Transcript: Introduction to Canadian ETFs and ETF Options

Introduction To Canadian ETFs and ETF Options
Patrick Ceresna

April 11, 2018

[Introduction to Canadian ETFs and ETF Options]

[Host:]

Hello everyone and thank you for joining us today. On behalf of CIBC Investor's Edge I would like to welcome you all to this webinar. My name is Dimple and I will be your host for this event.

[Controls]

Now, a few things to note before we get started. If you wish to view this webinar full screen please click on the expander arrows located on the top right-hand corner of your screen. And, should you have any questions during the presentation, kindly take a note and you will have the opportunity to submit your questions after the presentation.

[Disclaimer]

Also CIBC Investors Services Inc. does not provide investment or tax advice or recommendations. So everything we share today is for educational purposes only. We are recording today's session and the link will be emailed to anyone that registered online.

[Speaker]

Our topic for today's webinar is Introduction to Canadian ETFs and ETF Options. To present this we have Patrick Ceresna with us this afternoon and we are really excited and thrilled to have him here.

Patrick is the founder and Chief Derivative Market Strategist of Big Picture Trading. He is an instructor on derivatives for the TMX Montreal Exchange and also co-host to the Macro Voices weekly podcast. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities.

With great pleasure, please help me welcome Patrick. Patrick Ceresna: Well, thank you very much, and hello everyone and thank you for joining us.

[Introduction to Canadian ETFs and ETF Options]

Today I am very excited to have the opportunity to spend 45 minutes to an hour talking about a subject I'm very passionate about is the utilization of options with--and especially in this case associated with exchange-traded funds. And what we have is, when we talk about options and the idea of using options, often, most people have heard in the past that options are risky, that options are used to create high risk.

But I always like to describe options as a tool. And while the tool can be used to create leverage, it can also be used for protection. It can also be used to generate income. It can be used for all sorts of things that are far more conservative, and most people dismiss it and not take the opportunity to learn about it. So I look forward to over the next 45 minutes, taking you on our journey about all the different applications of options.

[Limitation of liability]

[Agenda]

So what I want to do though, is first, I want to spend a little bit of time going through what exchange-traded funds are, and how they work. We're gonna not spend too much time on that, we're gonna just kind of do a quick refresher of how they work and what's it all about. And, then we're going to get into understanding the options that are available on Canadian exchange-traded funds where we're gonna then be looking at the idea of using an option as a tool to buy call and put options to express a bullish or bearish view on the market.

[Exchange-Traded Funds]

And, then we will cover the idea of generating income using those options. So very quickly, let's just do a very--a review of how exchange-traded funds work. They have all of the diversification of a mutual fund, but yet the liquidity of a stock. And so, like a stock on the stock exchange, you could at 9:35 in the morning turn on the computer and press buy and buy it at a specific price. And if you choose to sell it in the afternoon, there is a bid and ask on the market, and you can turn around and sell it, and you can trade it. But yet you have the benefit of it having a basket of stocks within it to have all the benefits of diversification and other things that are associated with the benefits of mutual funds. Nonetheless, it contains investments to replicate the performance of a particular market sector, bonds, commodities, specific ETF's also specific indices and the ETF's are designed to track the net asset values of the basket of investments that they hold.

[Characteristics of ETFs]

And so what are the key characteristics or benefits of trading exchange-traded funds is that they have liquidity, the benefit of diversification. They have far more transparency, in terms of what their values are, particularly on an intraday basis. They are very cost-effective, as most of them have very low management fees, often far lower than mutual funds. Which certainly is a benefit for long-term returns and being able to mitigate a lot of the costs associated. Often there are tax efficiencies in them. The benefit, in my opinion, is of course that you are eligible to utilize option strategies on them. Something you can't do with traditional mutual funds.

[Types of ETFs]

So let's kind of go through and review some of the different types of exchange traded funds that are out there. So first of all, there are exchange traded funds that are fundamentally driven, use different accounting factors to weigh the companies into the ETFs so they can have a fundamental driver such as dividends or corporate cash flows or sales or book values. And they actually are fundamentally re-rated based upon some sort of fundamental criteria.

[Types of ETFs]

There are additional types of ETFs available such as index ETFs, which replicate the performance of the stock market. So you are have the benefit of the fact that if you want representation of the TSX60, which is for instance the index in Canada, that represents the 60 largest Canadian companies, and you would buy this ETF and it subsequently will track the index and these are by far the most popular form of ETFs out there because they--you know exactly the weightings you're getting in every investment, and the fees are very low because there isn't very much management involved with that.

Then there is the leveraged ETFs, which offer the ability to let's say get a participation in something like an index, but subsequently they do so on a leverage basis. So you get almost the benefit of margining and getting let's say two-to-one leverage or something like that on the markets. So there is also exchange traded funds that allow you to trade the inverse of the actual indexes. So what you can do, you can buy an exchange traded fund and it actually shorts the market. So if you have the view that you felt the stock market was vulnerable to going lower, you actually could buy an exchange traded fund that will profit, if the stock market actually goes down.

