Derivatives Chapter 10 Volume 1 PDF

Derivatives 10 CHAPTER OVERVIEW In this chapter, you will learn all about derivatives—what they are, what their underlying assets consist of, and who uses them. You will also learn about the different ca...

Derivatives 10 CHAPTER OVERVIEW In this chapter, you will learn all about derivatives—what they are, what their underlying assets consist of, and who uses them. You will also learn about the different categories of derivatives, including options, forwards, and futures contracts. Finally, you will learn about the rights and warrants by which investors benefit from the underlying stock on which derivatives are based. LEARNING OBJECTIVES CONTENT AREAS 1 | Explain the differences between over-the- The Role of Derivatives counter and exchange-traded derivatives. 2 | Identify the types of underlying assets on Types of Underlying Assets which derivatives are based. 3 | Describe how the various market participants The Users of Derivatives use derivatives. 4 | Describe call and put option positions and the Options option strategies used by market participants. 5 | Distinguish between forwards and futures Forwards and Futures contracts and the strategies used by market participants. 6 | Distinguish between the features, benefits, Rights and Warrants and intrinsic value of rights and warrants. © CANADIAN SECURITIES INSTITUTE 10 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. American-style option hedging arbitrage in-the-money assigned intrinsic value at-the-money Long-Term Equity Anticipation Security call option marking to market Canadian Derivatives Clearing Corporation naked call cash-secured put write offering price commodities offsetting transaction commodity futures opening transaction covered call open interest cum rights option default risk option premium derivative out-of-the-money European-style option performance bond ex-rights put option exercise record date exercise price rights expiration date strike price financial asset subscription price financial futures sweetener forward time value forward agreement trading unit futures contract underlying asset good faith deposit warrants © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 3 INTRODUCTION In the past two decades, we have witnessed phenomenal growth in the creation and use of various derivative instruments. The source of this growth, to a large extent, has been due to the increase in the volatility of interest rates, exchange rates, and commodity prices. Financial deregulation, advances in information technology, and breakthroughs in financial engineering have also contributed to the growth. Depending on the position taken, derivatives can act as a substitute for the underlying asset, act as an offset to an existing position in the underlying asset, make it possible to enhance overall portfolio returns and to hedge or reduce exposure to different sources of risk. Derivatives are not assets like stocks and bonds; their value is derived from an underlying asset, such as a financial security or a commodity. Institutional investors and portfolio managers rely on derivatives and consider them sensible investments that can enhance returns and protect against the inherent risk in the market. For many investors, however, particularly smaller retail investors, derivatives are considered risky, complex investments. This viewpoint can be attributed to the fact that derivatives are specialized financial instruments created by market participants. Certainly, the frenzied trading that the financial press often reports about oil and gas futures, foreign currencies, pork bellies, and gold does sound exciting. We have all heard stories about a commodity trader somewhere in the world betting the right way on a position in natural gas, for example, and making a fortune. Clearly, derivatives can be used in a variety of ways: as wildly speculative or rigorously conservative investment vehicles, and in strategies that fall between the two extremes. This chapter focuses on the building blocks of derivatives. The key to understanding these products is to become comfortable with the terminology and to understand the contractual obligations being assumed and the types of strategy being pursued. THE ROLE OF DERIVATIVES 1 | Explain the differences between over-the-counter and exchange-traded derivatives. A derivative is a financial contract between two parties whose value is derived from, or dependent on, the value of an underlying asset. The underlying asset can be a financial asset (such as a stock or bond), a currency, a futures contract, an index, or even an interest rate. It can also be a real asset or commodity, such as crude oil, gold, or wheat. Because of the link between the value of a derivative and its underlying asset, derivatives can act as a substitute for, or as an offset to, a position held in the underlying asset. As such, derivatives are often used to manage the risk of an existing or anticipated position in the underlying asset. They are also used to speculate on the value of the underlying asset. Some derivatives have more complex structures than others, but they all fall into one of two basic types: options and forwards. Both types are contracts between two parties: a buyer and a seller. The buyer in an option contract has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obliged to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is a call option; one that gives the right to sell the underlying asset is a put option. © CANADIAN SECURITIES INSTITUTE 10 4 CANADIAN SECURITIES COURSE      VOLUME 1 With forward contracts both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obliged to participate in the future trade. Despite this fundamental difference between options and forwards, the two types of derivatives have shared features. FEATURES COMMON TO ALL DERIVATIVES All derivatives have the following features in common: They are contractual agreements between two parties (often called counterparties): a buyer and a seller. The agreements spell out the rights (if any) and the obligations of each party. They have a price upon which the buyer and seller must agree; buyers try to buy them for as little as possible, whereas sellers try to sell them for as much as possible. They have an expiration date. Both parties must fulfill their obligations or exercise their rights under the contract on or before the expiration date. After that date, the contract is automatically terminated. When a derivative contract is drawn up, it includes a price, or formula for determining the price, of an asset to be bought and sold in the future, either on or before the expiration date. With forwards, no up-front payment is required. Sometimes one or both parties make a performance bond or good faith deposit, which gives the party on the other side of the transaction a higher level of assurance that the terms of the forward will be honoured. With options, the buyer makes a payment to the seller when the contract is drawn up. This payment, known as a premium, gives the buyer the right to buy or sell the underlying asset at a preset price on or before the expiration date. Another feature of derivatives is that, unlike financial assets such as stocks and bonds, they are considered a zero- sum game. Aside from commission fees and other transaction costs, the gain from an option or forward contract by one counterparty is exactly offset by the loss to the other counterparty. In other words, every dollar gained by one party represents a dollar lost by the counterparty. DERIVATIVE MARKETS As we discussed in previous chapters, most bonds trade in the over-the-counter (OTC) market, but stocks and derivatives trade both on the OTC market and in organized exchanges. The primary difference between exchange- traded and OTC stocks and bonds is trading mechanics, but the difference between exchange-traded and OTC derivatives is much more pronounced. OVER-THE-COUNTER DERIVATIVES The OTC derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of dealers who negotiate transactions directly with one another. Negotiations take place primarily over the telephone or through computer terminals. The OTC market is dominated by financial institutions, such as banks and investment dealers, that trade with their large corporate clients and other financial institutions. This market has no trading floor and no regular trading hours. Some traders and support staff work at their trading desks at night and during weekends and holidays. One of the attractive features of OTC derivatives to the corporations and institutional investors that use them is that contracts can be custom designed to meet specific needs. As a result, OTC derivatives tend to be somewhat more complex than exchange-traded derivatives, because special features can be added to the basic properties of options and forwards. