—  WHAT ARE OPTIONS?  —

Options are a type of financial instrument which derives its value from an underlying security - in this case these securities are stocks. Simply put, they allow buyers and sellers to essentially place bets on what will happen to a stock’s price in the future. Before we get into some examples, let’s learn some basic option terminology.

1. An option’s contract expiration date is the last date when an option holder can exercise their option. American style options allow option holders to exercise their options at any time up to and including the expiration date, while European style options allow option holders to exercise their options only on the expiration date.

2. Each option has a strike or exercise price, which is the contract price in which the buyer and seller will exchange the underlying shares for.

3. Power is always in the hands of option buyers. They have the right, but not the obligation, to exercise their options if it makes financial sense. In exchange for this power, they pay an option premium to the option seller. When an option holder decides to exercise their option, it is said that the seller has been assigned the option.

4. Buyers and sellers come together in an options marketplace such as Canada’s Bourse de Montreal (Montreal Exchange). Potential buyers enter bid prices while potential sellers enter ask prices. A transaction occurs when the two parties can agree on a price and the exchange facilitates this.

5. There are two types of options: call options and put options. Call options give the owner the right to purchase shares of a stock at a certain price up to and including the exercise date, while put options give the owner the right to sell shares of a stock at a certain price up to and including the exercise date.

6. Option buyers are said to be going long, while option sellers are said to be going short. Sometimes we refer to option sellers as option writers.

7. Option contracts are sold in lots of 100 shares, but it is not necessary to actually own 100 shares of a stock to trade options.

8. Like with shares of stocks, you can always attempt to reverse your position before the contract expiration date provided there is a willing counterparty, who is the investor on the other side of the transaction.

Know your way around options already and want to run some simulations? Scroll down to the bottom of this page and download my options workbook, pre-populated with real Canadian options which you can use to test out different strategies! Or continue reading on to get a solid background first before you get started.

— buying a call option —

If you choose to purchase a call option, you must pay what’s known as an option premium. Call options give the owner the right (but not the obligation) to purchase shares at a set price up to and including the expiration date. When deciding whether to purchase a call option, you must decide whether or not this pricing guarantee is worth the premium you are paying.

Consider these call options for Enbridge (Ticker: ENB) available for purchase on the Montreal Exchange. Take a look at the last one, for example - the October 23, 2020 contract with a Bid Price of $0.02, an Ask Price of $0.05, a Last Price of $0.06, Implied Volatility of 25.6%, Open Interest of 13, and a Strike Price of $41.50. Let’s unpack this.

Purchasing an option is similar to purchasing a stock - you have your bid prices which are the highest prices buyers are currently willing to pay, and you have your ask prices which are the lowest prices sellers are willing to accept. The market may end up somewhere in the middle, but for the sake of argument let’s say you wanted to purchase these call options immediately - this will cost you $0.05 per share. Since contracts are in sets of 100 shares, the total cost to you will be $5. In exchange for this premium, you will have the right to buy 100 shares of Enbridge at $41.50 per share at any time up to and including October 23, 2020.

Now, let’s consider the likelihood of this making good financial sense. If shares remain below $41.50 for the contract period (which is only nine days), there would be no reason for the call option holder to exercise the option at $41.50 - he or she could simply just buy them in the open market for that lower price. Call options only have value when the market price exceeds the strike price. If the price of Enbridge shares suddenly rose to $42, then it would make sense to exercise the option. The call option holder could then purchase shares for juts $41.50, sell them for $42, and net a $0.50 profit. After deducting the $0.05 per share premium they paid earlier, they are still in-the-money by $0.45 per share.

— SELLING a call option —

It’s important to remember that with options, it truly is a zero sum game. If one party wins, the other loses. So if you choose to sell (write) a call option, the exact opposite principles apply as for call option buyers. Investors who choose to sell options receive a guaranteed option premium, but in return they take on the risk that the option will be exercised. Let’s take a look at another example, this time with shares of Royal Bank.

