An overview of Options Trading Strategies (OPOL, OCPO, OKLI)

The 21st century is an era of innovative technology and rapid digitalization. It has brought revolutionary changes to the trade and investment industry with the proliferation of online trading platforms. This trend is important because it has given investors the flexibility to study and monitor their own investments without needing assistance from a financial specialist. It is also easier for investors to experiment with other non-conventional investment strategies such as options trading. Options trading is popular because it helps to mitigate risks of holding the underlying instrument and can potentially generate income in unfavourable conditions, depending on the chosen options strategy.

An option comes in the form of a contract which gives an investor the right to buy or sell an underlying instrument at a pre-determined price and date. Because of its flexibility, an option can potentially help to reduce portfolio risk and enhance income at a premium. However, a past study based on Chicago Mercantile Exchange data showed that about 75 percent of all option contracts sold over three years expired worthless, which means investors did not exercise their options. This could possibly be attributed to a lack of understanding in option trading strategies. In order to fully reap the benefits of investing in an option, sound understanding on its basic strategies is crucial.

Risk of Rise and Fall

An investor can buy a call or put option. A call option gives an investor the right to buy the underlying instrument at a pre-determined price, also known as strike price, and date. On the other hand, a put option gives an investor the right to sell. Simple strategies usually involve the buying and selling of a single option while more complex strategies involve a combination of simultaneously buying and selling options.

Option strategies can primarily be bullish, bearish, or neutral. Generally, an investor adopts the bullish strategy when there is an expectation for the price of the underlying instrument to go up, while the bearish strategy is adopted when the price of underlying instrument is expected to go down. The neutral strategy, naturally, combines both bullish and bearish strategies.

Long Call Option Strategy

If an investor holds a strong bullish view on the underlying instrument, the simplest strategy is to buy a long call option. However, things do not often transpire according to expectations. The price of the underlying instrument may not appreciate as much as expected or as much as the premium, or it may even decline, resulting in options that are eventually not exercised. The element of uncertainty gives rise to various option strategies which combine both profitability and insurance. Investing in long call options makes sense as the premium is usually cheaper than the price of the underlying instruments.

Covered Call Strategy

For investors who are moderately bullish or neutral and are holding the underlying instrument, a covered call strategy may appeal to them. In this case, the investor writes a call option with a strike price higher than current price and sells it at a premium. This strategy allows the investor to generate income via the option premium and reduces the average cost of owning the underlying instrument. However, the potential gain on the underlying will be limited up to the strike price. For example, assuming you sold 1 contract of OCPO Call (strike price of 2800) at a premium of RM150 when the underlying FCPO was trading at 2900. In one week later, if the underlying FCPO drops to 2750, you may realize your gain immediately by buying back the option at a lower market price, for example RM20. Your profit will be RM130 per MT or RM130 x 25 MT per contract = RM3250 (difference of the 2 premiums i.e. 150 - 20 = 130 x 25 MT per contract). Alternatively, if the underlying FCPO climbs up to 2950 and you are concern that the FCPO will go up further. Instead, you may choose to risk the loss and offset your short position immediately by buying back the option at market price, say RM185. So, your loss will be RM35 x 25 MT per contract= RM875 (difference of the 2 premiums i.e. RM150-RM185 = - 35 x 25 MT per contract). However, you may not need to worry about greater potential loss incurred if you keep your position until expiration. It is always good to assess your option possibilities; either:

1. Do nothing;
2. Offset your option by selling the same option contract in the market. The gain or loss will be the difference in the premium paid and received; or
3. Exercise it. But if it is not expiring, then this may not be an optimal strategy to consider.

Collar Strategy

As an extension to the covered call strategy, if the same investor would like protection against unlimited losses, the investor can adopt a collar strategy. A collar strategy includes the purchase of a put option, funded by the premium income generated from the sale of a call option. An example of selling Call Option using Crude Palm Oil Futures (OCPO). Suppose the investor is bearish on price of the crude palm oil. He/She can write a call option on crude palm oil futures and receives the premium. And assuming that the following calls are available:

1. 1-month 3150 call, premium 62
2. 1-month 3200 call, premium 47

The investor can sell a naked 1 -month call with a strike price of RM 3150 for a premium of 62. If the price of crude palm oil futures falls below RM 3150 at expiration, the option expires worthless and the investor earns RM62 x RM25 =RM 1,550.

However, if the futures price rises to RM 3280, the call option is in-the money and its automatically exercised by the Clearing House. The investor will have short position in the futures and pays an amount equal to the difference between the strike price and the settlement price. The open short position will be subsequently marked-to-market.

Generally, the purchase of put options acts more like an insurance. It helps investors protect themselves against a loss of value, while retaining the potential for profit.

Straddle Strategy

If an investor holds no physical stock and has no bias in the market direction, the investor can adopt a straddle strategy. This strategy is a combination of a long call option and a long-put option. They share the same strike price and expiry date which will help generate income for an investor if the price of the underlying stock appreciates or depreciates. The maximum loss of investing in this option is the sum of the premium of both contracts, and the maximum gain is unlimited. In the same example as above, an investor invests in a straddle with the current price of the underlying stock as the strike price, which is RM100. The premium of both contracts is at RM2 per stock. To earn minimal profit, the price of the underlying stock must be either at RM105 or RM95 at the expiry date. If the price remains the same, the maximum amount of loss for the investor would be RM400. In a nutshell, the straddle strategy is viable if markets are expected to be volatile.

Strangle Strategy

Another variation of the straddle strategy is the strangle strategy. The principle of this strategy is similar in the way that the underlying stock price needs to change significantly for an investor to profit. Instead of sharing the same strike price, one or both contracts will be in an out of money position. For example, stock A is now at RM100 and volatility is expected to rise. An investor can enter a call contract at RM105 and a put contract at RM95. The out of money position means the premium will likely be cheaper than a straddle strategy but will need a wilder price swing to generate profit.

In Malaysia, Bursa Malaysia Derivatives offers ways to trade options. An investor can consider to invest in these three (3) Options:

i. OPOL, US Dollar ("USD") denominated Options Contract with USD RBD Palm Olein Futures Contract (FPOL). This is the world’s first Options Contract on RBD Palm Olein, with an array of possible risk management tools for palm oil industry players as options contracts. It offers very different risk-reward profiles for futures contracts.

ii. OCPO, Ringgit Malaysia ("MYR") denominated Options Contract traded on Bursa Malaysia Derivatives ("BMD") with Crude Palm Oil Futures Contract (FCPO). Its underlying instrument also adds on to the array of possible risk management tools for palm oil industry players as options contracts with very different risk-reward profiles for futures contracts.

iii. OKLI, Ringgit Malaysia ("MYR") denominated Options Contract on FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI). This is a versatile risk management tool for industry investors to trade, hedge and manage the risk needed in equity portfolios.

While the choices are limited, there are also other platforms to consider for trading options such as binary option trading. The act of purchase and selling of both call and put options can create different option strategies. These option strategies can appeal to both bearish and bullish investors, regardless of whether they own the underlying instrument. It is a flexible hedging strategy that balances both risk management and profit generation. However, it is highly advisable for any investors to be well-versed with the basic concepts of option trading before participating. In conclusion, options trading is an alternative risk investment tool that can help one manage their cash flow, reduce risks by giving portfolio protection, diversify asset allocation and is an instrument that plays an integral part in enhancing an investor’s income to help them achieve their financial goals.