Often a tool that a lot of investors, particularly in today's types of market environments, turn to if they want to even hedge their existing portfolios. There are also exchange traded funds based on sectors. So you could have specifically one that's focused on let's say gold miners or energy companies, or there are exchange traded funds that focus on let's say just financial companies in Canada, such as the big banks. So you have these specific sector ETFs, as well as actively managed ones, where the managers in the ETFs are actually utilizing discretion as to which ones they are actually buying. In addition to that, there are ETFs focusing on currencies. So you can take on trades at bullish or bearish particular global currencies. And commodities, so you can turn around and have ETFs that are bullish gold or oil and other very popular commodities in the marketplace.

[How are ETFs Constructed]

So the question, of course, is how are these ETFs constructed? How do these ETFs get created? So ETFs, the companies themselves are still associated with a specific designated broker. In this animation here what you can see is that they are designated broker is obviously engaged in the capital markets, buying and selling the securities that will end up going into an exchange traded fund. And so what ends up happening is they create one of these baskets of securities, which is subsequently put into any one of these ETFs.

So there's a number of ETF companies such as BMO or Claymore or Horizons or the iShare ETFs, and they'll put the securities within one of these products and they subsequently create these creation units of ETFs that will subsequently be made available at the actual exchanges. And so what happens, these creation units or these new ETFs are subsequently put onto the exchange and in the open markets you'll have the availability of one of those ETFs to be able to be bought directly in your brokerage account.

Now that red square, the creation units, is actually where the ETF management companies are actually controlling or ensuring that the ETFs trade to their net asset values. So when you, as an investor buy one of these, what you're doing is you're buying the ETF, but as the ETF is trading let's say above or below its net asset value, the fund company is actually creating or collapsing creation units always to bring back the value of the ETF in the live markets back to its net asset value. So it is a process the ETF companies use to ensure that it can actively and in a very liquid way be trading within the marketplace. So this is how the ETFs are constructed.

[Tracking Errors]

Obviously in this process of them creating these creation units and ensuring the trades to a net asset value it always leads to some issues sometimes with these ETFs in their tracking errors. Where sometimes a fund will fall short in reflecting the exact move of the underlying because of the process that's used to actually trade these ETFs, or to manage the ETFs. And so that's the difference between a total net asset value of the securities held in the ETF and the actual share price itself.

[Options on ETFs]

So nonetheless, that's how ETFs work. And all of you can go into the open market and buy one of them exactly like a share. And subsequently own it in your CIBC Investor's Edge account and have a series of these ETFs in your account. Replicating that of if you owned the ETFs themselves. Sorry having a diversified portfolio in itself. And so in this situation though you are able to utilize options on these ETFs. So this is where I want to spend the remainder of the presentation, introducing all of you to options. Now many of you will know that options are also available on individual stocks, and most people experience options trading on individual stocks. But they are available on ETFs as well.

[Options]

So in this situation, let's just kind of review what an option is and how it works. An option is a contract between two counterparties. A buyer and a seller. And subsequently, they enter a contract to do business on a stock or an exchange traded fund at a specific price over a specific period of time in the future. And so in this situation there are two types of options.

[Call Options]

Because there are two types of transactions. There is a transaction to buy and a transaction to sell. So subsequently there's two option contracts, a call option is a contractual right to buy and a put option which is a contractual right to sell. And so let's review the first one of a call option. A call option has a buyer and a seller. And what's really fascinating is a lot of people initially, when they learn about options believe, the seller has the advantage and it's like this market maker behind the black curtain who's taking advantage of retail investors who are buying these options. But that's not the case. You as an investor actually can be the seller of an option just as easily as you're a buyer. And if you feel the selling of the option is the profitable and beneficial strategy, you can turn around and sell premiums. A little later on in today's presentation we are going to get into covered call writing as one of the ways of selling options to generate income as the seller.

But the way you want to think of it is as two counterparties. And so let's just say I was having a conversation with one of the hosts here and I was talking about the fact that I was thinking of selling my car. I'm just gonna give an example that all of you can relate to. And they said well I might be interested. In the end if they ask me how much are you thinking of selling your car for? And I say $20,000. What happens is that we now are talking about the idea of buying and selling a vehicle, a car.

What happens is that most of you know how to do the transaction as a spot transaction. Which is someone would sign a $20,000 check. I would sign the back of the ownership papers, we would exchange the car, and the ownership would exchange. And that's no different than buying or selling a stock on the stock market. But what if the counterparty was saying, you know what I like the idea of buying the car, but I don't know if I want to buy it yet. But I want to enter a contract with you to potentially buy the car from you. So what if the host here approaches me and says, you know Patrick, I'm gonna make you a deal. I'm going to give you $500 if you give me the right to buy your car from you over the next month for $20,000. By you taking the $500, you cannot sell the car to anyone else and you have to guarantee the $20,000 purchase price on the car. Now I'm thinking I was gonna sell the car for 20 grand, now I can make $500 income and over the next month I will find out whether or not I have to sell it at $20,000, what I was looking to get for it.

