What are Options?

Options are instruments that belong to the derivatives family, which means its price is derived from
something else. The price of an Option is intrinsically linked to the price of the underlying stock.
Here is a text book definition:
A stock option is a contract between two parties in which the stock option buyer (holder) purchases the
right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price
from/to the option seller (writer) within a fixed period of time.
Here is how I define Option:
Options are trading instrument for people who don’t like to invest heavily in stocks. It is basically an
agreement between two parties to sell or purchase the right to an underlying stock. For e.g. The buyer of an
Option pays a premium to the seller with a hope or speculation that the stock price may move up before the
expiration of the agreement or vice versa.
With Options you have an opportunity to practice a wide range of strategies with limited/unlimited
risk/profit potential, create hedging and speculative trading opportunities for yourself.

How are Options different from Stocks?

o The Options contract has an expiration date unlike stocks. The expiration can vary from weeks, months to
years depending upon the regulations and the type of Options that you are practicing. Stocks on the other
hand do not have an expiration date.
o Unlike Stocks, Options derive their value from something else and that’s why they fall under the
derivatives category
o Options are not definite by numbers like Stocks
o You can profit from a drop in the price of an underlying stock. In fact, you can profit in all directions
depending upon the type of position or strategy you are holding unlike stocks where you make a loss when
the stock price goes downwards
o Options owners have no right (voting or dividend) in a company unlike Stock owners

Characteristics of Options
It is quite often that some people find the Option’s concept difficult to understand though they have been
already following it in their other transactions for e.g. a car insurance or mortgages. In this part I will take
you through some of the most important aspects of Options trading.

Type of Options
In true sense there are only two type of Options i.e Call & Put Options rest all are the combination of
strategies based on these prime categories.
A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of
buying a Call Option you pay a certain amount of premium to the seller which grants you the right to but
the underlying stock at a specified price (strike price).
Whereas, a Put Option is an option to sell an underlying Stock on or before its expiration date. Purchasing
a Put Option means that you are bearish about the market and hoping that the price of the underlying stock
may go down. In order for you to make profit the price of the stock should go down from the strike price of
the Put Option that you have purchased before or at the time of its expiration.

What is Strike Price in Options Trading?

The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. It is
often referred as exercise.
In options trading the Strike Price for a Call Option indicates the price at which the Stock can be bought
(on or before its expiration) and for Put Option it refers to the price at which the seller can exercise its right
to sell the underlying stocks (on or before its expiration)

Premium
Since the Options themselves don’t have an underlying value, the Options premium is the price that you
have to pay in order to purchase an Option. The premium is determined by multiple factors including the
underlying stock price, volatility in the market and the days until the Option’s expiration.

Underlying Asset
Underlying asset can be stocks, futures, index, commodity or currency. The price of Option is derived
from its underlying asset and since we are specifically talking about Stock Options, we will consider the
underlying asset as the stock.
The Option of a stock gives the right to buy or sell the stock at a specific price and date to the holder.
Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.

Option Style
Since I have repeated multiple times regarding the expiration of Options I am sure by now you already
know that Stock Options have an expiration date. The expiration date is also the last date on which the
Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading the
expiration of Options can vary from week to months to years depending upon the market and the
regulations.
There are two major types of Options that are practised in most of the markets. The American Options
which can be exercised anytime before its expiration date and the European Options which can only be
exercised on the day of its expiration.

What is Moneyness (ITM, OTM & ATM) in Options Trading?

It is very important to understand the Options Moneyness before you start trading in Stock Options. Lot of
strategies are played around the Moneyness of an Option. It basically defines the relationship between the
strike price of an Option and the current price of the underlying Stocks.
When is an Option in-the-money?
Call Option – when the underlying stock price is higher than the strike price
Put Option – when the underlying stock price is lower than the strike price
When is an Option out-of-the-money?
Call Option – when the underlying stock price is lower than the strike price
Put Option – when the underlying stock price is higher than the strike price
What is at-the-money?
When the underlying stock price is equal to the strike price

Why is Options Trading attractive?

Options are attractive instruments to trade in because of the higher returns and fewer risks involved. An
option gives the right to the holder to do something, with the ‘option’ of not to exercise that right. This
way, the holder can restrict his losses and multiply his returns. However in reality, options are very
complex instrument to trade. That is because options pricing models are quite mathematical and complex.

Conclusion
Before you start with Stock Options it is important to understand the key determinants since Options
Trading carries a risk of unlimited loss. Once you understand how Options Trading works you can
leverage the unlimited profit part of it. You can start with paper trading some basic strategies of Options
to get an idea about how well you can perform in the live market.

Black Scholes Model

What Does Black Scholes Model Mean?

The Black Scholes Model is one of the most important concepts in modern financial theory.
The Black Scholes Model is considered the standard model for valuing options. A model of
price variation over time of financial instruments such as stocks that can, among other things,
be used to determine the price of a European call option. The model assumes that the price of
heavily traded assets follow a geometric Brownian motion with constant drift and volatility.
When applied to a stock option, the model incorporates the constant price variation of the
stock, the time value of money, the option's strike price and the time to the option's expiry.
Fortunately one does not have to know calculus to use the Black Scholes model.

