Creating an Income Stream for Your Clients: The Art

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Creating an Income Stream for Your Clients The
Art Science of Covered Call Writing

• David Salloum MBA CFP CIM FCSI TEP
• Vice President Portfolio Manager

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Objectives

• Review the basic terminology, concepts and
  characteristics associated with various
  derivative instruments
• Describe the different factors that influence the
  options premium
• Describe and illustrate this basic option
  strategy as well as the inherent risk and reward
  potential

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Presentation Summary

• Introduction
• Options
• Covered Call Writing
• Question Period

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Things to Keep in Mind

• For any transaction to take place there needs to
  be a willing buyer and a willing seller.
• Interest rates change.
• Stock prices change.

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• By far the most significant event in finance
  during the past decade has been the extraordinary
  development and expansion of financial
  derivativesthese instruments are an increasingly
  important vehicle for unbundling risks. They
  enhance the ability to differentiate risk and
  allocate it to those investors most able and
  willing to take it this process has undoubtedly
  improved national productivity growth and
  standards of living.
• Alan Greenspan, Chairman of the U.S. Federal
  Reserve Board of Governors, 1987-2006

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Definition

• Derivative instruments are financial instruments
  that derive their value from the value of an
  underlying asset, namely
• a stock,
• an index,
• a bond,
• an interest rate,
• a currency,
• a commodity.

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Definition

• Derivatives are contracts or agreements to
  purchase or sell assets at a future date.
• The contracts specify in advance
• the underlying interest
• the quantity/amount
• the purchase or sell price
• the expiry date of the contract

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Why do they use derivatives?

• To attain investment objectives
• Income strategy
• Free up cash
• Protect capital

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Exchange Market
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Elements in an Option Contract

• Type call or put.
• Underlying interest the underlying asset
  specified in the option contract.
• Expiry month the month during which the option
  ceases to exist (options expire on the Saturday
  following the 3rd Friday of each month).
• Strike price the price at which the holder can
  purchase or sell the underlying.
• Premium the options price (x multiplier 100
  for stock options).

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Call Options

• The buyer (holder) of a call option has the
  right, but not the obligation
• to buy a specific quantity of an underlying
• at a given price (strike price)
• for a specified time period (expiry date).
• In order to obtain this right, the holder must
• pay a premium to the writer.

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Call Options

• The seller (writer) of a call option has the
  obligation to sell to the holder
• A specific quantity of an underlying
• At the strike price indicated, if the holder
  exercises his right.
• In return for this obligation, the writer
  receives the premium paid by the holder.

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The Options Market
Call Put
Holder/Buyer (pays a premium) Right to buy (no obligation) Right to sell (no obligation)
Writer/Seller (receives a premium) Obligation to sell Obligation to buy
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Your Options

• The holder of the option can
• Exercise his right to buy or sell
• Close his position by selling back the option
• Let the option expire worthless (loss)
• The seller of the option can
• Accept to be assigned (deliver or take delivery)
• Close his position by buying back the option
• Let the option expire worthless (gain)

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Basic Strategies
Calls Puts
Buy (Holder) To benefit from a price increase To determine the future acquisition price To hedge a short sale To benefit from a price decrease To determine the future selling price To hedge a long position
Sell (Writer) To benefit from a price decrease To generate additional income To benefit from a price increase To generate additional income
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The Option Chain

• Call CM July 105 _at_ 2.00

Option type
Expiry month
Option premium

Underlying asset
Strike price
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Call Options

• April 07 G _at_ 29.63
• Buy 1 Call G July 30 _at_ 2.20
• Sell 1 Call G July 30 _at_ 2.20

Right to buy
Obligation to sell
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Call Options

• Buyer 1 Call G July 30 _at_ 2.20
• Seller 1 Call G July 30 _at_ 2.20
• Scenario 1 At expiration, G _at_ 36
• Scenario 2 At expiration, G _at_ 26

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Exercise Styles

• American-style options allow the holder to
  exercise at any time during the life of the
  option (all stock options and few index options).
• European-style options limit the holder to
  exercise the option only at expiry date (most
  index options).

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In, At, Out
Call
Out-of-the-money
In-the-money
Strike 62
Strike58
Intrinsic Value
At-the-money (strike 60)
In-the-money
Out-of-the-money
Put
Strike 58
Strike 62
Intrinsic Value
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Factors Influencing the Option Price

• PremiumIntrinsic Value Time Value
• Intrinsic Value is the amount by which the
  option is in-the-money.
• Time Value an option is a wasting asset its
  value declines over time.
• Time to expiration
• Volatility
• Risk-Free Interest Rate
• Dividends
• Whats the value of an option at expiration?

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Factors Influencing the Option PriceVolatility

• Volatility measures the amount by which the price
  of the underlying stock fluctuates during a
  specified period of time.
• The higher the volatility, the higher the
  options premium.

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The Options Market

• April 2007 SLF _at_ 53
• Call July 50 is trading _at_ 3.95
• Intrinsic value? 0.95
• Time value?

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Factors Influencing the Option Price Time to
Expiration

• RIM is trading _at_ 168.85 (April 07)
• Call RIM May 170 _at_ 9.15
• Call RIM September 170 _at_ 18.55
• The more time to expiration, the higher the
  value of the call.

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www.m-x.ca

• Options Guide and Strategies
• Options Newsletter
• Options Calculators
• Covered Call Calculator
• Quotes and Implied Volatility
• Options summary

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Covered Call Writing Worksheet
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Covered Call Writing Worksheet
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Covered Call Writing Worksheet