So what we've actually done is created an over-the-counter transaction of a call option on the car. The buyer, which was the counterparty, paid $500 to me, who I own the car and I have an obligation as a counterparty to sell them the car if they wanted it. In the end, what does the counterparty do? They turn around and list it in the Auto Trader for $25,000 and they see if they can turn around and profit from the car. In the end, if they find a buyer for the car they will come back to me and say, Patrick, I'm going to exercise my right to buy the car from you on the agreed-upon $20,000 amount. And so now that's an example of using just a car.

But we can do this on stocks and exchange-traded funds. And so there is a counterparty where the buyer of that call option has a contractual right to buy the shares at a specific price over a specific period of time. So if let's say Suncor was trading at $40 a share as a stock and I said I want to buy contractual right to buy the stock at $40, but I want three months to decide if I want to buy it at that. It might cost me $2 a share to buy that contract. The seller receives the $2 as income but subsequently undertakes the obligation to have to honour the counterparty deal of delivering those Suncor shares. So we will look at an example of that in a moment with exchange-traded funds.

[Put Options]

There is a second type of an option that contractually has all the same characteristics as a call option. But subsequently has just one very important difference. Rather than it being a contract to secure the right to buy the stock or ETF at a specific price, it's a right to sell it at a specific price over a specific period of time.

Often many people will utilize these put options as insurance on stocks and exchange traded funds they own. Because by paying money, it's no different than me buying insurance on my car. If you think about it, when you pay $1,000 in insurance on your car, what you are doing is synthetically buying a put option on your car that if you total it, you can exercise your right to make a claim to the insurance company to buy the car from you at its value. So you are in a way buying a put option in the same way you're buying a put option on a stock, which is you can secure a guaranteed sale price. So if the stock crashes or if the ETF crashes lower, you're not losing the money, because you've entered a contract that gives you a guaranteed specific price to be able to sell at.

The counterparty, on the other end, received the income from that premium for selling that insurance and subsequently profits from it as income, but undertakes the counterparty obligation to have to buy those shares from you.

[Contract Information]

If you wanted to force that on them. So the best way of doing this example, so let's actually get to some different examples. What are some of the specifics to options? First of all, every option represents 100 shares, at least for the majority of options out in the marketplace they represent 100 shares. So when you are buying or selling a call or a put you have to do it in 100 share increments and so, this is the first key. So what you want to think is that if I buy one call option, on let's say an exchange traded fund like the XIU I am buying a contract that gives me the right to buy 100 shares of the XIU. So if I wanted to have the right to buy 1,000 shares of something then I would buy ten call options, which each represent 100 shares, so ten call options would give me the right to buy 1,000 shares of an underlying stock.

[Options on ETFs]

So in this case options on ETFs, they represent an alternative to buying or shortselling an actual exchange traded fund. You have the potential to profit from the ETF share value increasing or decreasing, but with a limited and definable risk exposure. Those options can be used as protection, as we suggested, because you can buy the put as a way to secure a guaranteed sale price on your stock. But you can also use that option as a way of generating cash flow, or income by being the seller, and we'll illustrate that in example in just a moment.

[Trading a Directional View Bullish]

So let's go into some real examples using exchange traded funds. And so in this case, let's take a view that you're trading a directional view that is bullish on the markets. And you wanted to participate on the upside of a particular ETF, and we're now going to kind of compare what is the structural difference between buying the actual shares of ETF, or alternatively buying a call option that gives you the future right to buy those shares?

[Why Buy a Call Option]

So in this scenario we are going to go through a couple of criteria. First of all you as the buyer of that exchange traded fund, need to believe that the exchange traded fund or the actual stock is actually going to increase in price. You have to have a bullish view and believe that it's going to go higher. In this case you could use the call option as a stock purchasing--stock replacement strategy, and you can utilize it for leverage. So one of the interesting aspects is that in a tax-free savings account, or let's say an RRSP or a RRIF, you are unable to utilize margin, you cannot borrow something on margin in those accounts. But you are actually able to get those registered accounts approved for options. So you can actually synthetically leverage your registered accounts.

By the way, that is not advice, and it is not appropriate for everybody. But options can be used as a mechanism to create leverage in a registered account, if you feel that's appropriate for you. Nonetheless, one of the benefits of course with options, is you can never lose more than the premium paid for the option. So let's actually utilize that as an example. By the way, I do want to point out something that is actually very important to kind of consider.

Options can also be used in registered accounts as a way of strategically locking in the purchase of an ETF before you make an RRSP contribution. So let's just say this is October and you're two or three months away from the new year. Where you know you're going to make a $20,000 RRSP contribution in the new year. So you know in January you're going to make an RRSP contribution, but you really like the market right now in October. And you would love to secure the purchase price of these exchange traded funds or these stocks at this price level.

What you could do in October, is buy a call option that gives you the right to, in January, buy that ETF at a specific price and you buy enough of the call options for the exact amount that you'd be buying of the shares when you make your RRSP contribution in January. So you are not using the option as this leverage tool to speculate. But you're actually using it as a strategic tool to get your exposure into the market in your registered accounts in advance, knowing what things you want to buy, at price levels you want to buy them, well in advance of let's say you making an RRSP contribution.

