Options ABCs. Jason Ayres, DMS Director, R N Croft Financial Group
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1 Options ABCs Jason Ayres, DMS Director, R N Croft Financial Group
2 Limitation of liability The opinions expressed in this presentation are those of the author(s) and presenter(s) only and do not necessarily represent the views of of the Bourse de Montréal Inc. (the Bourse ) and/or its affiliates. This document is offered for general information purposes only. The information provided in this document, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely for information purposes and shall not be construed in any jurisdiction as providing any advice or recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as providing legal, accounting, tax, financial or investment advice. The Bourse recommends that you consult your own advisors in accordance with your needs. All references in this document to specifications, rules and obligations concerning a product are subject to the rules, policies and procedures of the Bourse and its clearinghouse, the Canadian Derivatives Clearing Corporation, which prevail over this document. Although care has been taken in the preparation of this document, the Bourse and/or its affiliates do not guarantee the accuracy or completeness of the information contained in this document and reserve the right to amend or review the content of this document any time and without prior notice. Neither the Bourse, nor any of its affiliates, directors, officers, employees or agents shall be liable for any damages, losses or costs incurred as a result of any errors or omissions in this document or of the use of or reliance upon any information appearing in this document.
3 Agenda Options fundamentals Exercise and assignment Option Pricing Time Decay and Volatility Options as a stock replacement 3
4 Option Fundamentals
5 What are Options? Contract to buy or sell a stock in the future at a specific price over a specific period of time 5
6 Two Types of Options Call option Put option Rights and obligations are dependent on: Which type is chosen Are you a buyer or a seller of the option
7 Call Options Call Option Buyer Pays for: Right to buy Specific Price Specific Time Call Option Seller (writer) Gets paid for: Obligation to sell Specific Price Specific Time
8 Put Options Put Option Buyer Pays for: Right to sell Specific Price Specific Time Put Option Seller (writer) Gets paid for: Obligation to buy Specific Price Specific Time
9 Contract Specifications One contract represents 100 shares Price is displayed per share You must multiply the quoted price by 100
10 Key Variables Strike Price The price at which the option buyer has the right to transact the security Expiration Weekly options expire every Friday Monthly options expire the 3 rd Friday of the month
11 Option Chain Stock XYZ trading at $15.00 Option Last Bid Ask Jan2018 $14.00 Call $2.00 $1.95 $2.05 Jan2018 $15.00 Call $1.50 $1.45 $1.55 Jan2018 $16.00 Call $0.90 $0.95 $1.05 $1.55 per share X 100 shares = $
12 Option Exercise and Assignment
13 Exercise and Assignment Exercise Assignment An option buyer can exercise their rights The option seller is assigned the obligation to deliver
14 Type of Options American Style Most equity and ETF options are American style Can be exercised at any time prior to or at the expiration day The exercise involves the physical exchange of the shares Sellers of options have obligation that can be assigned at any point
15 Type of Options European Style Mostly used for index options While they can be bought and sold any time, they can only be exercised at expiration The exercise/assignment is cash settled for difference (no physical exchange of shares)
16 Call Option on Suncor Suncor shares trading at $40.00 Jan 2018, $40.00 call is $2.00 Buyer pays $ for the call and has a right to purchase Seller receives $ income and has an obligation to sell