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 5 EXCHANGE-TRADED DERIVATIVES A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. The exchange provides the facilities for trading: either a trading floor or an electronic trading system—in some cases, both. The exchange also stipulates the rules and regulations governing trading in order to maintain fairness, order, and transparency in the marketplace. Derivative exchanges evolved in response to OTC issues, including concerns around standardization, liquidity, and default risk. Canada has one derivative exchange: The Montréal Exchange lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, money market rates, and indexes. EXCHANGE-TRADED VERSUS OVER-THE-COUNTER DERIVATIVES You may wonder how organized exchanges and OTC markets successfully co-exist when the interests that underlie derivative instruments in both markets are basically the same. Over time, it seems logical that one of the two markets would prevail. The co-existence has proven successful and long-lasting because the two markets differ in significant ways. Each market offers advantages depending on the particular needs of the users. STANDARDIZATION AND FLEXIBILITY One of the most important differences between exchange-traded and OTC derivatives is flexibility. In the OTC market, the terms and conditions of a contract can be tailored for specific users, who may choose the most appropriate terms to meet their particular needs. In contrast, for exchange-traded derivatives, the exchange specifies the contracts that are available to be traded; each contract has standardized terms and other specifications, which may or may not meet the needs of certain derivative users. PRIVACY Another important difference is the private nature of OTC derivatives. In an OTC derivative transaction, neither the general public nor others (including competitors) know about the transaction. On exchanges, all transactions are recorded and known to the general public. However, the exchanges do not announce, nor do they necessarily know, the identities of the ultimate counterparties to every transaction. LIQUIDITY AND OFFSETTING Because they are private and custom designed, OTC derivatives cannot be easily terminated or transferred to other parties in a secondary market. In many cases, these contracts can only be terminated through negotiations between the two parties. By contrast, the standardized and public nature of exchange-traded derivatives means that they can be terminated easily by taking an offsetting position in the contract. DID YOU KNOW? To offset a position means to close the position by taking the exact opposite position in the contract. For example, if you buy a call option on XYZ, you would offset the position by selling a call option on XYZ with exactly the same features. © CANADIAN SECURITIES INSTITUTE 10 6 CANADIAN SECURITIES COURSE      VOLUME 1 DEFAULT RISK Another downside to the private nature of OTC derivatives is that default risk (also called credit risk) is a major concern. Default risk is the risk that one of the parties to a derivative contract will not be able to meet its obligations to the other party. Given this risk, many derivative dealers in the OTC market do not deal with customers that are unable to establish certain levels of creditworthiness. In addition, the size of most contracts in the OTC market may be greater than most investors can manage. For this reason, the OTC market is restricted to large institutional and corporate customers. Individual investors are generally limited to dealing in exchange-traded derivatives. Default risk is not a significant concern with exchange-traded derivatives. Clearinghouses, which are set up by exchanges to ensure that markets operate efficiently, guarantee the financial obligations of every party and contract. The clearing corporation becomes, in effect, the buyer for every seller and the seller for every buyer. The Canadian Derivatives Clearing Corporation (CDCC) is responsible for clearing Montréal Exchange futures and option trades. REGULATION Because exchange-traded contracts are public, whereas OTC contracts are private, derivative transactions on exchanges are extensively regulated by the exchanges themselves and by government agencies, whereas OTC derivative transactions are generally unregulated. On one hand, the regulated environment of exchange-traded derivatives brings about fairness, transparency, and an efficient secondary market. On the other hand, the largely unregulated environment in the OTC markets permits unrestricted and explosive growth in financial innovation and engineering. Generally, no government approval is needed to offer new types of OTC derivatives; the innovative contracts are simply created by parties that see mutual gain in doing business with each other. The transactions are not bound by costly constraints or bureaucratic red tape. SUMMARY COMPARISON OF EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVES Table 10.1 summarizes the differences between exchange-traded and OTC derivatives. Table 10.1 | Exchange-Traded and Over-the-Counter Derivatives Exchange-Traded Over-the-Counter Traded on an exchange Traded largely through computer and/or phone lines Standardized contract Transparent (public) Terms of the contract agreed to between buyer and seller Easy termination prior to contract expiry Private Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading parties Early termination more difficult Performance bond required, depending on the type No third-party guarantor of derivative Performance bond not required in most cases Gains and losses accrue on a day-to-day basis Gains and losses generally settled at the end of (marking to market) the contract, rather than marking to market Heavily regulated Much less regulated Delivery rarely takes place Delivery or final cash settlement usually occurring Commission visible Fee usually built into price Used by retail investors, corporations and Used by corporations and financial institutions institutional investors © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 7 TYPES OF UNDERLYING ASSETS 2 | Identify the types of underlying assets on which derivatives are based. The two general categories of underlying assets for derivative contracts are commodities and financial assets. The assets that underlie derivative contracts traded on organized exchanges in the United States and Canada are detailed below. In the OTC markets, the choice of underlying assets is limited only by the imagination and needs of market participants. COMMODITIES Commodity futures and options are commonly used by producers, merchandisers, and processors of commodities to protect themselves against fluctuating commodity prices. Speculators also use commodities to profit from the fluctuating prices. Depending on the commodity, prices are affected by supply and demand, agricultural production, weather, government policies, international trade, demographic trends, and economic and political conditions. Commodities that underlie derivative contracts include the following types: Grains and oilseeds (e.g., wheat, corn, soybeans, and canola) Livestock and meat (e.g., pork bellies, hogs, live cattle, and feeder cattle) Forest, fibre, and food (e.g., lumber, cotton, orange juice, sugar, cocoa, and coffee) Precious and industrial metals (e.g., gold, silver, platinum, copper, and aluminum) Energy products (e.g., crude oil, heating oil, gasoline, natural gas, and propane) Most of these commodities—such as soybeans, crude oil, and copper—are purchased to be consumed. Others—such as gold and silver—are used primarily for investment purposes. Other than the energy category, most commodity derivatives are exchange-traded contracts. FINANCIAL ASSETS In recent decades, we have witnessed an explosive growth in derivatives, especially in financial derivatives. This growth has been fuelled by the following forces: Increasingly volatile interest rates, exchange rates, and equity prices Financial deregulation and intensified competition among financial institutions Globalization of trade and the tremendous advances in information technology Extraordinary theoretical breakthroughs in financial engineering The most commonly used financial derivatives are summarized below. EQUITIES Equity is the underlying asset of a large category of financial derivatives. The predominant equity derivatives are equity options (options on individual stocks). These derivatives are traded mainly on organized exchanges such as the Montréal Exchange, the Chicago Board Options Exchange, the International Securities Exchange, the Boston Options Exchange, the NYSE AMEX Options, and the NYSE Arca Options markets. © CANADIAN SECURITIES INSTITUTE 10 8 CANADIAN SECURITIES COURSE      VOLUME 1 INTEREST RATES Exchange-traded interest rate derivatives are generally based on interest rate-sensitive securities rather than on interest rates directly. In Canada, underlying assets include Government of Canada bonds. All interest rate futures trading in Canada takes place at the Montréal Exchange. In the OTC market, interest rate derivatives are generally based on well-defined and well-known floating interest rates. Examples of such underlying rates include the yields on Treasury bills and Treasury bonds and the London Interbank Offer Rate, which is the interest earned on Eurodollar deposits in London. Because these OTC derivatives are based on an interest rate, rather than an actual security, the contracts are settled in cash. CURRENCIES The most commonly used underlying assets in currency derivatives are the U.S. dollar, British pound, Japanese yen, Swiss franc, and European euro. The types of contracts traded include currency futures and options on organized exchanges, and currency forwards and currency swaps in the OTC market. DID YOU KNOW? A swap is a private, contractual agreement between two parties used to exchange (swap) periodic payments in the future based on an agreed to formula. Swaps are essentially equivalent to a series of forward contracts packaged together. The concept of swaps is explained more fully in the Derivatives Fundamentals Course (DFC). THE USERS OF DERIVATIVES 3 | Describe how the various market participants use derivatives. Derivative users can be divided into four groups: Individual investors Institutional investors Businesses and corporations Derivative dealers The first three groups are the end users of derivatives. They use derivatives either to speculate on the price or value of an underlying asset, or to protect the value of an anticipated or existing position in the underlying asset. The latter application, a form of risk management, is known as hedging. The last group, derivative dealers, are the intermediaries in the markets who buy and sell to meet the demands of the end users. Derivative dealers do not normally take large positions in derivative contracts. Rather, they try to balance their risks and earn profits from the volume of deals that they arrange with their customers. INDIVIDUAL INVESTORS For the most part, individual investors are able to trade exchange-traded derivatives only. They are active investors in exchange-traded options markets and, to a lesser extent, futures markets. Individual investors should use derivatives only if they fully understand all of the risks and potential rewards. They should also consider speculative strategies only if they have a high degree of risk tolerance and risk capacity, © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 9 because of