[Stock vs. Option]

It has nothing to do with speculation or leverage, but you utilizing them as a tool. So in that situation, let's just say we were talking about comparing the idea of buying a call option, instead of buying the stocks. So in this case we are going to use the BMO equal weight banks ETF, which trades on the TSX under the symbol ZEB, and so on the TSX you can go on the Canadian exchange literally like a stock symbol you type in ZEB.

And when you buy this ETF you're buying an equal weighting in all of the major Canadian banks. So it has an equal weight into CIBC shares, TD and all the other major banks all in there in one equal weight basket. So rather than buying all the individual Canadian bank stocks, you can buy one ETF that's like a fund, that holds all the bank stocks within it. So what we're going to now do is do a comparison of us actually buying these ZEB shares versus that of buying a call option on them.

[Buying the Stock]

So let's kind of go through the different scenarios. So in our first example we have Peter here, who is bullish on Canadian banks in this scenario. And is looking to buy 1,000 shares. So at the time of this example, ZEB for instance was trading at $29 a share. So in this case Peter would have to pay $29,000 to actually buy 1000 shares of the ZEB, and he would own essentially a fund that is holding all of these Candian banks in there in one shot. So he doesn't have to go and buy all the individual shares. He can just get all of his bank exposure in one unit this way.

[Buying Call Options]

Alternatively we have Jackie here. And Jackie also is bullish on the same ZEB equal weight banks index. And at the same time the shares are trading at $29. But what now Jackie does, is she turns around and looks at a June, $29 call option, which is listed on the exchange at $0.50. So now remember, it's $0.50 per share. So what we have to do is multiply that times 100 to know it's $50 per call option in order to buy. But what Jackie is securing is between today and June, the June expiration which is the third Friday in the month of June. She has the choice at any point to exercise her right to be able to buy the shares at $29.

Now some of you that have been introduced into options know that some people will trade options. They will buy a call, later sell the call option for a profit and never exercise their right to buy the shares. They are using the option as a trading vehicle in itself. And that's okay. You as traders, traders can trade options this way.

But I don't like to teach it that way. Because what you want to think is that you want to understand the root of what makes an option have its value. And what makes an option have its value is the fact that you contractually have the right to buy the shares at $29, and can exercise your right to do so.

[Buying the Stock]

Now what happens in this situation, because Jackie wants to replicate the exact same 1,000 shares as Peter, so in this prior example, Peter, was trying to buy 1,000 shares at $29 or did by 1,000 shares at $29 and $29,000.

[Buying Call Options]

Jackie wants to buy the same 1,000 share exposure. So she buys ten call options and because each of those call options are $0.50 per share or $50 a contract, she pays $500 for these call options which are actually giving her the control or the ability to buy $29,000 of ZEB shares anytime between now and June. Now these particular options are what we would define as American style options. Which basically means that while Jackie can buy and sell the option any time in the open market, she actually contractually has the right to exercise the right to buy the shares anytime she wants between now and June.

So this could be middle of May, and Jackie can phone up the options desk at CIBC and give the options trader instructions to exercise those options to buy the shares at $29. And those instructions are sent to the Options Clearing Corporation. And the next morning, Jackie will wake up and find 1,000 shares of ZEB in her account at $29. She doesn't get the $0.50 back, so her breakeven actually would be $29.50, the $500 would be a cost. But she can actually exercise her right to buy the shares anytime she wants. This is important to know, because this is what gives the option value in that way.

[Long Stock vs. Call]

So let's talk about the scenario of both Peter and Jackie being right. And the Canadian bank stocks end up doing very well and proceed to rally 5-10% higher. In this case they went from $29 to $31 between now and prior to the June expiration of the option. And so we have a scenario where ZEB or the ETF is now trading at $31, and both of them are right. And now we're just going to compare the difference of what would have happened. So now--so in this first scenario, Peter had 1,000 shares. The first thing we want to point out, well what was Peter's risk? And what we can identify is that Peter's risk is quite undefined. While most people consider Canadian banks to be blue chip, and I certainly won't dispute that on air.

But in the end when we enter a bear market or if they dropped, can we say that they can't drop 10% or 20% or 30%? It's ambiguous. We don't know how to define the downside risk of what you would expose yourself to in owning the ETF. But at the same time, the shares did go up. Because Peter bought them at $29 a share and subsequently owns them at $31, he is currently up $2,000, or $2 per share.

Now Jackie, on the other hand did not spend $29,000. Often I like to think that Jackie did have the $29,000 sitting in her account to buy the shares if she wanted to. Because speculators could obviously leverage themselves considerably. But in this example I don't want this to be thought of as a leveraged unit. In the end Jackie had the money to buy the shares, she just chose to spend only $500 right now to find out whether or not the investment was a worthwhile one to make.

In the end, her risk was defined to $0.50. So if we have one of these events, obviously over the last few months we've experienced some considerable volatility in the stock market and corrections to the downside.