The unknown piece of information here is what will happen to shares of Royal Bank up until and including October 23, 2020. Will they go up, go down, or stay about the same? Remember, the call option buyer wants the price of the shares to rise so they can buy them from you at a cheaper price than the market offers. Therefore, call option sells want the opposite - for the price to go down. As share prices decrease, it becomes less likely (and less profitable) for the buyer. If, on October 23, 2020 the share price has dropped to $96 then the buyer will still exercise the option - but you will only lose $1 per share ($96 - $95), or $100, but your option premium of $221 will still net you a profit of $121.

— BUYING a PUT option —

Put options are the opposite of call options in the sense that they give the owner the right to sell shares at the specified strike price rather than buy them. In this way, call option holders can lock in a sale price in return for paying a premium.

— SELLING a PUT option —

As mentioned earlier, selling an option is going to net you a premium, which is the primary motivator for anyone selling options. By selling a put option, you agree to buy shares at the strike price at any time up to and including the contract date. Recall that buyers of put options want the share price to decrease because they can then sell it at their locked-in higher prices. Naturally, sellers of put options want the opposite - for the share price to increase so that the option is either never exercised, or exercised where the loss on the share price difference is less than the premiums earned.

— A SUMMARY OF EACH OPTION TYPE —

In this section, I will briefly summarize each of the four different option types.

CALL OPTION BUYER: A call option buyer has paid a premium in order for the right to purchase shares at a specified price on a later date. In this case, this investor would want the share price to rise as much as possible so that they can buy it at the lower strike price and sell it right away in the open market. Therefore, the upside is theoretically unlimited. The downside is limited to the amount of premium paid - they are under no obligation to purchase shares if the economics don’t make sense.

CALL OPTION SELLER: A call option seller receives a premium in order for their commitment to sell shares at a potentially unfavorable price later on. They have no upside except for the amount of option premium. Their downside is theoretically an unlimited amount less the option premium received. If the share price rises to an extraordinary amount, the call option seller must sell shares to the buyer for the lower price.

PUT OPTION BUYER: A put option buyer has paid a premium in order for the right to sell shares at a specified price on a later date. In this case, this investor would want the share price to decrease as much as possible so that they can sell it for the higher strike price to the seller. Therefore, the upside is theoretically limited to the strike price value since shares cannot trade below zero. The downside is again limited to the amount of premium paid - they are under no obligation to sell their shares if the economics don’t make sense.

PUT OPTION SELLER: A put option seller receives a premium in order for their commitment to buy shares at a potentially unfavorable price later on. They have no upside except for the amount of option premium. Their downside is theoretically limited to the strike price value less the premium, again since shares cannot trade at $0. If the worst situation were to occur where shares of the underlying traded at $0.01, the put option buyer could force you to buy their shares at the much higher strike price, leaving you with shares that are only worth a penny.

— MANAGING RISK —

The unlimited risks with writing call options may have caught your attention, as it should have. Option trading can be a very risky strategy and generally speaking, I do not believe it is something a novice investor should consider. With that being said, options can be terrific risk management tools if used correctly. Three common strategies which have merit are the covered call, protective put, and costless collar strategies, which I will describe now.

— COVERED CALL WRITING —

Recall that when you sell (write) call options, you receive a premium in exchange for your commitment to purchase shares of an underlying stock at potentially unfavourable prices. The reason the downside risk is unlimited is because theoretically, there is no limit to how high a share price can rise. If you agree to sell shares to a buyer for $50 and then all of a sudden, the share price rises to $1,000, what will you do? Well, you need to come up with a way to purchase 100 shares of a stock now trading at $1,000 (i.e. $100,000) just so you can sell it back to the buyer for $50 per share, netting yourself a massive loss of $95,000 (not including the small premium, which is immaterial at that point). This is where option traders get themselves into trouble. They convince themselves that the scenario I just described is so unlikely it might as well be impossible, so they continue to write call options and earn small premiums for months or maybe even years. And then one day, the impossible happens. How would you handle it? Investors underestimate their ability to tolerate risk all the time, instead choosing only to focus on their willingness to tolerate risk.

A covered call writing strategy is a much safer way to go about trading options. The situation described above is referred to as naked call writing, which happens when an investor writes call options on securities they do not own. In contrast, covered call writing is done on securities which the investor already owns. In other words, to write one covered call option contract would require the investor to already own 100 shares of that stock.