the potential to suffer large losses in derivative trading. Risk management strategies, on the other hand, can be beneficial to all investors, from the most conservative to the most aggressive. Individual investors in Canada can trade exchange-traded derivatives directly by opening a special type of account with a full-service or self-directed brokerage firm registered to offer such accounts. To deal with investors in exchange-traded derivatives, investment advisors at full-service firms and investment representatives at self- directed firms must be properly licensed. INSTITUTIONAL INVESTORS Institutional investors that use derivatives include mutual fund managers, hedge fund managers, pension fund managers, and insurance companies, among others. Like individual investors, institutional investors use derivatives for both speculation and risk management. In contrast to individuals, most institutional investors are able to trade OTC derivatives in addition to exchange-traded derivatives. From a risk management perspective, hedging is the attempt to eliminate or reduce the risk of either holding an asset for future sale or anticipating a future purchase of an asset. Hedging with derivatives involves taking a position in a derivative with a payoff that is opposite to that of the asset to be hedged. For example, if a hedger owns an asset, and is concerned that the price of the asset could fall in the future, a short derivative position in the asset would be appropriate. A decline in the price of the asset will result in a loss on the asset being held, but would be offset by a profit on the derivative contract. In general, speculation is inconsistent with the objective of risk management because it increases risk, instead of reducing it. Specifically, speculation involves a future focus, the formulation of expectations, and the willingness to take positions in order to profit. In other words, speculators bet on the direction of the market and take positions accordingly to profit from a certain predicted movement of the market. Other common investment strategies using derivatives include market entry and exit, arbitrage, and yield enhancement, as explained below: Market entry Quickly exiting and entering a market in the conventional way, by buying and selling the actual and exit stocks, can be inefficient and more costly than expected. The costs associated with trading include commission fees, bid-ask spreads, and other administrative fees. These costs can be high in some cases, and may affect the decision to enter or exit a market. In addition, buying or selling a large quantity of certain securities can produce adverse price pressures on the market. A large sell order may push the price down, whereas a large buy order may bid up the price. These adverse price effects, which are a hidden cost to the transaction, can be especially severe in thinly traded equity or bond markets (that is, markets for illiquid securities). It is usually more efficient and cost-effective to carry out temporary change to the portfolio using derivatives, rather than trading in the underlying assets directly. For example, the manager of a global equity fund may want to temporarily change the composition of her portfolio by moving out of British stocks and into French and German stocks for only a few months. To do so, she could sell British index contracts and buy French and German index contracts. When market conditions subsequently change, a reverse of those contracts would bring the portfolio back to its original composition. © CANADIAN SECURITIES INSTITUTE 10 10 CANADIAN SECURITIES COURSE      VOLUME 1 Arbitrage An arbitrage opportunity refers to a scenario where the same asset or commodity is traded at different prices in two separate markets. By purchasing low in one market and selling high in the other market simultaneously, an investor locks in a fixed amount of profit at no risk. For example, suppose an arbitrageur spots an exploitable market mispricing and attempts to profit by buying in the cheap market and selling in the rich market. If the two transactions are executed simultaneously, or nearly simultaneously, then there is no investment or risk involved in the arbitrage. Yield Yield enhancement is a method of boosting returns on an underlying investment portfolio by enhancement taking a speculative position based on expectations of future market movements. The most popular way to enhance an investment’s yield is by selling options against the position. CORPORATIONS AND BUSINESSES Corporations of all types and sizes use derivatives. For the most part, however, users tend to be larger companies that make use of borrowed money, have multinational operations that generate or require foreign currency, or produce or consume significant amounts of one or more commodities. Corporations and businesses use derivatives primarily for hedging purposes. In particular, they tend to focus on derivatives that help them hedge interest rate, currency, and commodity price risk. Corporations that hedge with derivatives do so because, rather than focusing on these risks, they prefer to direct their efforts toward running their primary business. On the other hand, a company that anticipates buying an asset in the future may be concerned that the price could rise before the purchase is made. Hedging risk by buying a forward contract or a call option is appropriate in this case. A price increase will result in the hedger paying a higher price, but this cost will be offset by a profit on the forward or call option. A hedger starts with a pre-existing risk that is generated from a normal course of business. For example, a farmer growing wheat has a pre-existing risk that the price of wheat will decline by the time it is harvested and ready to be sold. In the same way, an oil refiner that holds storage tanks of crude oil waiting to be refined has a pre-existing risk that the price of the refined product may decline in the interim. To reduce or eliminate these price risks, the farmer and the refiner could take short derivative positions that will profit if the price of their assets declines. Any losses in the underlying assets will be offset by gains in the derivative instruments. That being said, any gains in these assets would be offset by derivative losses of roughly the same size, depending on the type of derivative chosen and the overall effectiveness of the hedge. Derivative strategies were once little used and poorly understood by corporations, but they have increasingly become an important corporate-level concern. It is now expected that a company’s board of directors will use derivatives in an appropriate fashion as a risk management tool. Although it may seem like a simple decision, determining whether or not to hedge and how to hedge can be a complex process. Hedging is not always the right choice, nor does it always result in the complete elimination of all risks. DERIVATIVE DEALERS Dealers in the exchange-traded market take the form of market makers that stand ready to buy or sell contracts at any time. Exchange-traded market makers include banks, investment dealers, and professional individuals. Derivative dealers play a crucial role in the OTC markets by taking the other side of the positions entered into by end users. In Canada, the primary OTC derivative dealers are the chartered banks and their investment dealer subsidiaries, as well as the Canadian subsidiaries of large foreign banks and investment dealers. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 11 OPTIONS 4 | Describe call and put option positions and the option strategies used by market participants. An option is a contract between two parties: a buyer (known as the long position or holder) and a seller (known as the short position or the writer). This contract gives certain rights or obligations to buy or sell a specified amount of an underlying asset, at a specified price, within a specified time. The buyer of the option has the right, but not the obligation, to exercise the terms of the contract, whereas the seller is obliged to fulfill his or her part of the contract if called upon to do so. An option that gives its holder the right to buy, and the seller the obligation to sell, the underlying asset is known as a call option. An option that gives its holder the right to sell, and its writer the obligation to buy, the underlying asset is referred to as a put option. Table 10.2 describes the four basic option positions and illustrates in each position whether the investor expects the price of the underlying asset to rise or fall. Table 10.2 | The Four Basic Option Positions Call Option Put Option Holder PAYS premium to the writer PAYS premium to the writer (Long Position) Has the RIGHT to BUY the Has the RIGHT to SELL underlying asset at the the underlying asset at the predetermined price predetermined price Expects the price of the underlying Expects the price of the underlying asset to RISE asset to FALL Writer RECEIVES premium from the buyer RECEIVES premium from the buyer (Short Position) Has the OBLIGATION to SELL Has the OBLIGATION to BUY the underlying asset at the the underlying asset at the predetermined price, if called upon predetermined price, if called upon to do so to do so Expects the price of the underlying Expects the price of the underlying asset to REMAIN THE SAME OR FALL asset to REMAIN THE SAME OR RISE When traders and investors discuss options, they usually describe the specific option they are talking about by quickly summarizing the option’s most salient features in one phrase. They generally use the following syntax: {Number of Option Contracts} + {Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type} EXAMPLE An investor wants to buy 10 exchange-traded call options on XYZ stock with an expiration date in December and a strike price of $50. The investor states, “I want to buy 10 XYZ December 50 calls.” Just as he would if he were buying a stock, the investor also indicates the price he is willing to pay. He can buy the options at market, in which case he agrees to accept the best price currently available, or he can enter a limit order by specifying the highest price he is willing to