A lot of people are struggling with the downside uncertainty of how low the stock market can go, or how far it can go on the downside. What Jackie knows, is that her risk is limited to that $0.50 or $500. She can walk away, not exercise, and take a $500 loss. But her loss cannot be greater than that. She has a very limited defined risk to that. But at the same time, for being right and the stocks rising, she also has the right to buy the stock at $29 and they also can be sold at $31, when the stock is there, but she paid $0.50 for the call. So she's not profitable by $2, she's only profitable by $1.50. Because she has to take into account the $0.50 cost that came into buying the call option. So she finds herself only profitable by $1,500. Now the speculator in all of us wants to look at this from a percentage return. Which is well she turned a $0.50 option into $2 and made these hundreds of percent of return on her risk outlay, and this is obviously what attracts a lot of speculators to speculate in options.

But I don't like to look at options that way. To me what Jackie did, was she had the same intention of wanting to control the same thousand shares Peter did. But what she was doing is utilizing the option as a risk managed tool from which to express her bullish view on the market, and know in advance what her worst-case scenarios were. And so that's just a different perspective one can use in approaching the idea of utilizing call options as a strategic tool.

[Trading a Directional View Bearish]

Similarly, one can also express bearish views on the stock market. So for the average investor, the idea of short selling stock is something that is intimidating and left to hedge fund managers and other more sophisticated investors.

[Why Buy a Put Option]

But, let's kind of touch on it loosely, because in the end, an investor who believes an exchange traded fund is going lower can buy a put option as an alternative to short selling stock in an attempt to profit from anticipating the stock market actually declining. As well similarly, one can through the use of put options, you can buy puts in registered accounts while at least from the perspective of RRSPs and tax-free savings accounts, you cannot short sell in those accounts. But you can buy puts.

And so while puts can be used for protection, they can also be used as a way of expressing your view that you feel a particular stock or security may decline in its price. The best part of options of course, again, is that your risk is limited to the premium you outlaid, versus short selling has a huge risk because when you short sell a stock, you don't know how high it can go. You don't know how far it can go and therefore you have a very undefined risk.

[Stock vs. Option]

So let's look at this as an example using the XIU. And the XIU is the S&P/TSX60 exchange traded fund. So it's basically the Canadian stock market. And in this situation it's trading at $22.50. And both of our investors believe that the Canadian stock market can decline down to $21, or have a correction close to 5-10% lower in the stock market downwards over the next three months.

[Investor Short Selling Stock]

And both are trying to express a view that the market's going to go down. So in this case, we have John, who is bearish and chooses outright to short sell 1,000 shares of the XIU at $22.50. So he is short the stock--short $22,500 of the stock. Again, I will reiterate that cannot be done in registered accounts or tax-free savings accounts. We are assuming you have a margin account that's been approving for short-selling, in this case for John.

[Put Buyer]

But, now we have Jackie here, who, as well, is in this case bearish on the XIU and believes as well that it is going down. But instead of short-selling the shares, turns around and instead of short selling 1,000 shares, chooses to buy ten June put options at the $22.50 strike. So she is securing a guaranteed sale price of $22.50 on stock she doesn't own. So it's sort of like buying insurance on a stock you don't own and therefore you can cash in the insurance on the stock, even though you never owned it. So in this case it was $0.40 a share. So for a 1,000 shares, it's $400 to buy the put options to actually participate on the downside anticipation of the market.

[Short Stock vs. Put]

So let's once again do a comparison. Let's assume that both John and Jackie are right and the XIU does proceed to decline down to the $21 target. Well, first of all, let's talk about John. He is short $22,000 of the XIU and has a very undefined risk. In the end, if he is wrong and, now he may be using a stop-loss order or some other way to manage the risk, but if he's wrong, and the stock market goes into a roaring bull market and proceeds to go to $26-$27 on the upside, John has an undefined risk. He is losing money by being short the stock, or in this case the ETF, while it's rising. Now at the same time, when he is correct and it does decline down to $21, he profits from the $1.50 decline in the XIU and is profitable by $1,500 from being right about correctly anticipating the stock decline.

At the same time, here we have Jackie, who alternatively chose to buy those June $22.50 put options and chooses to do so for $0.40 or $400. So in this situation, her risk is limited to $0.40 or that $400. So if her view that the stock market was going to decline did not materialize and the stock market rallied, she doesn't have an undefined risk the way John does. Her risk was $400, and in all fairness, she has the risk of losing that entire $400. You can never outlay money into an option that you're not willing to risk. You have to think of that if you are incorrect about the view, the risk of the option expiring at a zero value is definitely there. And so you should only ever outlay the risk component of the trade.

But at the same time here, if she turned around and ended up being right, she profited from the same $1.50 decline that John did. But, so she's profitable by the same $1,500, but she paid $400 for the put, so therefore she is only net profitable by $1.10 come the expiration or $1,100. But again, the speculator in everyone wants to see well that someone turn $400 into an $1,100 profit, and look at it from that kind of percentage gain. But, I don't like to look at it that way I emphasized.

Now, of course what is the one blatant thing you have to accept? Which is that both John, and in the earlier example when we were buying that ZEB for our other buyer of the shares, they are not constrained by time. They could hold that position for six months or a year to see it actually come to fruition. In both of our options examples, the investor that bought these options had three months. They chose to buy something that had a three month time frame, and if in that three months the move did not happen, they have lost their opportunity to profit from it. And so that is another limitation of options is that they are constrained by a certain time frame from which you want to trade.

