money. (adapted from www.investopedia.com)