pay. © CANADIAN SECURITIES INSTITUTE 10 12 CANADIAN SECURITIES COURSE      VOLUME 1 OPTIONS TERMINOLOGY The following different terms include common phrases used when discussing options: Strike price The strike price (or exercise price) is the price at which the underlying asset can be purchased or sold in the future. The buyer and the seller agree on this future price when they enter into the option contract. Option premium To obtain the right to buy or sell the underlying asset, option buyers must pay the sellers a fee, known as the option price or option premium. Once the premium has been paid, the option buyer has no further obligation to the writer, unless the buyer decides to exercise the option. Therefore, the most that the buyer of an option can lose is the premium paid. On the other hand, writers of options must always stand ready to fulfill their obligation to buy or sell the underlying asset. Expiration date Exchange-traded options expire at specific and pre-established dates. For example, the expiration months for a series of options on ABC stock may be January, April, July, and October. This means that there are four different sets of options for ABC stock, each of which expires in a different month. Typically, the day that the option expires is the third Friday of the expiration month. Traditionally, options are listed with relatively short terms of nine months or less to expiration. Exchanges have also introduced weekly options for some indexes and equities. Weekly options are listed for trading at the open on Thursdays, with expiration dates on any of the five Fridays following the listing week. Weekly options provide investors with more targeted trading opportunities, such as taking advantage of earning releases, government reports, and central banks’ interest rates policy announcements. Trading unit An option’s trading unit describes the size or amount of the underlying asset represented by one option contract. For example, exchange-traded stock options in North America have a standard trading unit of 100 shares. Therefore, the holder of one call option has the right to buy 100 shares of the underlying stock, while the holder of one put option has the right to sell 100 shares. Options on other underlying assets have a variety of trading units. The premium of an option is always quoted on a per unit basis, which means that the premium quote for a stock option is the premium for each share of the underlying stock. To calculate the total premium for a contract, multiply the premium quote by the option’s trading unit. For example, if a stock option is quoted with a premium of $1, it will cost the buyer $100 for each contract. American-style American-style options can be exercised at any time, up to and including the expiration options date. All exchange-traded stock options in North America are American-style options. European-style European-style options can be exercised only on the expiration date. Most index options are options European-style options. Long-Term Equity A Long-Term Equity Anticipation Security is simply a long-term option contract offering the Anticipation same risks and rewards as a regular option. Securities © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 13 Opening An opening transaction occurs when an investor establishes a new position in an option transaction contract. An opening buy transaction results in a long position in the option, whereas an opening sell transaction results in a short position in the option. On or before an option’s expiration date, one of three things will happen to all long and short option positions: The position will be offset. Positions may be liquidated prior to expiration by way of an offsetting transaction, which, in effect, cancels the position. Offsetting a long position involves selling the same type and number of contracts; offsetting a short position involves buying the same type and number of contracts. Unless they are specifically designed to be transferable, OTC options can only be offset through negotiations between the long and short parties. Exchange-traded options, however, can be offset simply by entering an offsetting order on the exchange on which the option trades. The party holding the long position will exercise the option. When this happens, the party holding the short position is said to be assigned on the option. For the owners of call options, the act of exercising involves buying the underlying asset from the assigned call writer at a price equal to the strike price. For the owners of put options, the act of exercising involves selling the underlying asset to the assigned put writer at a price equal to the strike price. The party holding the long position will let the option expire worthless. Buyers of options have rights, not obligations. They do not have to exercise an option before it expires if it is not in their best interest to do so; they can allow it to expire instead. In such cases, the option buyer loses money with the premium paid, and the option writer makes money with the premium received. In-the-money Owners of options will exercise only if it is in their best financial interest, which can only occur when an option is in-the-money. A call option is in-the-money when the price of the underlying asset is higher than the strike price. If this is the case, the call option holder can exercise the right to buy the underlying asset at the strike price and then turn around and sell it at the higher market price. A put option is in-the-money when the price of the underlying asset is lower than the strike price. If this is the case, the put option holder can exercise the right to sell the underlying asset at the higher strike price, which would create a short position, and then cover the short position at the lower market price. © CANADIAN SECURITIES INSTITUTE 10 14 CANADIAN SECURITIES COURSE      VOLUME 1 Out-of-the- Owners of options will definitely not exercise if they are out-of-the-money or at-the- money and At- money. the-money A call option is out-of-the-money when the price of the underlying asset is lower than the strike price. A put option is out-of-the-money when the price of the underlying asset is higher than the strike price. Call and put options are at-the-money when the price of the underlying asset equals the strike price. In either case, it is not in the financial best interest of an option holder to exercise. If a call option is out-of-the-money, it does not make financial sense for the call option holder to buy the underlying asset at the strike price (by exercising the call) when it can be purchased at a lower price in the market. Similarly, if a put option is out-of-the-money, it does not make financial sense for the put option holder to sell the underlying asset at the strike price (by exercising the put) when it can be sold at a higher price in the market. Because there is generally no advantage to exercising an at-the-money option (for which the strike price equals the market price of the underlying asset), at-the-money options are normally left to expire worthless. Intrinsic value Intrinsic value is the value of certainty. The in-the-money portion of a call or put option is referred to as the option’s intrinsic value. Intrinsic value is calculated using the following formulas: Intrinsic Value of an In-the-Money Call Option = Price of Underlying − Strike Price Intrinsic Value of an In-the-Money Put Option = Strike Price − Price of Underlying For example, if XYZ stock is trading at $60, a call option on XYZ stock with a strike price of $55 has $5 of intrinsic value (calculated as $60 − $55 = $5). Similarly, a put option on XYZ with a strike price of $65 has $5 of intrinsic value (calculated as $65 − $60 = $5). If an option is not in-the-money, it has zero intrinsic value. For example, a call option on XYZ with a $65 strike price has no intrinsic value when XYZ is trading at $60, as does a put option with a strike price of $55. Intrinsic value is a relatively easy concept to understand: it is the amount that the owner of an in-the-money option would earn by immediately exercising the option and offsetting any resulting position in the underlying asset. Time value Time value is a more subtle concept than intrinsic value. Simply put, time value represents the value of uncertainty. Option buyers want options to be in the-money at expiration; option writers want the reverse. The greater the uncertainty about where the option will be at expiration—either in-the-money or out-of-the-money—the greater the option’s time value. Prior to the expiration date, most options trade for more than their intrinsic value. The option’s time value is the amount that an option is trading above its intrinsic value. It is calculated using the following formula: Option Price − Option’s Intrinsic Value = Time Value of an Option For example, if a call option on XYZ with a strike price of $55 is trading for $6 when XYZ stock is trading at $60, the option has $1 of time value, calculated as follows: $6 − ($60 − $55) = $1 © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 15 You can re-arrange the equation for the time value of an option to find that the price of any option is simply the sum of its intrinsic value and its time value: Option Price = Intrinsic Value + Time Value OPTION EXCHANGES In Canada, the Montréal Exchange lists options on individual stocks, stock indexes, financial futures, exchange traded funds (ETFs), and the U.S. dollar. Just like stocks, exchange-traded option prices and trading information are reported on the exchanges’ websites, by financial data providers, and in the business press the next day. Table 10.3 provides an illustration. Table 10.3 | Equity Option Quotation XYZ Inc. 17.75 Bid Ask Last Opt Vol Opt Int Mar. $17.50 3.80 4.05 3.95 50 1595 $17.50P 2.35 2.60 2.40 5 3301 Sept. $17.50 1.10 1.35 1.25 41 3403 $17.50P.95 1.05 1.00 30 1058 Dec. $20.00P 1.85 2.00 1.90 193 1047 Total 319 10,404 Explanation XYZ Inc. This is the underlying for the option. 17.75 This number represents the last sale price of the underlying. Mar. This is the options’ expiration month (March, September, December). $17.50 This number represents the strike or exercise price of each series. $17.50P The P indicates that the option is a put. 3.80 This number represents the latest bid price for each XYZ option, expressed as a per share price. 