[Income Strategies Covered Call Writing]

This is why often options trading is often very popular amongst people that use some form of technical analysis. Because they are trying to bridge the gap of is there an opportunity for a move to occur within a period that I have for the option? By the way, I used three-month examples, but I do want to emphasize that the options market in Canada has weekly options. So you can literally buy an option that expires in one week, three weeks, five weeks out, but you can also buy one for several months and you can even buy options that are several years out.

For instance the Canadian bank stocks you can go out and buy an option now out to 2020, giving you the right to buy let's say Canadian bank or something like that. So there are options that have different duration. But what you want to think with options, from a duration perspective, is that you pay for time. And so the longer you want an option to be in terms of time, the more it will cost you for it. So this is about trying to find the right option for the theme that you're building in your idea.

[The Strategy]

So I want to now go into the idea of covered call writing and the idea of generating income using options. So in this situation, covered call writing involves you buying or already owning shares. So in this situation you get paid a premium upfront for taking on the obligation of having to sell the shares at a specific price over a specific period of time. And so in this situation, we are now the counterparty to our earlier example where Peter was buying the call option. We're now the one who is selling Peter the call option.

Like I was trying to explain at the beginning of the presentation, as an investor you can be the buyer of the option as easily as you can be the seller of the option. And so if you feel that buying the option is a silly idea, because it costs so much money, well then you are a fan of selling the call option, because therefore you're profiting from the income generated from the option being sold. But you've undertaken an obligation to secure a sale of a security.

So if you owned an exchange traded fund and you said--this is--I love to use the famous adage of 'Bird in Hand Versus Two in the Bush'. It's this idea--if someone who's a covered call writer, sells the covered call to generate a guaranteed income but forfeits the opportunity to make a capital gain on the stock for a certain income that they're guaranteed to make today. They have given the call buyer the upside potential of the underlying security in return for a consistent income.

[Option Buyers and Sellers]

So let's say in this situation we have Jackie, who is the option buyer, who turns around and pays a premium to buy the call option and in this case pays the money for buying the call to Peter, who sells her the call option and collects the income premium from her.

In the exchange, when we are buying and selling options, while often the market makers facilitate the middleman role on the exchanges, often when a retail investor is selling a call, it is often another retail investor that is on the buy side of the call. Because these options are fungible and interchangeable on the exchanges, you don't know exactly who the counterparty is. But in this example I like to just bridge that connection. A call option can be a contractual agreement between two retail counterparties, using the exchange as the intermediary.

[Why?]

In this situation you can create a static income upfront that provides some added protection, because it reduces your cost base of your investments. Now you do not require the investment to increase to make profits, but you do forfeit the upside appreciation for that certainty of income. So understand, it is not like a Holy Grail thing of this amazing thing, there is a trade-off.

[Option Writing Basics]

Let's use an example. Now, I always want to say when you are the seller of a covered call you physically own an exchange traded fund and you sell a call, giving someone else the right to buy it from you. One of two outcomes occurs. Either "A" the option gets exercised and you are forced to sell your shares, to the counterparty at the agreed-upon price. Think of the example at the beginning of the presentation when I used the example of me selling my car.

In the example, when I received the $500 income in that example of my car, when the counterparty said I want to elect to buy the car, I am now under the obligation to sell them the car at the $20,000 price. And the same example here, I could be obligated to be forced to sell my exchange traded fund, but I do get to keep the income. And this is key, now of course, the counterparty may choose not to buy the shares and the option could expire and you got to keep the income.

[Covered Call Example]

Let's use that as an example. So in this case Peter buys 1,000 shares of the XIU, which is trading and buys the physical shares at $22,000. And sells a three-month covered call at the $23 strike for $0.40. Now, so what has Peter done? He sells the call option, receives $0.40 per share income, but has undertaken the obligation that if someone wanted to buy the shares from him at $23.

Remember, Peter bought it at $22, but has entered a contract that someone has the right to buy it from him at $23. For this scenario what we have is Peter received, literally what you would see in your CIBC account, you would have been credited $400 cash. That would immediately appear in your cash balance of your account, that is your income, that is real as a dividend, for you having entered a counterparty of this contract. Now you have an obligation, if you sell this, you receive $400 income, guaranteed to make. But if the counterparty wanted those XIU shares at $23 per share, you are under the obligation to be forced to sell it to them at $23. Now that means if the XIU rallied to $24, to $25, what price do you have to sell it at? At $23.

So in other words you forfeited the upside potential of the shares, but you did so for a guaranteed $400 income. That $400 income represented 1.8% return in just three months. Now think about that. If you made 1.8% income in three months. Let's say that expired and you did it again and then you did it again and that annualizes near 8%. What happens here, is Peter is generating almost an 8% annualized rate of return of income without actually needing this ETF to rise.