17 Suncor Call Option Exercise Call Buyer Exercises the calls Call Seller Assigned on the stock
18 Option Pricing
19 Option Pricing Variables Stock Price Strike Price Time Interest Rates Dividends Volatility Price of the underlying stock Price that the option buyer has to exercise The number of days until expiration The risk free rate of interest Any monthly or quarterly dividends to be paid during the life of the option The implied volatility of the underlying stock
20 Intrinsic vs Time Value
21 Impact of Time More time until expiration the higher the premium Time value is a function of unpredictability Uncertainty decreases as expiration approaches
22 Option Chain Stock XYZ trading at $15.00 Option Last Bid Ask Nov2017 $15.00 Call $0.50 $0.45 $0.55 Jan2018 $15.00 Call $0.95 $0.90 $1.10 Jun2018 $15.00 Call $1.50 $1.40 $
23 Components of an Option Time Value Option premium Intrinsic value = Time value Time value erodes to zero by expiration
24 Components of an Option Intrinsic Value Call = current stock price - strike price Put = strike price - current stock price
25 Call Option Time Value Example Stock is at $20.00 $15.00 call option has an intrinsic value of $5.00 Call is currently trading at $6.50 $6.50 $1.50 Decaying Time Value $5.00 Equity Intrinsic Value
26 Put Option Time Value Example Stock is at $20.00 $25.00 put option has an intrinsic value of $5.00 Put is currently trading at $5.95 $5.95 $0.95 Decaying Time Value $5.00 Equity Intrinsic Value
27 Strike Price and Stock Price As a stock is moving higher or lower, the option can move above and below the strike price Option moneyness: 1. In-the-money (ITM) 2. At-the-money (ATM) 3. Out-of-the-money (OTM)
28 Option Chain Stock XYZ trading at $15.00 Option Last Bid Ask Nov $12.00 call $3.10 $3.10 $3.20 ITM Nov $13.00 call $2.20 $2.20 $2.30 Nov $14.00 call $1.30 $1.30 $1.40 ATM OTM Nov $15.00 call $0.50 $0.50 $0.60 Nov $16.00 call $0.25 $0.25 $0.35 Nov $17.00 call $0.10 $0.10 $0.20
29 Time Value vs. Intrinsic Value Time value erodes to zero as an option approaches expiration Intrinsic value reflects the real value and does not erode with time Intrinsic value is directly related to the value of the underlying security
30 Volatility
31 Historical Volatility Historical Volatility is the average deviation from the average price in a given time period The annualized standard deviation of the past price movements
32 Implied Volatility Implied Volatility (IV) is determined by the market place Is demonstrating the anticipated future volatility for all known information Forecast by the market place as to the magnitude (not the direction) of the future price move IV represents one annualized standard deviation
33 How to interpret Implied Volatility $50.00 stock Implied Volatility 20.00% Implies $10.00 standard deviation (annual) ($50.00 x 20.00%) Probability 1 Year Price Range 16% < $ % $ $ % > $60.00
34 Implied Volatility of Shorter Time Implied Volatility Calculator Sq. Rt. Days Stock Price $ Implied Volatility 20.00% 1 Year Range 20.00% Implied Range $ Year 1 SD High Range $ Year 1 SD Low Range $ Month Implied 5.82% 29.09% Implied Range $ Month 1 SD High Range $ Month 1 SD Low Range $ Week Implied 2.77% 13.87% Implied Range $ Week 1 SD High Range $ Week 1 SD Low Range $ Day Implied 1.24% 6.20% Implied Range $ Day 1 SD High Range $ Day 1 SD Low Range $ You can determine the shorter timeframe implied range: (Stock price) x (Annualized Implied Volatility) x (Square Root of [days to expiration / 365])
35 Implied Volatility Variable Implied Volatility is the probability adjustment within the option pricing model Creates a probabilities distribution curve
36 Understanding the Anticipated Range ABC stock is trading at $50.00 The implied volatility is 10% 10% of $50.00 is $5.00
37 Implied Volatility and Probability Range ABC stock at $50.00 with 10% Implied Volatility $ % $55 $35 $40 $45 $50 $55 $60 $65
