AGENDA OPTIONS: What are they? Why buy CALLS AND PUTS? OPTIONS: Terminology How options work
: AN INTRO OPTIONS: AN INTRO Options represent claims on an underlying common stock Created by investors and sold to other investors The corporation whose common stock underlies these claims have NO DIRECT INTEREST in the transaction The corporation is NOT responsible for creating, terminating or executing options
CALL OPTIONS Call option contract – gives holder the right TO BUY (or “CALL AWAY”) 100 shares of a particular common stock at a SPECIFIED PRICE any time prior to a SPECIFIED EXPIRATION DATE. REASON FOR BUYING CALLS: Investors buy CALLS if they expect the stock price to RISE because the price of the call and the common stock will move together. Calls allow investors to speculate on a rise in the price of the underlying common stock WITHOUT BUYING THE STOCK ITSELF.
CALL OPTIONS: EXAMPLE A KWA six-month call option at $30 per share gives the buyer a right (an option) to buy 100 shares of KWA at $30 per share from a WRITER (SELLER) of the option anytime during the 6 months before the specified expiration date no matter what happens to KWA’s market price, even if it rises.
PUT OPTIONS Put option contract – gives the buyer the right TO SELL (or “PUT AWAY”) 100 shares of a particular common stock at a SPECIFIED PRICE any time prior to a SPECIFIED EXPIRATION DATE. If exercised, shares are sold by the owner (BUYER) to the put contract writer (SELLER) of this contract who is required to take the shares and pay a specified price REASON FOR BUYING PUTS Investors buy PUTS if they expect the stock price to FALL because the VALUE of the put will RISE as the stock price DECLINE. Puts allow investors to speculate on a decline in the stock price without selling the common stock short.
PUT OPTIONS: EXAMPLE The writer (SELLER) of a KWA six-month put option at $30 per share is OBLIGATED, under certain circumstances, to receive from the holder of this put 100 shares of KWA paying $30 per share (i.e. seller is obligated to buy back shares of KWA for $30 per share no matter what happens to KWA’s market price, even if it drops).
WHY BUY OPTIONS? 1. Puts and calls provide opportunities for investors to use risk-return combo’s that would otherwise be impossible or improve the risk-return balance of a portfolio; i.e. an investor can sell a stock short and buy a call thus reducing the risk on the short sale for the life of the call because the investor has a guaranteed maximum purchase price until the call option expires. 2. Calls allow an investor to control a claim on the underlying common stock for a much smaller investment than required to buy the stock itself; i.e. because he/she can purchase more stock at a specified price before the expiration date.
WHY BUY OPTIONS? 3. Puts allow an investor to duplicate a short sale without a margin account and at a modest cost in relation to the value of the stock; i.e. because he/she is still betting on the price of the stock to decline without having to put up a large margin to the dealer (i.e. 130% to 200% of the market value of a stock in a short sale) 4. The options buyer’s maximum loss is known in advance, i.e. if the option expires worthless, the most the buyer can lose is the cost (price) of the option.
WHY BUY OPTIONS? 5. Options provide leverage by magnifying the percentage gains in relation to buying or short selling an underlying stock. Options can provide greater leverage potential than fully margined stock transactions. 6. Options on a market index such as the TSX 60 Index allow investors to participate in market movements with a single trading decision
OPTIONS: TERMINOLOGY Exercise (Strike) Price – The per-share price at which the common stock may be purchased from (i.e. a call) or sold to (i.e. a put) a writer. Most options are available at several different exercise prices; as stock price changes, options with new exercise prices are added Expiration Date – the date on which an option expires; the last date on which an option can be exercised. Puts and Calls are designated by the month of expiration. Usually the Saturday following the third Friday of the month to force clients to make their exercise decisions on the Friday.
OPTIONS: TERMINOLOGY Option Premium – the price paid by the option buyer to the seller (writer) of the option, whether put or call. The premium is stated on a per share basis for options; since the standard contract is for 100 shares, a $4 premium represents a $400 cost for a standard option contract. Option exchanges have standardized expiration dates (i.e. TRADING CYCLES) and standardized exercise/strike prices (i.e. usually in multiples of $5 and with additional option series introduced as time passes or if the stock price changes).
OPTIONS: TERMINOLOGY LEAPS (Long Term Equity AnticiPation) – long term options with maturities greater than one year and ranging to two years and beyond. Only availably on relatively few well-known stocks such as INCO.
HOW OPTIONS WORK: THE BASICS Recall, a standard CALL or PUT contract gives the buyer the right to BUY or SELL 100 shares of a particular stock at a specified exercise/strike price before the expiration date. PUTS and CALLS are created by SELLERS/WRITERS by creating a particular contract.
HOW OPTIONS WORK: THE BASICS These WRITERS are investors or institutions that want to make profit from their beliefs about the underlying stock’s likely price performance, just like the BUYER. Therefore, the BUYER and WRITER have OPPOSITE EXPECTATIONS about the stock’s performance.
HOW OPTIONS WORK: THE BASICS – –The CALL WRITER expects the price of the stock to remain roughly steady or maybe move DOWN – –The CALL BUYER expects the price of the stock to move UP and relatively soon – –The PUT WRITER expects the price of the stock to remain roughly steady or maybe move UP – –The PUT BUYER expects the price of the stock to move DOWN and relatively soon
HOW OPTIONS WORK: AMY’S EXAMPLE Amy thinks stock YAY price is going to go up. She tells her broker to buy a March 2007 CALL OPTION on YAY at a strike price of $55. Amy and her broker negotiate a premium $2 which represents a one option contract cost of $200 (100 shares) plus brokerage commissions 3 THINGS CAN HAPPEN!
AMY’S EXAMPLE 1.Amy’s call option expires worthless – YAY’s price fluctuates but falls to $50 on the strike date. The call gives the Amy the right to purchase YAY at $55 but it’s worthless because she can buy YAY for $50 on the open market.
AMY’S EXAMPLE 2.Amy exercises the call option – YAY’s price ends up being over $55 on the strike date. Amy exercises the option by paying $5,500 ($55 times 100 shares) and receiving 100 shares of YAY. For example, YAY goes up to $65 before the strike date and Amy exercises her option to buy 100 shares of YAY at $55 (plus commission fees) and resell them in the market for $6,500 (minus commission fees). Amy’s profit would be $6,500 - $5,500 - $200 (the original cost of the option contract) = $800 (minus commission fees)
AMY’S EXAMPLE 3.Amy sells the call option in the secondary market – YAY appreciates and therefore the value (price) of the call increases too. Amy sells the call in the secondary market to another investor who wants to bet on YAY going up even more. Most investors trading puts and calls do not exercise those that are valuable; rather, they sell them on the open market exactly as they would the common stock.
ANOTHER EXAMPLE A writer sells a February 2007 put option contract of TEE with an exercise price of $55 when the stock price is $50. A premium of $3 represents a total cost of $300 per option contract (100 shares). Jim buys the put from the writer for $500. The price of TEE falls to $45 before the expiration date. Jim, who does not own TEE previously, tells his broker to purchase 100 shares of TEE in the open market for $4,500. Then he exercises his put and the put writer must accept the 100 shares of TEE and pay Jim $55 per share or $5,500 total. Jim earns $5,500 (put exercise price) - $4,500 (market price) - $300 (cost of the put contract) = $700 (minus commission fees). The put writer suffers an immediate paper loss because the 100 shares of TEE he just paid $5,500 for are only worth $4,500 in the open market.