So this is that adage that I said 'Bird in the Hand Versus Two in the Bush'. What Peter is saying, I would rather create a consistent income stream from my shares, and have a certainty of income, then the potential of the upside of the ETF rising and I make a big capital gain. And that's to be debated. Some of you out there are saying 'that's a silly idea, I want the upside'. And another person's saying, 'No I actually would rather have a guaranteed consistent income stream, than the chance of this big capital gain potential'. And that's what makes a market.

So one person sees this as a great opportunity to generate income. Another person wants to use it--the other side of it and say I want to speculate on the upside potential of the gain of the market. Nonetheless, in this situation, Peter is using that as a way of generating returns.

[Strike Price Selection]

So in this situation, we always ask, well where should you sell the covered call? You know they could--CIBC could always invite me back and we can even do a whole webinar just on covered call writing and we could debate the idea of what strike price should you sell covered calls out? Should you do them in-the-money, at-the-money, out-of-the-money, that's actually financial jargon rules we use in the options market for terminology we use for what strike price do you choose for selling the covered call?

And so there are all sorts of theories behind it. Obviously, you will receive the greatest income return by selling it at the same strike price from which the stock is trading. But a lot of people like to sell their covered calls a little bit higher out of the money, so they have room to participate in some capital appreciation before the stock is called away from them.

[Expiration Month Selection]

Nonetheless, what months--obviously you could sell a covered call one year out, you could a sell a covered call that expires next week. Obviously, shorter-term options will actually compound at a much higher annualized number, but they are far more transactional. They'll incur far more commissions. And so it's a trade-off. So you have to look at whether you have the economies of scale, and more importantly, the willingness to be very active.

I know a lot of retirees that will say I'm much more interested in being on the golf course and vacationing on a cruise ship than to be sitting there managing short-term covered calls. And they'll turn around and sell a one-year covered call for a year get a guaranteed income even though it compounds at a smaller rate. But they don't have to manage it, they can go and enjoy their summer and come back and then they'll look at it in the year where they stand. So there are different approaches to this from that perspective.

[Which Approach]

Nonetheless, you have a scenario here that's all about your objectives. Are your objectives more driven by short-term trading or are you just looking for more consistent retirement income. A lot of covered call writers, their objective is very simple. They just want to double their dividend. If they own a series of high-quality dividend paying stocks and they're earning 3-4% in dividends.

If they can, through strategic covered call writing make another 3% over the course of a year in income, now they have turned all of their stocks into a 6%-7% income stream and they strategically try to do it without losing the stock. Obviously, you're always at risk of that. But you know there is all sorts of strategies associated with it. Nonetheless, they're all sorts of really neat ways of approaching this for doing it.

[Conclusion]

[Summary]

Nonetheless, just as a conclusion, I want to just emphasize that there are over 50 options eligible exchange traded funds in Canada. So you don't just have to go to the U.S. markets to do this. Many Canadian ETF's have options available through the TSX and the Montréal Exchange and you can just go to the Montréal exchange website www.m-x.ca, to be able to review all of the different ETF's that are eligible for options on them. Obviously, there is about four or five of them that are incredibly liquid, particularly some of the ones that I covered the XIU, there is the iShares gold ETF, the energy ETF, there's a whole series of these that have very relatively liquid option chains on them. So, there are some really interesting places for all of you to consider as some of the ways that you can add options and ETF's into your investment portfolios.

[TFSA/RRSP Eligible Strategies]

The other thing I wanted to touch on is options are eligible in TFSAs and RRSPs. So, you can turn around and now you do have to get your RRSP or TFSA approved for options. So many of you when you opened your accounts may not have marked off options trading in there so, you have to go to your local CIBC branch or call into the Investor's Edge and upgrade your account to be options eligible. But it is available for you. And so that idea of let's say covered call writing is available for income generation.

A lot of people love to do covered call writing in their RRSPs, because there is no tax consequences to being forced to sell the stock and then buy it back. There's no tax disposition in it, in that tax-sheltered account. So a lot of popular ways of doing that. So there are different types of strategies you can do in there.

[To Learn More...]

Nonetheless, there is amazing resources at the Montréal Exchange for that including a great options blog on one of the option contributors to the blogs at the TMX. Free for all of you to go in there and read all the different things about different option strategies. They're all sorts of option trading newsletters, videos, webinars, trading guides and strategy guides. There's a lot of people ask about the taxation of options.

Montreal exchange provides a free KPMG tax opinion on the treatment of options in Canada, it's like a ten-page report. So all of you can download that for free from the Montréal Exchange.

I know CIBC provides all sorts of amazing webinars like this, but there's all sorts of great resources as well out there, including option simulators and paper trading accounts, and things like that that you can use to practice and get the idea of learning and using options in your portfolios. Nonetheless, this is when we are going to move to questions.

[Q&A]

So, let's open up the floor over here. So, what we are gonna do here, is if any of you have any questions you can feel free to type them into the Q and A.

So one of the first questions that I wanted to address was, they ask, Can I use option spreads in my RRSP? The answer is no. Registered accounts are limited to simply buying a call, buying a put, doing a covered call. So for income. And you could also buy the put option as protection for your stocks that you own. So you could turn around and hedge the downside risks of stocks you own and use the options. But all the more advanced option strategies have to be done in your margin accounts. But you do have basic option strategies that are available to you.

