Introduction to Derivatives

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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
Presentation Summary
 Introduction
 Options
 Covered Call Writing
 Question Period
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
Exchange Market
CLIENT A
RISK
CLIENT B
Broker
Exchange Market
Broker
Margin
Clearing
Corporation
Margin
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
Holder/Buyer
(pays a premium)
Writer/Seller
(receives a premium)
Call
Put
Right to buy
(no obligation)
Right to sell
(no obligation)
Obligation to sell
Obligation 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
Calls
Puts
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
Option type
Option premium
Expiry month
Call CM July 105 @ $2.00
Underlying asset
Strike price
Call Options
April 07: G @ $29.63
Right to buy
Buy 1 Call G July 30 @ $2.20
Sell 1 Call G July 30 @ $2.20
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…
Call
In-the-money
Strike
$58
Market
PCA = $60
Out-of-the-money
Strike
$62
Intrinsic Value
At-the-money (strike $60)
Out-of-the-money
Put
Strike
$58
Market
PCA = $60
In-the-money
Intrinsic Value
Strike
$62
Factors Influencing the Option
Price
 Premium=Intrinsic Value + Time Value


Intrinsic Value: is the amount by which the option is inthe-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.
www.m-x.ca
 Options Guide and Strategies
 Options Newsletter
 Options Calculators
 Covered Call Calculator
 Quotes and Implied Volatility
 Options summary
Options Montage
Last Trade Price
Symbol: TD Calls & Puts
TD-T
Y/M/S
OCT072
OCT074
OCT076
OCT078
L
Opn
PCls
%Chg
Last
3.80
2.85
1.50
1.15
73.51
73.85
74.25
-1.00%
Change
-0.35
-
Chg
Hi
EPS
CE
Bid
3.45
2.25
1.35
0.75
-0.74
74.00
4.63
1.37
Ask
3.60
2.45
1.55
0.95
B
Low
PE
FPE
73.50
73.26
15.88
13.48
A
AH
Div
73.51
74.89
2.12
AL
Yld
55.62
2.88%
Covered Call Writing Worksheet
In the Money
Buy
1000 shares
Total
Sell
10 OCT
TD
@
$
73.51
=
A
$ 72.00
calls @
$3.80
B
$ 74.00
calls @
$2.85
B
$ 78.00
calls @
$1.15
B
Total Investments (A-B)
Out of the
Money
At the Money
$ 73,510.00
$ 73,510.00
$
3,800.00
$
2,850.00
$
=
$ 69,710.00
$ 72,000.00
$ 70,660.00
1,150.00
$ 72,360.00
If Exercised
Sell
1000 shares
TD
@
$72
D
@
$74
D
@
$78
D
Profit (D-C)
In
Dividends $ 1.06
138
days
$ 2.12 # Dividends Received
X
$ 78,000.00
E
Annualized
Annual Dividend
$ 74,000.00
1000
Total Annual Return
=
2
$
1,060.00
$
2,290.00
$ 3,340.00
$
5,640.00
=
3.29%
4.73%
7.79%
=
8.93%
12.99%
21.96%
1.44%
1.44%
1.44%
10.37%
14.43%
23.40%
=
=
$
1.06
Options Montage
Symbol: TRP Calls & Puts
TRP-T
Y/M/S
OCT036
OCT038
OCT040
OCT042
L
Opn
PCls
%Chg
Last
4.40
2.30
1.10
0.35
38.78
39.17
39.35
-1.45%
Change
-
Last Trade Price
Chg
Hi
EPS
CE
Bid
3.15
1.70
0.75
0.25
-0.57
39.25
2.17
0.47
Ask
3.25
1.85
0.85
0.30
B
Low
PE
FPE
68.76
38.54
17.87
18.91
A
AH
Div
38.78
41.35
1.36
AL
Yld
31.35
3.51%
Covered Call Writing Worksheet
In the Money
Buy
1000 shares
Total
Sell
10 OCT
TRP
@
$
38.78
=
A
$ 36.00
calls @
$4.40
$ 38.00
calls @
$2.30
B
$ 40.00
calls @
$1.10
B
Total Investments
Out of the
Money
At the Money
$ 38,780.00
$ 38,780.00
$
4,400.00
$
2,300.00
$
=
$ 34,380.00
$ 36,000.00
$ 36,480.00
1,100.00
$ 37,680.00
If Exercised
Sell
1000 shares
TRP
@
$36
D
@
$38
D
@
$40
D
Profit (D-C)
In
Dividends $ 0.68
138
days
$ 1.36 # Dividends Received
X
$ 40,000.00
E
Annualized
Annual Dividend
$ 38,000.00
1000
Total Annual Return
=
$
$
1,620.00
$
1,520.00
$
2,320.00
=
4.71%
4.17%
6.16%
=
12.95%
11.40%
17.12%
1.75%
1.75%
1.75%
14.70%
13.16%
18.87%
2
=
680.00
=
$
0.68
Options Montage
Last Trade Price
Symbol: CCO Calls & Puts
CCO-T
Y/M/S
OCT054
OCT056
OCT058
OCT060
L
Opn
PCls
%Chg
Last
6.60
5.45
4.15
3.3
57.58
55.66
56.3
2.27%
Change
1.55
0.85
-
Chg
Hi
EPS
CE
Bid
6.5
5.35
4.35
3.5
1.28
57.58
0.92
0.39
Ask
6.7
5.5
4.45
3.65
B
Low
PE
FPE
57.55
55.61
62.59
30.15
A
AH
Div
57.58
57.49
0.20
AL
Yld
35.35
0.35%
Covered Call Writing Worksheet
In the Money
Buy
1000 shares
Total
Sell
10 OCT
CCO
@
$
57.38
=
A
$ 56.00
calls @
$5.45
B
$ 58.00
calls @
$4.15
B
$ 60.00
calls @
$3.30
B
Total Investments (A-B)
Out of the
Money
At the Money
$ 57,380.00
$ 57,380.00
$
5,450.00
$
4,150.00
$
C
$ 51,930.00
$ 56,000.00
$ 53,230.00
3,300.00
$ 54,080.00
If Exercised
Sell
1000 shares
CCO
@
$56
D
@
$58
D
@
$60
D
Profit (D-C)
In
Dividends $ 0.10
138
days
$ 0.20 # Dividends Received
X
$ 60,000.00
E
Annualized
Annual Dividend
$ 58,000.00
1000
Total Annual Return
=
$
$
4,070.00
$
4,770.00
$
5,920.00
=
7.84%
8.96%
10.95%
=
22.09%
25.48%
31.62%
0.17%
0.17%
0.17%
22.26%
25.65%
31.79%
2
=
100.00
=
$
0.10
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