1 INTRODUCTION TO DERIVATIVE SECURITIES Cleary Text, Chapt. 19 CALL & PUT OPTIONS Learning Objectives l Define options and discuss why they are used. l Describe how options work and give some basic strategies. l Explain the time value and intrinsic value of options.

2 INTRODUCTION TO DERIVATIVE SECURITIES CALL & PUT OPTIONS an option grants the holder or owner, the right to buy or sell a certain quantity of a specific security at a set price for a specified period of time  like a ticket

3 CALL OPTIONS  A call conveys the right to buy a fixed number of shares of a stock at a predetermined price (strike or exercise price) on, or before a specific date (expiry date) in the future  when an investor buys a call they expect the price of the underlying security to rise

4 OPTIONS TERMINOLOGY  strike or exercise price: the price the holder of the option can buy the underlying security  price or premium: the price of the option  expiry date: when the option becomes valueless (0$  3 rd Friday of month) –American style –European style

5 CALL OPTIONS: CALL BUYER (Bullish) l example: Tudor buys one RIM 64$ April call option for $3 premium from Kyle. l  this call option gives Tudor the right to buy one RIM share from Kyle for 64$ between now and the third Friday in April. l RIM is currently at $63 per share. RIM shares need to increase to $67 for Tudor’s calls to be in the money

6 call buyer example cont’d… 64 67= exercise + premium Break even point P&L RIM share price -3

7 CALL OPTIONS: CALL WRITER (neutral / bearish) The writer is selling the call, thus receives the premium example: Kyle receives $3 when he sells the call to Tudor. Kyle is obligated to sell Tudor one RIM share at $64 if Tudor desires to buy that share

8 call writer example cont’d… 64 67= exercise + premium Break even point P&L RIM share price -3 +3

9 PUT OPTIONS l A put conveys the right to sell a fixed number of shares of a stock at a predetermined price (strike or exercise price) on, or before a specific date (expiry date) in the future l when an investor buys a put they expect the price of the underlying security to drop

10 PUT OPTIONS PUT BUYER (bearish) example:

11 put buyer example cont’d... + share price = exercise - premium Break even point - P&L 64

12 PUT OPTIONS: PUT WRITER (bullish / neutral) The writer is selling the put, thus receives the premium example:

13 put writer example cont’d... + share price = exercise - premium Break even point - P&L

14 OPTIONS l “zero sum game” the profit made on the option is equal to the loss by the other party. example: If the holder makes $5, then the writer loses $5  refer to P&L graphs

15 “zero sum game” the profit made on the option is equal to the loss by the other party.

16 PREMIUM (PRICE) – CALLS RIM shares at $70 example: Jan 75 calls have a premium of $1.50 Intrinsic Value  zero Time Value  1.50 l example: Jan 65 calls have a premium of $6.75 Intrinsic Value  five Time Value  1.75

17 PREMIUM (PRICE) - PUTS RIM shares at $70 example: Jan 80 puts have a premium of $12.80 Intrinsic Value  ten Time Value  2.80 l example: Jan 65 puts have a premium of $0.75 Intrinsic Value  zero Time Value  0.75

18 VOLATILITY AFFECTS TIME VALUE l Greater the volatility (fast price changes) of the underlying stock, the greater the premiums of the options

19 TIME VALUE OF OPTIONS l because options expire worthless, they have a limited lifespan l options have a time value, and as the expiry date for the option approaches, the time value decreases to zero l the decay from time value is not linear but accelerates as the expiry date approaches l this means that of two options with the same strike price, the one that has a longer time to expirey will be worth more

20 TIME VALUE OF OPTIONS

21 OPTION PRICING  time value  intrinsic value: relationship between the strike price and the share price  dividends  stock (and market) volatility  dividends  interest rates  supply & demand

22 OPTION COMMISSIONS The broker always charges the buyer and the writer of options commissions l commission on buying and selling options –WLU commission = 1% of premium –TD Waterhouse = $35 + sliding scale l commission on delivery of shares if option is exercised as per regular rates

23 BULLISH STRATEGIES l Buying calls l Selling puts

24 BEARISH STRATEGIES l Buying puts l Selling calls

25 COVERED CALL WRITING Selling calls on shares that you already own.  You receive the premium  If they are exercised you receive the strike price (that’s OK!)  If the calls are not exercised you keep both the premium and the shares! (that’s even better!)

26 FINAL NOTES ON OPTIONS l option contracts expire on the third Friday of the month l unexercised options have zero value at expiry date l options held in your portfolio, may be re- sold on the market l priced per option; bought in multiples of 100 (one contract) like board lots

27 l Hedging strategy that provides a minimum return on the portfolio while keeping upside potential l Buy protective put that provides the minimum return – Put exercise price greater or less than the current portfolio value? l Problems in matching risk with contracts Portfolio Insurance

28 l Stock-Index Options: option contracts on a stock market index l Interest Rate Options: option contracts on fixed income securities l Currency Options: Option contracts whose value is based on the value of an underlying currency Other Types of Options

29 l Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc. l Bullish on capital markets implies buying calls or writing puts l Bearish on capital markets implies buying puts or writing calls l At maturity or upon exercise, cash settlement of position Basics of Stock-Index Options

30 Appendix 19-B Rights and Warrants l Right – to purchase a stated number of common shares at a specified price with a specified time (often several months) l Warrant – to purchase a stated number or common shares at a specified price with a specified time (often several years)