1. 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. 2 INTRODUCTION TO DERIVATIVE SECURITIES CALL & PUT OPTIONS

3. 3 CALL OPTIONS  A call conveys the ______________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 _____

4. 4 OPTIONS TERMINOLOGY  strike or exercise price:  price or premium:  expiry date: –American style –European style

5. 5 CALL OPTIONS: CALL BUYER l example:

6. 6 call buyer example cont’d…

7. 7 CALL OPTIONS: CALL WRITER The writer is selling the call, thus receives the premium example:

8. 8 call writer example cont’d…

9. 9 PUT OPTIONS l A put conveys the _____________ 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_____

10. 10 PUT OPTIONS PUT BUYER example:

11. 11 put buyer example cont’d...

12. 12 PUT OPTIONS: PUT WRITER The writer is selling the put, thus receives the premium example:

13. 13 put writer example cont’d...

14. 14 OPTIONS l “zero sum game” the profit made on the option is equal to the loss by the other party. example:

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

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

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

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

19. 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 expiry will be worth more

20. 20 TIME VALUE OF OPTIONS

21. 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. 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. 23 BULLISH STRATEGIES l

24. 24 BEARISH STRATEGIES

25. 25 COVERED CALL WRITING Selling calls on shares that you already own.

26. 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. 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. 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. 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. 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)