Let’s refer to the earlier example. If you own shares of a stock trading at say, $49 and you write a covered call option with a strike price of $50, your commitment is to sell shares to the buyer for $50 if, all of a sudden, the stock price increases above $50. So let’s say it does, and shares skyrocket to $1,000 and the buyer exercises their option. What would you do? Well, you would simply sell them the 100 shares you already own and earn a dollar plus the option premium in the process. Did you miss out on a once-in-a-lifetime gain of 1,900%? Yes, but you also saved yourself from losing the equivalent, and that is how I want everyone to think about investing. Protection of capital needs to be your primary objective, with growth being a secondary objective. You can take calculated risks, but an investment strategy where a few bad moves can destroy years’ worth of progress is not a strategy - it’s a gamble.

— PROTECTIVE PUTS —

The earlier example involving the options for CNQ is a classic example of a protective put strategy. An investor who already owns 100 shares of the underlying stock buys a put option contract in order to lock in an acceptable strike price should the shares fall in value. It is useful to think of protective puts as the same as insurance - if something bad happens (namely the share price of a stock you own plummets), you’ll have a mechanism in place to recover at least some of your losses.

So how much insurance do you need? Well, when you purchase health insurance for a one month trip to foreign country, would you purchase one week’s worth of insurance, one month, or one year? Think of protective puts in the same context - what are you insuring for? An upcoming earnings report? A new product release? Macroeconomic factors? Assuming that you’ve made the decision that you need insurance to begin with, having an understanding for how long you’ll require insurance is the next crucial step. Before deciding which contract is right for you, take some time to make some basic cost per day of insurance calculations. Let’s return to the CNQ example from earlier.

Suppose an investor currently own 100 shares of CNQ and they are extremely nervous about their upcoming earnings report on November 5, 2020. They decide some insurance is needed in case of a big negative earnings surprise, so they look into buying a protective put. The above is a snippet of the put options with a contract expiration date of November 6, 2020 at various strike prices. In the last column I have calculated the cost per day of insurance, which is simply the ask price divided by the number of days left in the contract. Setting up a table like this is a really great way to visualize your analysis.

In the table above I note that the cheapest level per protection is only 1.3 cents per day for the contract with the $20.50 strike price. However, given that this would represent a significant drop from its current share price of 23.65 (~13%), this may be an unacceptable loss. On the other hand, an investor purchasing a protective put is mostly concerned with limiting downside risk so contracts with strike prices significantly above the current price, such as the $26 per share one with a cost per day of protection of 11.3 cents, don’t make much sense. Instead, an investor may choose between contracts with strike prices between $23 and $24 and then decide for themselves what the right balance is between cost and level of protection.

— costless COLLARS —

Creating an option collar is an effective strategy for those not willing to take much downside risk and are also willing to forgo some upside opportunity as well. Creating an option collar involves buying an out-of-the-money put option while simultaneously selling an out-of-the-money call option. The idea is to lock in a share price range for little to no cost. Collars are best used with an example, so let’s take a look at the options available for Bank of Montreal (BMO).

If the share price were to drop to $70, the investor would exercise their put option to sell at $76 per share. This, along with their net $0.90 per share option premium, would give a total value per share of $76.90. On the other extreme end, if the share price were to increase to $90, the call option they sold would be exercised and the investor would have to sell their shares for only $86 per share. This, along with their net $0.90 per share option premium, would give a total value per share of $86.90.

With collars, investors can lock in a particular range of prices while minimizing their costs (or even netting a small gain like the one in this example). While true costless collars (where the cost to purchase the put option equals the income generated from selling the call option) are hard to find, you can usually get pretty close. As you can see, the investor is still ultimately bullish on the stock but has relinquished some upside potential in favor of limiting their downside risk with no upfront costs.

— COVERED CALLS VS. PROTECTIVE PUTS —

Writing covered calls differs from buying protective puts in that the investor actually receives the option premium rather than paying out. While the near-term outlook for a stock’s price may be similar (i.e. negative), there are differences in both the upside and downside protection offered to the investor. Consider the following example of an investor looking to protect their position in 100 Royal Bank shares which have a cost basis of $90 per share.

