Define options and discuss why they are used.

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

2. INTRODUCTION TO DERIVATIVE SECURITIESCALL & PUT OPTIONS an option grants the holder or owner, the rightto 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$  3rd Friday of month) • American style • European style

5. CALL OPTIONS:CALL BUYER (Bullish) • example: Tudor buys one RIM 64$ April call option for $3 premium from Kyle. •  this call option gives Tudor the right to buy one RIM share from Kyle for 64$ between now and the third Friday in April. • 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… P&L 64 67= exercise + premium RIM share price -3 Break even point

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… +3 P&L 64 67= exercise + premium RIM share price Break even point -3

9. PUT OPTIONS • 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 • when an investor buys a put they expect the price of the underlying security to drop

10. PUT OPTIONSPUT BUYER (bearish) example:

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

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

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

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

19. TIME VALUE OF OPTIONS • because options expire worthless, they have a limited lifespan • options have a time value, and as the expiry date for the option approaches, the time value decreases to zero • the decay from time value is not linear but accelerates as the expiry date approaches • 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 COMMISSIONSThe broker always charges the buyer and the writer of options commissions • commission on buying and selling options • WLU commission = 1% of premium • TD Waterhouse = $35 + sliding scale • commission on delivery of shares if option is exercised as per regular rates

23. BULLISH STRATEGIES • Buying calls • Selling puts

24. BEARISH STRATEGIES • Buying puts • 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 • option contracts expire on the third Friday of the month • unexercised options have zero value at expiry date • options held in your portfolio, may be re-sold on the market • priced per option; bought in multiples of 100 (one contract) like board lots

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

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

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

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