Next question, from Teresa. Are these slides available to review again later? Absolutely, CIBC will be sending out the recording of this afterward, so you can re-review the content at a later time. Next question, what is the best strategy for beginners with small amounts of capital? The one that I would actually ... I mean, you have to invest.

The beautiful thing about ETF's is that you get the diversification in buying one ETF. So one of the big things is that a lot of people want to buy a lot of different stocks, and when you have a small amount of capital it becomes commission intensive having to buy very small positions in there.

But when you think about, if you turn around and buy one ETF, it may have 60 different stocks inside of it so you're getting all the benefit of diversification, like a mutual fund in just buying one ETF. So the benefit of ETF's is that you can turn around and get that and buy just one ETF in a small account. The one lure of a lot of small investors is to use options to gain huge leverage. I usually discourage that, but that's just me.

Obviously, the lure is to speculate with options but I look at options as a strategic tool. And you have to use them in a very smart way. Understand what they are, what you're trying to achieve with them as you are trading.

Next question here is, is the cost of options, for example, $500 tax deductible? Again, David, the tax opinion on the treatment of options, there's a KPMG tax opinion at Montreal Exchange. Actually, one of the simplest things to do rather than navigating through the Montréal Exchange publications, you can just go to Google and literally type in Montréal Exchange and then put KPMG tax opinion Canada. And when you do so, it will automatically take you to the publication on the Montréal Exchange website. It will explain all of the tax treatment in Canada for all of these options.

Next question, are option premiums a fixed dollar amount per share? Or does it change value? Option premiums are based upon the implied volatilities of the stocks. So for instance, BlackBerry will have a much higher volatility premium than let's say BCE. Because what happens, stocks that are less volatile will have a lower implied volatility and the options will be cheaper on a relative basis. While a stock that is more volatile will have more expensive options.

The next question here is, is 1.8% a typical three-month covered call premium? Again the option markets are dynamic and they're always changing. There is active price discovery. If you, for instance, are covered call writing on a more volatile ETF, let's say you take the gold miners ETF. It naturally has a much higher implied volatility, you will be compounding at a much higher percentage return for covered call writing there than if you take let's say equal rates bank index because bank stocks tend to be less volatile, having a lower implied volatility means you will make a lower percentage return. So think of it as risk-adjusted return. Think of it ... those things you're making a higher covered call income on are also riskier.

The market is very good at adjusting for volatility within the markets. Is the PowerPoint available itself? Yes. The PDF's slides are going to be available for all of you to download, absolutely. Are the commissions on option buying the same as they are for stocks? I'm going to ... Did any of you guys want to answer that?

[Host:]

It is available on our website so if they go in and look at the fees and commission schedule it's available there.

[Speaker:]

Andre, you can go on to the website and see the different commission structure for options trading for your portfolio. Now if you are the seller of options do you actually have to own the stock? That's a very good question.

To be the seller of an option, a covered call let's say, it's not covered if you don't own the stock. The whole point of the word being covered call is you own the shares and you sell a call against the shares that you own.

If you sell a call option and generate the income, but you don't own the shares, in the industry we call that a naked call. Now you need to have a special options approval and special margin rules associated if you wanted to do that. It is usually considered higher risk, obviously, in that manner.

But it is something that you could theoretically do. But it is certainly not available in registered accounts. So what happens if you are out of the money in the account? I'm not sure what you mean by that, Maria. I will move on, if you can clarify what your question is a little bit there.

Jeff, do in the money option prices automatically fluctuate based upon the stock or ETF price? Absolutely. Jeff, because an option can be exercised any time, the option at any one moment has to reflect its intrinsic value. If it does not, it gives the opportunity for arbitrage and the ability for someone to harvest free money from the market. And so then because the market is not in the business of giving away free money, the option is always going to reflect its intrinsic value, so yes to that answer.

Next question, is it wise to stay within Canadian market, or extend to U.S.? Look, the U.S. markets are very large and they also have a lot of liquidity associated with them. But the moment a Canadian goes out of the Canadian market to the U.S. market you are dealing with exchange rate risks and all sorts of other added variables.

So those of you that have a Canadian dollars and Canadian accounts, and you don't want to have exchange rate risks and things like that, staying within the Canadian market and Canadian dollars is definitely a choice for you. And so that is just the benefit of having the versatility of going from one to another. We are going to have to wrap up things here.

[Host:]

Thanks again, Patrick. It looks like that's all the time we have for today, we have to wrap up. In case-- For those who would like to have the PowerPoint, you can just-- on our Contact Us on our website, there is an e-mail address available and you can e-mail us and we would be more than happy to send you the PowerPoint by e-mail.

Patrick, I'm sure I speak on behalf of the audience that we thoroughly enjoyed listening to you today and your insight. Thank you for such a great presentation, and your precious time. On behalf of CIBC Investor's Edge I would like to thank the audience, we really appreciate you being here.

Should you have any questions, comments please visit our Investor's Edge website or please feel free to get in touch with us by phone, chat or e-mail. Thank you for joining us today, and we will see you next time.