4.05 This number represents the latest asked price for each XYZ option, expressed as a per share price. 3.95 This number represents the last sale price (last premium traded) of an option contract, expressed as a per share price. For example, the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this series. Opt Vol This is the number of options traded (50 + 5 + 41 + 30 + 193 = 319). For example, 50 XYZ March 17.50 calls were traded in the trading session shown, representing 5,000 underlying XYZ (calculated as 50 × 100). Opt Int This is the open interest—that is, the total number of option contracts in the series that are currently outstanding and have not been closed out or exercised. For example, the figure 1595 refers to the open interest for the XYZ March 17.50 calls. The figure 10,404 refers to the open interest of all series of XYZ options, including the series that did trade as well as the series that did not trade. © CANADIAN SECURITIES INSTITUTE 10 16 CANADIAN SECURITIES COURSE      VOLUME 1 OPTION STRATEGIES FOR INDIVIDUAL AND INSTITUTIONAL INVESTORS The range and complexity of options trading strategies are practically limitless. However, we will examine eight option strategies commonly used by individual and institutional investors. Each strategy is either a speculative or risk management strategy, and each is based on exchange-traded options on the shares of the fictitious company XYZ Inc. Note: These strategies, and the majority of the results, are equally applicable to options on any underlying asset. DIVE DEEPER If you want to learn more about options, the Derivatives Fundamentals and Options Licensing Course (DFOL) offered by CSI explains the strategies commonly used in the market to speculate or to hedge portfolios. For all of the strategies presented below, assume that we are currently in the month of June and that XYZ Inc. stock is trading at $52.50 per share. The discussions that follow make use of one of the four options listed in Table 10.4. Table 10.4 | Four Options on XYZ Inc. Stock Trading at $52.50 Option Type Expiration Strike Price Premium Call September $50 $4.55 Call December $55 $2.00 Put September $50 $1.50 Put December $55 $4.85 Note: To keep things simple, commissions, margin requirements, and dividends are ignored in all of the examples in this chapter. BUYING CALL OPTIONS Investors buy call options with either of two investment strategies in mind: to speculate in the hope of earning a profit or to manage risk. The most popular reason for buying calls is to profit from an expected increase in the price of the underlying stock. The buyer profits by investing only a fraction of the amount required to buy the stock. This speculative strategy relies on the fact that call option prices tend to rise as the price of the stock rises. The challenge with this strategy is to select the appropriate expiration date and strike price to generate the maximum profit, given the expected increase in the price of the stock. There are two ways that investors can realize profit on call options when the underlying increases in price: they can exercise the option and buy the stock at the lower exercise price, or they can sell the option directly into the market at a profit. Calls are also bought to establish a maximum purchase price for the stock, or to limit the potential losses on a short position in the stock. In this sense, options act much like insurance by protecting the buyer when the stock price moves higher. These strategies are considered risk management strategies. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 17 The examples that follow illustrate the two types of call option strategies. EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: BUYING CALLS TO SPECULATE Assume that an investor buys five XYZ December 55 call options at the current price of $2. We break down this purchase to its individual parts as follows: five = The number of contracts (each contract worth 100 shares) XYZ = The underlying stock on which the call option is based December = The expiration month 55 = The strike price $2 = The premium or cost to purchase the call option In this example, the holder (i.e., the investor) pays a premium of $1,000 (calculated as $2 × 100 shares × 5 contracts) to obtain the right to buy 500 shares of XYZ Inc. at $55 per share on or before the December expiration. Because the options are out-of-the-money (i.e., the strike price is greater than the stock price of $52.50), the $2 premium consists entirely of time value. The options have no intrinsic value. If the holder is a speculator, the intent of his call purchase is to profit from the expectation of a higher XYZ stock price. He probably has no intention of actually owning 500 shares of XYZ. Rather, he will want to sell the five XYZ December 55 calls before they expire, preferably at a higher price than what he paid for them. His chance of success depends on many factors, most importantly the price of XYZ shares. If the price of XYZ shares rise, the price of the calls will likely rise, and the holder will be able to sell them at a profit. Of course, he faces the risk that the stock price will not rise or, worse, will fall. If the price does fall, the price of the calls will likely fall as well. In that case, he may be forced to sell them at a loss. For example, if by September the price of XYZ stock is $60, the XYZ December 55 calls will be trading for at least their intrinsic value, which in this case is $5. Because there are still three months remaining before the options expire, the premium will also include some time value. Assuming that the calls have $1.70 of time value, they will be trading at $6.70. Therefore, the holder could choose to sell the options at $6.70 and realize a profit of $4.70 per share, equal to the difference between the current premium ($6.70) minus the premium paid ($2), or $2,350 in total (calculated as $4.70 × 100 shares × 5 contracts). If, however, XYZ shares are trading at $45 per share in September, the XYZ December 55 calls might be worth only $0.25 (the time value of $0.25 is an assumption made as part of the example). At this time, and indeed, at all other times before expiration, the holder will have to decide whether to sell the options or hold them in the hope that the stock price (and the options’ price) recovers. If he decides to sell at this time, he will incur a loss equal to $1.75 per share (calculated as $2 − $0.25) or $875 in total (calculated as $1.75 × 100 shares × 5 contracts). © CANADIAN SECURITIES INSTITUTE 10 18 CANADIAN SECURITIES COURSE      VOLUME 1 The decision to sell prior to the expiration of a call option is not easy. On one hand, selling before expiration allows the holder to earn any time value that remains built into the option premium. On the other hand, the option holder gives up the chance of reaping any further increases in the option’s intrinsic value. The call holder’s outlook for the price of the stock obviously plays a crucial role in the decision. An attractive feature of a speculative call option strategy is the potential to achieve larger profits, on a percentage basis, through leverage. Conversely, of course, by buying call options instead of buying the stock directly, the investor is also at risk of greater losses. EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: BUYING CALLS TO SPECULATE (Continued) Assume that the price of XYZ Inc. stock rises to $60 in September. If the call holder sells the XYZ December 55 calls for a profit of $4.70, the rate of return on the investment, based on the initial cost of $2, is 235%, calculated as follows: $4.70 ´ 100 = 235% $2 If the stock price declines to $45, however, and the call buyer sells the options for a loss of $1.75, and the rate of return is −87.5%, calculated as follows: -$1.75 ´ 100 = -87.5% $2 To see how leverage increases both profits and losses on a percentage basis, compare these returns to the returns from simply buying the stock at $52.50. If the stock is sold at $60, for a profit of $7.50 per share, the return is 14.3%, calculated as follows: $7.50 ´ 100 = 14.3% $52.50 If the stock falls to $45, and the loss is $7.50 per share, the rate of return is −14.3%, calculated as follows: -$7.50 ´ 100 = -14.3% $52.50 From this example we can see that the call provided a greater rate of return when the stock price increased but a lower rate of return when the stock price fell. This potential loss is the risk faced by all investors who use leverage when they buy call options. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 19 The other reason that investors buy call options is to manage risk. EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: BUYING CALLS TO MANAGE RISK Assume that a fund manager intends to buy 50,000 shares of XYZ stock, but will not receive the funds until December. Buying 500 XYZ December 55 call options will protect the fund manager from any sharp increase in the price of XYZ above the $55 strike price by establishing a maximum price at which the shares can be purchased. For example, if XYZ shares increase to $60 just prior to the expiration date in December, the options will trade for their intrinsic value only, in this case $5 (calculated as $60 − $55). Because the call buyer now has the money to buy the shares, she can exercise the calls, at which point she will purchase 50,000 shares of XYZ at the strike price of $55. Because the options originally cost $2, the call buyer’s net purchase price is actually $57 per share. If, however, XYZ shares are trading at $45 just prior to the expiration date, she will let the options expire and will buy the shares at the going price of $45 each. Her effective cost is $47, which includes the $2 paid for the calls. Call options can also be used to manage risk by protecting a short sale. Let’s assume that the investor sells short 500 shares of XYZ stock at its current price of $52.50, but wants to limit the loss in case the stock price rises. By buying 5 XYZ December 55 call options, she protects her investment from any sharp increase in the price of XYZ above the $55 strike price because the call establishes a maximum price at which the shares can be purchased back. For example, if XYZ shares increase to $60 just prior to the expiration date in December, the options will be trading for their intrinsic value only, which in this case is $5 (calculated as $60 − $55). The investor exercises the calls and purchases 500 shares of XYZ at the strike price of $55. Because the options originally cost $2, her net purchase price is actually $57 per share. And because she sold the stock short at $52.50 and bought it back at $57, her loss is limited to $4.50 per share. If, however, XYZ shares are trading at $45 just prior to the expiration date, the investor will let the options expire and will buy the shares at the market price of $45 per share. Her effective purchase price is $47, which includes the $2 paid for the calls. In this case, her profit is $5.50 on the short sale (i.e., sell at $52.50, buy back at $47 to close the position). WRITING CALL OPTIONS Investors write call options primarily for the income they provide in the form of the premium. The income is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Call writing strategies are primarily speculative in nature, but they can be used to manage risk as well. Call option writers can be classified as either covered call writers or as naked call writers: Covered call writers own the underlying stock, and use this position to meet their obligations, if they are assigned. Naked call writers do not own the underlying stock. If a naked call writer is assigned, the underlying stock must first be purchased in the market before it can be sold to the call option buyer. Because call option buyers will only exercise if the price of the stock is above the strike price, assigned naked call writers must buy the stock at one price (the market price) and sell at a lower price (the strike price). However, naked call writers hope that this loss is less than the premium they originally received, so that the overall result for the strategy is a profit. The maximum loss that a naked call writer can face is theoretically unlimited, because there is no limit to how high the price of the underlying stock can rise. © CANADIAN SECURITIES INSTITUTE 10 20 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: COVERED CALL WRITING Assume that an investor purchases 1,000 shares of XYZ at $40 per share. She writes 10 XYZ September 50 call options at the current price of $4.55. She receives a premium of $4,550 (calculated as $4.55 × 100 shares × 10 contracts) to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 per share on or before the expiration date in September. Because the options are in-the-money (i.e., the strike price is less than the stock price), the $4.55 premium consists of both intrinsic value and time value. Intrinsic value is equal to $2.50, and time value is equal to $2.05. Because the investor owns shares of XYZ, the overall position is known as a covered call, and the investor is the covered call writer. If, at expiration in September, the options are in-the-money (i.e., the price of XYZ stock is greater than $50), the covered call writer will be assigned and will have to sell the stock to the call buyer at $50 per share. From the covered call writer’s perspective, however, the effective sale price is $54.55 because of the initial premium of $4.55. Overall, the total profit on this position is $14.55 per share because the investor bought XYZ at $40, sold it for $50, and made $4.55 from the premium. If, however, the price of the stock at expiration in September is less than $50, the covered call writer will not be assigned, and the options will expire worthless. Call buyers will not elect to buy the stock at $50 when it can be purchased for less in the market. The covered call writer will retain the shares and the initial premium. In this case, the premium reduces the covered call writer’s effective stock purchase price by $4.55 per share. Because the covered call writer bought the XYZ stock at $40, and the options expired worthless, the covered call writer’s effective purchase price is now $35.45 (calculated as $40.00 − $4.55). Therefore, writing the call slightly reduces the risk of owning the stock. STRATEGY: NAKED CALL WRITING Assume that a different investor writes 10 XYZ September 50 call options at the current price of $4.55. This investor does not already own the shares, so he is considered a naked call writer. The naked call writer’s hope is that the price of XYZ stock will be lower than $50 at expiration. If this happens, the calls will expire worthless, and the naked call writer will earn a profit equal to $4.55 per share (i.e., the initial premium received). This premium is the most that the call writer can expect to earn from this strategy. If the price of the shares increases, the naked call writer will realize a loss if the stock price is higher than the strike price plus the premium received, in this case $54.55. If this happens, the naked call writer will be forced to buy the stock at the higher market price and then turn around and sell the shares to the call buyer at the $50 strike price. When the stock price is greater than $54.55, the cost of buying the stock is greater than the combined proceeds from selling the stock and the premium initially received. For example, if the price of the XYZ rises to $60 at expiration, the naked call writer will suffer a $10 loss on the purchase and sale of the shares (i.e., buy at $60, sell at $50). This loss is offset somewhat by the initial premium received of $4.55, so that the actual loss is $5.45 per share, or $5,450 in total (calculated as $5.45 × 100 shares × 10 contracts). © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 21 BUYING PUT OPTIONS A popular reason for buying put options is to profit from an expected decline in the price of the stock. This speculative strategy relies on the fact that put option prices tend to rise as the price of the stock falls. Just like buying calls, the selection of an expiration date and strike price is crucial to the success (or lack thereof) of the strategy. Puts are also bought for risk management purposes because they can be used to lock in a minimum selling price for a stock. They are popular with investors who own stock because they can protect the investors from a decline in the price of a stock below the strike price. EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: BUYING PUTS TO SPECULATE Assume that an investor buys 10 XYZ September 50 put options at the current price of $1.50. The put buyer (the investor) pays a premium of $1,500 (calculated as $1.50 × 100 shares × 10 contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 per share on or before the expiration date in September. Because the options are out-of-the-money (i.e., the strike price is less than the stock price), the $1.50 premium consists entirely of time value. The option has no intrinsic value. The put buyer could have an opinion about the price of XYZ stock exactly opposite that of the call buyer. That is, the put buyer might believe that the price of XYZ stock will fall, and that put options on XYZ can be bought and sold for a profit. The put buyer might have no intention of actually selling 1,000 shares of XYZ stock. In fact, in this case, he probably doesn’t even own 1,000 XYZ shares to sell. He only wants to speculate that the price of XYZ shares will fall. If the stock price falls, the XYZ September 50 put options will likely rise in value, which will allow the put buyer to sell his options for a profit. Of course, if the stock price rises, the put options will most likely lose value, and the put buyer may be forced to sell the options at a loss. For example, if XYZ stock is trading at $45 one month before the September expiration date, the XYZ September 50 puts will be trading for at least their intrinsic value, or $5. Because there is still one month before the expiration date, the options will have some time value as well. Assuming that they have time value of $0.25, the options will trade at $5.25. Therefore, the put buyer could choose to sell the puts for $5.25 and realize a profit of $3.75 per share, which is equal to the difference between the current put price and the put buyer’s original purchase price of $1.50. Based on 10 contracts, the put buyer’s total profit is $3,750 (calculated as $3.75 × 100 shares × 10 contracts). If, however, XYZ were trading at $60 per share, the XYZ September 50 puts might be worth only $0.05. Because the options are so far out-of-the-money, and because there is only one month left until the options expire, the options will not have a lot of time value. The low option price implies that the market does not expect XYZ shares to fall below $50 anytime over the next month. The put buyer would have to decide whether to sell the options at this price, or hold them in hope that the price of XYZ does fall to below $50. If the stock does fall, the price of puts will rise. If the stock doesn’t fall below $50, the puts will be worthless when they expire. If the put buyer decides to sell the options at $0.05, he will incur a loss equal to $1.45 per share ($0.05 − $1.50) or $1,450 in total (calculated as $1.45 × 100 shares × 10 contracts). © CANADIAN SECURITIES INSTITUTE 10 22 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE (cont'd) STRATEGY: BUYING PUTS TO MANAGE RISK Assume that a different investor buys 10 XYZ September 50 put options at the current price of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. In this case, the put purchase will act as insurance against a drop in the price of the stock. Recall that put buyers have the right to sell the stock at the strike price. Therefore, buying a put in conjunction with owning the stock (a strategy known as a married put or a put hedge), gives the put buyer the right to sell the stock at the strike price. If the price of the stock is below the strike price of the put when the puts expire, the put buyer will most likely exercise the puts and sell the stock to the put writer. The strike price acts as a floor price for the sale of the stock. For