Black-Scholes Model Assumptions

There are several assumptions underlying the Black-Scholes model of calculating options
pricing..

The exact 6 assumptions of the Black-Scholes Model are :

1. Stock pays no dividends.

2. Option can only be exercised upon expiration.

3. Market direction cannot be predicted, hence "Random Walk."

4. No commissions are charged in the transaction.

5. Interest rates remain constant.

6. Stock returns are normally distributed, thus volatility is constant over time.

These assumptions are combined with the principle that options pricing should provide no
immediate gain to either seller or buyer.

As you can see, many assumptions of the Black-Scholes Model are invalid, resulting in
theoretical values which are not always accurate. Therefore, theoretical values derived from
the Black-Scholes Model are only good as a guide for relative comparison and is not an exact
indication to the over- or underpriced nature of a stock option.

Limitations of the Black Scholes Model

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is
widely used as a useful approximation, but proper use requires understanding its limitations –
blindly following the model exposes the user to unexpected risk.

Among the most significant limitations are:

1. The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility are
constant.

2. The Black-Scholes Model assumes that stock prices are continuous and that large changes
(such as those seen after a merger announcement) don’t occur.

3. The Black-Scholes Model assumes a stock pays no dividends until after expiration.

4. Analysts can only estimate a stock’s volatility instead of directly observing it, as they can
for the other inputs.

5. The Black-Scholes Model tends to overvalue deep out-of-the-money calls and undervalue
deep in-the-money calls.

6. The Black-Scholes Model tends to misprice options that involve high-dividend stocks.
 The Black Scholes Model

Binomial Options Pricing Model

The binomial option pricing model is an options valuation method developed in
1979. The binomial option pricing model uses an iterative procedure, allowing
for the specification of nodes, or points in time, during the time span between
the valuation date and the option's expiration date.
What are Futures Contracts?
Before we define a futures contract, there are a couple other financial terms we need
to define. A derivative is a financial instrument that obtains its value from something
else, known as the underlying asset. For example, an actual barrel of oil is an
underlying asset, and let's say the price of oil right now is $50 per barrel.
A futures contract is an agreement to buy or sell an agreed upon quantity of an
underlying asset, at a specified date, for a stated price. So, while the price of oil is
currently at $50, if you think the price of oil will increase, instead of buying the oil
now and storing it until you need it, you can buy a futures contract for oil with a
specific date of delivery and price per barrel.

Types of Financial Futures

Eurodollar Futures

Eurodollar futures are U.S. dollars that are deposited outside the country in commercial banks
mainly in Europe which are known to settle international transactions. They are not guaranteed
by any government but only by the obligation of the bank that is holding them.

U.S. Treasury Futures

Because U.S. Dollars is the reserved currency for most countries, the stability of the dollars
allows for treasury futures market and instruments such as treasury bonds and treasury bills.
Foreign Government Debt Futures

Most government issue debt that are corresponded to the futures markets that are listed around
the world.

Swap Futures

This is generally agreements that are between two parties to exchange periodic interest
payments.

Forex Futures

This type of futures is to manage the risks and take advantage of related forex exchange rate
fluctuations.

Single Stock Futures

Most popular futures contracts are related to the equity markets, they are also known as security
futures. There are about 10 companies in Malaysia that offer single stock futures. They are Bursa
Malaysia Bhd, Air Asia Bhd, AMMB Holdings Bhd, Berjaya Sports Toto Bhd, Genting Bhd, IOI
Corporation Bhd, Maxis Communications Bhd, RHB Capital Bhd, Scomi Group Bhd and Telekom
Malaysia Bhd.

Index Futures

Futures that are based on the stock index. In the case of the Kuala Lumpur Composite Index, the
index futures will be the FTSE Bursa Malaysia KLCI Futures (FKLI).

Types of Commodities Futures

Metals

Major metals traded with futures contracts include copper, gold, platinum, palladium and silver,
which are listed on the New York Mercantile Exchange which has merged with the Chicago
Mercantile Exchange.

Energy

The most popular energy futures contracts are crude oil, heating oil and natural gas. They have
become an important indicator of world economic and political developments and are very much
influenced by producing nations such as Malaysia.

Grains & Oil Seeds

Grains such as soybeans and oil seeds are essential to food and feed supplies, and prices are
sensitive to the weather conditions, and also to economic conditions that affect demand.
Because corn is integral to the increasing popularity of ethanol fuel, the grain markets also are
affected by the energy markets and the demand for fuel.
Livestock

Commodity futures on live cattle, feeder cattle, lean hogs and pork bellies are commodities
traded at CME Group Inc and prices are affected by consumer demand, competing protein
sources, price of feed, and factors that influence the number of animals born and sent to market,
such as disease and weather.

Food and Fiber

The food and fiber category for futures trading includes cocoa, coffee, cotton and sugar. In
addition to consumer demand globally, factors such as disease, insect’s infestation and drought
affect prices of these commodities.

FUTURE Vs FORWARD
FUTURE Vs OPTIONS