Presentation on theme: "Creating an Income Stream for Your Clients: The Art & Science of Covered Call Writing David Salloum MBA CFP CIM FCSI TEP Vice President & Portfolio Manager."— Presentation transcript:
Creating an Income Stream for Your Clients: The Art & Science of Covered Call Writing David Salloum MBA CFP CIM FCSI TEP Vice President & Portfolio Manager
Objectives Review the basic terminology, concepts and characteristics associated with various derivative instruments Describe the different factors that influence the option’s premium Describe and illustrate this basic option strategy as well as the inherent risk and reward potential
Things to Keep in Mind For any transaction to take place there needs to be a willing buyer and a willing seller. Interest rates change. Stock prices change.
“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives…these instruments are an increasingly important vehicle for unbundling risks. They enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it… this process has undoubtedly improved national productivity growth and standards of living.” Alan Greenspan, Chairman of the U.S. Federal Reserve Board of Governors, 1987-2006
Definition Derivative instruments are financial instruments that derive their value from the value of an underlying asset, namely: a stock, an index, a bond, an interest rate, a currency, a commodity.
Definition Derivatives are contracts or agreements to purchase or sell assets at a future date. The contracts specify in advance: the underlying interest the quantity/amount the purchase or sell price the expiry date of the contract
Why do they use derivatives? To attain investment objectives Income strategy Free up cash Protect capital
Elements in an Option Contract Type: call or put. Underlying interest: the underlying asset specified in the option contract. Expiry month: the month during which the option ceases to exist (options expire on the Saturday following the 3rd Friday of each month). Strike price: the price at which the holder can purchase or sell the underlying. Premium: the option’s price (x multiplier: 100 for stock options).
Call Options The buyer (holder) of a call option has the right, but not the obligation: to buy a specific quantity of an underlying; at a given price (strike price); for a specified time period (expiry date). In order to obtain this right, the holder must pay a premium to the writer.
Call Options The seller (writer) of a call option has the obligation to sell to the holder: A specific quantity of an underlying; At the strike price indicated, if the holder exercises his right. In return for this obligation, the writer receives the premium paid by the holder.
The Options Market CallPut Holder/Buyer (pays a premium) Right to buy (no obligation) Right to sell (no obligation) Writer/Seller (receives a premium) Obligation to sellObligation to buy
Your Options The holder of the option can: Exercise his right to buy or sell Close his position by selling back the option Let the option expire worthless (loss) The seller of the option can: Accept to be assigned (deliver or take delivery) Close his position by buying back the option Let the option expire worthless (gain)
Basic Strategies CallsPuts Buy (Holder) To benefit from a price increase To determine the future acquisition price To hedge a short sale To benefit from a price decrease To determine the future selling price To hedge a long position Sell (Writer) To benefit from a price decrease To generate additional income To benefit from a price increase To generate additional income
The Option Chain Call CM July 105 @ $2.00 Option type Underlying asset Expiry month Strike price Option premium
Call Options April 07: G @ $29.63 Buy 1 Call G July 30 @ $2.20 Sell 1 Call G July 30 @ $2.20 Right to buy Obligation to sell
Call Options Buyer 1 Call G July 30 @ $2.20 Seller 1 Call G July 30 @ $2.20 Scenario 1: At expiration, G @ $36 Scenario 2: At expiration, G @ $26
Exercise Styles American-style options: allow the holder to exercise at any time during the life of the option (all stock options and few index options). European-style options: limit the holder to exercise the option only at expiry date (most index options).
In, At, Out… Out-of-the-money Call Strike $62 Strike $58 Put Strike $58 In-the-money At-the-money (strike $60) Strike $62 In-the-money Out-of-the-money Intrinsic Value Market PCA = $60
Factors Influencing the Option Price Premium=Intrinsic Value + Time Value Intrinsic Value: is the amount by which the option is in- the-money. Time Value: an option is a wasting asset; its value declines over time. Time to expiration Volatility Risk-Free Interest Rate Dividends What’s the value of an option at expiration?
Factors Influencing the Option Price Volatility Volatility measures the amount by which the price of the underlying stock fluctuates during a specified period of time. The higher the volatility, the higher the option’s premium.
The Options Market April 2007: SLF @ $53 Call July 50 is trading @ $3.95 Intrinsic value? $0.95 Time value?
Factors Influencing the Option Price Time to Expiration RIM is trading @ $168.85 (April 07) Call RIM May 170 @ $9.15 Call RIM September 170 @ $18.55 The more time to expiration, the higher the value of the call.