The investor does not wish to purchase protective puts - after all, options are wasting assets - in other words, when they expire they have no value. Instead, they would like to protect their position and earn a little bit of income in the meantime, so they sell a $95 call option to cover their position. Let’s compare the implications of this versus buying a protective put option for the same amount.

1. If the share price falls to a level below the strike price, say by $5 to $92.09, the person who purchased the call option from this investor would not exercise the option. This is because they could simply buy it in the open market for $92.09 rather than $95, so there would be no point. In this case, the investor writing the covered call open has simply earned the option premium of $2.21 (the bid price). They have also lost $5 from the current share price, however, so their total net loss is $2.79 per share. Contrast this with the investor purchasing the protective put option. In this case they would pay the highest ask price of $0.54 per share and they could exercise their right to sell for $95 which would limit their loss to just $2.09 per share. All in all, their total net loss is $2.63 per share. Note that the two results are pretty similar if the share price drops below the strike price.

2. If the share price falls to a level that is between the strike price and the current price (say, $96 per share), the person who purchased the call option from this investor would exercise the option. The investor would lose $1.09 in share price depreciation ($97.09 - $96), another $1.00 in having to sell the shares for a dollar cheaper than what the market is asking, but would still earn their $2.21 option premium for a total net gain of $0.12. Contrast this with the investor purchasing the protective put option. In this case they would not exercise their option to sell it for $95 per share because they could just sell it in the open market for $96 per share instead. Their total net loss is $0.54 per share, which is the option premium.

3. If the share price rises above the current price, say by $5 to $102.09, then the person who purchased the call option from this investor would exercise their option to purchase for $95. The call option seller would earn the option premium of $2.21 and would not participate in any capital gains, leaving their total net gain to be $2.21 per share. Contrast this with the investor purchasing the protective put option. In this case they would pay the option premium of $0.54 per share, not exercise their option but instead realize the $5 capital gain leaving them with a total net gain of $4.46 per share.

As you can see, protective puts are more advantageous when the share price rises. This is because the investor can still participate in any share price appreciation because they are in control whether they exercise their option or not. The upside is unlimited. On the other hand, selling covered call options are more likely to be advantageous if the share price does not move very much. With less upwards price movement, there is less chance the buyer will exercise the option and force the investor to sell shares to them at unfavorable prices. This, coupled with the cushion provided by the guaranteed option premium, is an attractive proposition for call option sellers.

If the share price does fall down below the strike price, there is a good chance that the two payout profiles will look similar for both covered calls and protective puts (assuming an efficient options exchange of course). If this were to occur, I would lean more toward preferring covered calls because you would get to keep your shares rather than be forced to exercise your option to limit your loss. Of course, you could always exercise your protective put option and then immediately repurchase the shares in the open market, but this additional trading activity is costly and unnecessary given the two similar payout profiles. And of course, receiving a guaranteed option premium is better than paying one.

— A FINAL WORD ABOUT OPTIONS —

It is important to remember that options are just another category of investment products available to investors. They carry many of the same risks as stocks do, and since they are sold in lots of 100 shares these risks are amplified, possibly to the point where they are entirely unsuitable for the average investor. While options are certainly useful for risk management, they should be reserved for skillful investors who are comfortable calculating payout profiles and assessing volatility. Therefore:

1. Do not begin your investing journey with options trading.

2. Do not sell options to generate additional income unless you are certain of the risks involved.

3. Always make sure you can handle the worst case scenario.

Finally, a word about social media as it is the unfortunate home to many self-styled experts, several of whom target novice investors to sign up for their options trading services. While there are undoubtedly those who are skilled and have your best interests at heart, the majority have little to no education and are going based on their personal experiences alone. While I do not wish to suggest that education matters more than experience, a person who has invested both time and money into learning as much as they can about options strategies is more likely to lead you down the correct path. Trading options is not easy money. Option exchanges are not a home where novice investors can take advantage of the professionals simply by selling low-probability, low return options. Extreme events can and will happen, and if you’re caught on the wrong side and you’re not prepared, the results can be devastating.

If you found this material educational then I encourage you to download from the Bourse de Montreal’s free Guides and Strategies page. Much of the information I have discussed here is nicely summarized. You can also try their free Options Trading Simulator - a great way to get started without taking any risk. Learn from your mistakes, just don’t pay for them!

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