38 Call Options Chain Plot Time Value
39 Options as a Stock Replacement Strategy - Bullish
40 Stock vs. Option Comparing the idea of buying a call option instead of buying the stock Royal Bank (TSX:RY) is trading at $92.00 (08/21/17) Our two investors are both bullish on Royal Bank and believe there is considerable upside
41 Why Buy a Call Option? Investor is bullish on the stock Using option as a stock replacement strategy Risk defined to the premium paid Does not receive dividends (though discounted into option price)
42 Buying the Stock Investor #1 is bullish on RY Buys 1000 shares at $92.00 Pays $92, Is entitled to the dividends the company pays
43 Buying Call Options Investor #2 is also bullish RY Jan 2018, $90.00 call is $4.00 Buys 10 contracts (each contact controls 100 shares) Pays $4,000.00
44 Scenario 1: Strong Bullish Advance Royal Bank rises to $ over the next 5 months Both investors participate The call option builds deep intrinsic value giving a stock ownership experience
45 Share vs. Stock Royal Bank shares hit $ target before expiration Investor #1 Investor #2 +$18.00 $18, $16.00 ($ $4.00) $16, shares at $92.00 ($92,000.00) 10 Jan18 $90 calls $4.00 ($4,000.00)
46 Scenario 2: Modest Bullish Rise Royal Bank rises to $96.00 over the next 5 months Both investors participate The time value erosion dilutes the returns but is often still considered a good, risk adjusted return
47 Share vs. Stock Royal Bank shares hit $96.00 target before expiration Investor #1 Investor #2 +$4.00 $4, $2.00 ($ $4.00) $2, shares at $92.00 ($92,000.00) 10 Jan18 $90 calls $4.00 ($4,000.00)
48 Scenario 3: Stock Remains Unchanged Royal Bank remains at $92.00 over the next 5 months Investor keeps the shares as the price remain unchanged The time value on the option erodes into a loss
49 Share vs. Stock Royal Bank shares remain at $92.00 before expiration Investor #1 Investor # shares at $92.00 ($92,000.00) +$0.00 $ Jan18 $92 calls $4.00 ($4,000.00) -$2.00 ($ $4.00) -$2,000.00
50 Scenario 4: Stock Materially Declines Royal Bank declines to $82.00 over the next 5 months Investor remains invested at a loss The option will expire with no value
51 Share vs. Stock Royal Bank shares hit $82.00 target before expiration Investor #1 Investor # shares at $92.00 ($92,000.00) 10 Jan18 $90 calls $4.00 ($4,000.00) -$ $10, undefined risk -$4.00 -$4, max risk
52 Leverage and Risk Investor #2 was able to control $92,000 of stock with only $4,000 of call options Many investors drawn to the leverage to seek extraordinary returns Options add the variable of needing to be right on the amount of time needed on the option The premium is a decaying cost Options can be purchased in registered accounts
53 Thank you
54 2017 Bourse de Montréal Inc. All rights reserved. BAX, OBX, ONX, OIS-MX, CGZ, CGF, CGB, LGB, OGB, SXO, SXF, SXM, SCF, SXA, SXB, SXH, SXY, and USX are registered trademarks of the Bourse. OBW, OBY, OBZ, SXK, SXU, SXJ, SXV, Montréal Exchange and the Montréal Exchange logo are trademarks of the Bourse. TMX and TMX Group are registered trademarks of TSX Inc. The S&P/TSX 60 Index, S&P/TSX Composite Index, S&P/TSX Global Gold Index, S&P/TSX Capped Financials Index, S&P/TSX Capped Information Technology Index, S&P/TSX Capped Energy Index, S&P/TSX Composite Index Banks (Industry Group), S&P/TSX Capped Utilities Index (collectively, the Indices ) are products of S&P Dow Jones Indices LLC ( SPDJI ) and TSX Inc. ( TSX ). Standard & Poor s and S&P are registered trademarks of Standard & Poor s Financial Services LLC ( S&P ); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC ( Dow Jones ); and TSX is a registered trademark of TSX. SPDJI, Dow Jones, S&P and TSX do not sponsor, endorse, sell or promote any products based on the Indices and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions or interruptions of the Indices or any data related thereto.
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