example, if XYZ shares are trading at $45 just prior to the expiration date in September, the puts will trade very close to their intrinsic value of $5. (They are in-the-money, and there is very little time left until the expiration date.) The put buyer may choose to exercise the puts and sell the stock at the $50 strike price. She has been protected from the drop in the stock price below $50, but the protection was not free: she had to pay $1.50 for the puts. The put buyer’s effective sale price is actually only $48.50 (calculated as $50 − $1.50), after deducting the cost of the puts. However, this sale price is still better than the stock’s $45 market price. WRITING PUT OPTIONS Investors write put options primarily for the income they provide in the form of the premium. The income is the writer’s to keep, no matter what happens to the price of the underlying asset or what the put buyer eventually does. Like their call-writing cousins, put-writing strategies are primarily speculative in nature, but they can be used to manage risk as well. Put option writers can be classified as either covered or naked. Covered put writing, however, is not nearly as common as covered call writing because, technically, a covered put write combines a short put with a short position in the stock. It’s a simple fact of the stock markets that there are many more long positions in stocks than there are short positions. Another put writing strategy, similar to covered put writing, is the cash-secured put write. A cash-secured put write involves writing a put and setting aside an amount of cash equal to the strike price. If possible, the cash should be invested in a short-term, liquid money market security such as a Treasury bill so that it will earn some interest. If the cash-secured put writer is assigned, the cash (or the proceeds from selling the Treasury bill) will be used to buy the stock from the exercising put buyer. Naked put writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock. However, naked put writers must be prepared to buy the stock, so they should always have the financial resources to do so. Naked put writers hope to profit from a stock price that stays the same or goes up. If this happens, the price of the puts will likely decline as well, and the chance of being assigned will also be less. The naked put writer may then choose to buy back the options at the lower price to realize a profit. If the stock price does not rise, the put writer may be assigned and may suffer a loss. Depending on how low the stock price is and the amount of premium received, naked put writers may still profit even if they are assigned. The maximum loss that the naked put writer may face is limited because the price of the underlying stock can fall to a price no lower than $0. The loss would be offset somewhat by the premium received for writing the put. Although this situation is favourable compared to the unlimited risk faced by the naked call writer, it is still a substantial risk to consider. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 23 EXAMPLE Refer to Table 10.4 for figures presented in the following strategy. STRATEGY: CASH-SECURED PUT WRITING Assume that an investor writes five XYZ December 55 put options at the current price of $4.85. The put writer receives a premium of $2,425 (calculated as $4.85 × 100 shares × 5 contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. Because the options are in-the-money (i.e., the strike price is greater than the stock price), the $4.85 premium consists of both intrinsic value and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.35. If the put writer has an amount of cash equal to the purchase value of the stock set aside, the strategy is a cash- secured put write. The put writer in this case would have to set aside $27,500 (calculated as $55 strike price × 100 shares × 5 contracts). Some investors actually use cash-secured put writes as a way to buy the stock at an effective price that is lower than the current market price. The effective price is equal to the strike price minus the premium received. For example, if at expiration in December the price of XYZ stock is less than $55, the put writer will be assigned and will have to buy 500 shares of XYZ at the strike price of $55 per share. The effective purchase price is actually $50.15 because the put writer received a premium of $4.85 when the options were written. This price is less than the $52.50 price of the stock when the cash-secured put write was established. If, at expiration in December, the price of XYZ stock is greater than $55, the cash-secured put writer will not be assigned because the options are out-of-the-money. However, he gets to keep the premium of $4.85 and will have to decide whether to use the cash to buy the stock at the market price. STRATEGY: NAKED PUT WRITING Assume that a different investor writes five XYZ December 55 put options at the current price of $4.85. The put writer does not have a short position in 500 shares of XYZ or set aside a specific amount of cash to cover the potential purchase of the stock, so she is considered a naked put writer. The naked put writer wants the price of XYZ to be higher than $55 at expiration. If this happens, the puts will expire worthless and the writer will earn a profit equal to $4.85 a share, the initial premium received. If the price of XYZ stock falls, however, the naked put writer will most likely realize a loss, because put buyers will exercise their options to sell the stock at the higher strike price. (In this case, she will suffer a loss only if XYZ stock is trading for less than $50.15 at option expiration.) The naked put writer will have to buy stock at a price that is higher than the market price. If she does not want to hold the shares in anticipation of a higher price, she can sell them. For example, if the price of XYZ falls to $45 at expiration, the naked put writer will suffer a $10 loss on the purchase and sale of the shares (i.e., buy at the strike price of $55, sell at the market price of $45). This loss is offset somewhat by the initial premium of $4.85, so that the actual loss is $5.15 a share, or $2,575 in total (calculated as $5.15 × 100 shares × 5 contracts). OPTION STRATEGIES FOR CORPORATIONS Unlike individual and institutional investors, corporations do not normally speculate with derivatives because they do not want to risk their shareholders’ money betting on the price of an underlying asset. They are, however, interested in managing risk, and they often use options to do so. The risks that corporations most often manage are related to interest rates, exchange rates, or commodity prices. For example, corporations regularly take on © CANADIAN SECURITIES INSTITUTE 10 24 CANADIAN SECURITIES COURSE      VOLUME 1 debt to help finance their operations. Sometimes the interest rate on the debt is a floating rate that rises and falls with market interest rates. Just like the investor who buys a call to establish a maximum purchase price for a stock, corporations can buy a call to establish a maximum interest rate on floating-rate debt. EXAMPLE STRATEGY: CORPORATE CALL OPTION PURCHASE Assume that a Canadian company knows that it will buy US$1 million worth of goods from a U.S. supplier in three months’ time. Based on an exchange rate of C$1.32 per U.S. dollar, the U.S. dollar purchase will cost the company C$1.32 million. The company can do two things to secure the US$1 million: buy it now and pay C$1.32 million, or wait three months and pay whatever the exchange rate is at that time. The company would prefer to wait, but by doing so, it faces the risk that the value of the U.S. dollar will strengthen relative to the Canadian dollar. The Canadian dollar cost of the purchase, in such a scenario, would be higher than C$1.32 million. To protect itself against this risk, the corporation buys a three-month U.S. dollar call option with a strike price of C$1.35. This option can be bought at the Montréal Exchange or in the OTC market. If, at the end of three months, the exchange rate turns out to be C$1.40, the corporation will exercise the call and buy the U.S. dollars for C$1.35 million. If, however, the U.S. dollar weakens so that in three months the exchange rate is C$1.30, the corporation will let the option expire and buy the U.S. dollars at the lower exchange rate. The purchase of the call option has capped the exchange rate at C$1.35, plus the cost of the option. STRATEGY: CORPORATE PUT OPTION PURCHASE Assume that a Canadian oil company will have 1 million barrels of crude oil to sell in six months’ time. The current price of crude oil is US$40 per barrel, but the company is not sure what the price will be in six months. To lock in a minimum sale price, the company buys a put option on 1 million barrels of crude oil with a strike price of US$38 per barrel. This will protect the company from an oil price lower than US$38 per barrel. If, in six months, the price of crude oil is less than US$38, the company will exercise its put option and sell the oil to the put option writer at the strike price. If the price is greater than US$38, the company will let the option expire and will sell the oil at the going market price. KEY OPTION TERMS How familiar are you with options terminology? Complete the online learning activity to assess your knowledge. TRADING OPTIONS Can you describe the trading mechanics of options? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 25 FORWARDS AND FUTURES 5 | Distinguish between forwards and futures contracts and the strategies used by market participants. A forward is a contract between two parties: a buyer and a seller. The buyer of a forward agrees to buy the underlying asset from the seller on a future date at a price agreed on today. Unlike options agreements, both parties are obligated to participate in the future trade. Forwards can trade on an exchange or OTC market. When a forward is traded on an exchange, it is called a futures contract. Futures are usually classified into two groups, depending on the type of underlying asset: Financial futures are contracts with a financial asset as the underlying asset. Common underlying assets include: Stocks Bonds Currencies Interest rates Stock Indexes Commodity futures are contracts with a physical asset as the underlying asset. Common underlying assets include: Precious and base metals Crude oil and natural gas Grains and oilseeds Meats and dairy Lumber When a forward is traded over the counter, it is generally referred to as a forward agreement. The predominant types of forward agreements are based on interest rates and currencies. KEY TERMS AND DEFINITIONS Futures are simply exchange-traded forward contracts. As such, they have many of the features inherent to all forward contracts. They are agreements between two parties to buy or sell an underlying asset at a future time at a predetermined price. The party that agrees to buy the underlying asset holds a long position in the futures contract. This party is also said to have bought the futures contract. The party that agrees to sell the underlying asset holds a short position in the futures contract, and is said to have sold the futures contract. The buyer of a futures contract does not pay anything to the seller when the two enter into the contract. Likewise, the seller does not deliver the underlying asset right away. The futures contract simply establishes the price at which a trade will take place in the future. As it turns out, most parties end up offsetting their positions prior to expiration, so that few deliveries actually take place. If a contract is not offset and is held to the expiration date, the seller is obliged to deliver the underlying asset and accept payments from the buyer. Likewise, the buyer is obliged to accept delivery of the underlying asset and make payments to the seller. © CANADIAN SECURITIES INSTITUTE 10 26 CANADIAN SECURITIES COURSE      VOLUME 1 Like all exchange-traded derivatives, futures are standardized with respect to the amount of the asset underlying each contract, expiration dates, and delivery locations. Standardization allows users to offset their contracts prior to expiration and provides the backing of a clearinghouse. CASH-SETTLED FUTURES Many financial futures are based on underlying assets that are difficult or even impossible to deliver. For these types of futures, delivery involves an exchange of cash from one party to the other. The amount is based on the performance of the underlying asset from the time that the future was entered into until the time that it expires. These futures are known as cash-settled futures contracts. An equity index futures contract is an example of a cash-settled futures contract. Parties holding long positions in a stock index futures contract are not obliged to accept delivery of the stocks that make up the index. Likewise, those who are short are not required to deliver the stocks. Instead, if the position is held to the expiration date, either the long or the short will make a cash payment to the other based on the difference between the price agreed to in the futures contract and the price of the underlying asset on the expiration date. If the price agreed to in the futures contract is greater than the price of the underlying asset at expiration, prices have fallen, and the long must pay the short. If the price agreed to in the futures contract is less than the price of the underlying asset at expiration, prices have risen, and the short must pay the long. As with all other futures contracts, cash-settled futures can be offset prior to expiration. MARGIN REQUIREMENTS AND MARKING TO MARKET Buyers and sellers of futures contracts must deposit and maintain adequate margin in their futures accounts. Futures margins are meant to provide a level of assurance that the financial obligations of the contract will be met. In effect, futures margins represent a good faith deposit or performance bond. Two levels of margin are used in futures trading: initial margin (also called original margin) and maintenance margin. Initial margin is required when the contract is entered into. Maintenance margin is the minimum account balance that must be maintained while the contract is still open. Minimum initial and maintenance margin rates for a particular futures contract are set by the exchange on which it trades. Investment dealers may impose higher rates on their clients, but they may not charge less than the exchange minimums. One of the important features of futures trading is the daily settlement of gains and losses. This process is known as marking to market. At the end of each trading day, those holding long positions in a contract make a payment to those who are short, or vice versa, depending on the change in the price of the contract from the previous day. If either party accumulates losses that cause their account balance to fall below the maintenance margin level, they must deposit additional margin into their futures account. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10      DERIVATIVES 10 27 EXAMPLE Greg buys a futures contract and Leila sells the same futures contract on the same day. The initial margin required in each account is $2,000, and the maintenance margin is $1,500. Both Greg and Leila put up the initial margin required. The first day, the futures gain $200. At the end of this day, Greg’s account is credited $200 and Leila’s is debited $200. Greg’s account now shows a balance of $2,200 and Leila’s account shows a balance of $1,800. On the second day, the futures drop $300. At the end of the second day, Greg is debited $300 and Leila is credited $300. Greg’s account now shows a balance of $1,900 and Leila’s account shows a balance of $2,100. As you can see, Greg and Leila’s accounts are debited and credited each day by the amount of the gain or loss on the futures contract until they offset or close their positions. When the futures drop another $500 on the third day, Greg’s account is debited $500. It now shows a balance of $1,400, which is below the maintenance margin. Greg’s dealer sends him a margin call, and Greg must deposit $600 so that the account is back to the initial margin. This is how initial and maintenance margins and marking to market work. FUTURES TRADING AND LEVERAGE Futures margin requirements are typically 3% to 10% of a contract’s value. In contrast, investors can buy or sell equities with margin deposits ranging from 30% to 80%. For example, a $10,000 long position in a security eligible for reduced margin can be arranged with a $3,000 deposit. That same $3,000 deposit, however, could secure a futures position with a value of $100,000. With such a small percentage of a contract’s value required to trade, futures contracts become highly leveraged, so it is possible to lose more than the amount of money initially deposited. Although leverage is often associated with futures trading, it should be noted that it is not inherent in a futures contract. A futures trader could decide to deposit a contract’s full value as margin rather than the minimum margin required. For example, a trader that goes long in a gold futures contract could deposit the contract’s value of US$120,000 (100 troy ounces at an assumed price of US$1,200 per ounce) as margin. In this scenario, the trader is not leveraged at all. FUTURES EXCHANGE The Montréal Exchange lists financial futures and offers contracts on index futures, two-year, five-year, 10-year, and 30-year Government of Canada bonds, and the Canadian Overnight Repo Rate Average (CORRA). FUTURES STRATEGIES FOR INVESTORS Futures are inherently simpler than options. With options there are four basic positions: long a call, short a call, long a put, or short a put. Futures contracts have only two basic positions: long and short. Options also have strike prices, so that an almost uncountable number of different strategies can be designed by combining options with different strike prices and expiration dates, as well as with a position in the underlying asset. The number of strategies that can be designed with futures is limited because there are only two basic positions for each expiration date. BUYING FUTURES Investors buy futures either to profit from an expected increase in the price of the underlying asset, or to lock in a purchase price for the asset on some future date. The former application is a speculative strategy, whereas the latter is one of risk management. © CANADIAN SECURITIES INSTITUTE 10 28 CANADIAN SECURITIES COURSE      VOLUME 1 BUYING FUTURES TO SPECULATE Buying a futures contract to profit from the expectation of rising prices is a speculative strategy. This investor probably has no intention of actually buying the underlying asset. Rather, the investor wants to sell the futures contract at a higher price than what was originally paid. The chances of this happening depend primarily on the change in the price of the underlying asset in the spot or cash market. If the spot price of the underlying asset rises, then the price of the futures contract will also rise. Of course, the investor faces the risk that the price of the underlying asset will fall. If this happens, the price of the futures contract will fall as well, and the investor may be forced to sell the contract at a loss. BUYING FUTURES TO MANAGE RISK Buying a futures contract to lock in a purchase price is a risk management strategy. In this case, the investor does not offset the contract. At expiration, the investor takes delivery of the underlying asset for the amount agreed upon when the contract was originally bought. The purchase of the futures contracts locks the investor into a pre- determined purchase price of the underlying asset, regardless of what happens to the price of the underlying in the spot market. SELLING FUTURES Investors sell futures for the same reasons that they buy them: either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date. SELLING FUTURES TO SPECULATE Selling a futures contract simply to profit from an expectation of lower prices is a speculative strategy. The investor probably has no intention of actually selling the underlying asset. Rather, he or she wants to buy back the futures in the market at a lower price than what the contract originally sold for. The chances of this happening depend primarily on the change in price of the underlying asset in t