Minimize Losses And Profit From A Recession Using Options
Jason Ayres
May 29, 2019 12:00 pm to 1:00 pm ET

[MINIMIZE LOSSES AND PROFIT FROM A RECESSION USING OPTIONS WITH JASON AYRES ] 

Hi everyone, my name is Jason Ayres, I'm the director of market specialists by designation and of course Montreal exchange options instructor. And we're gonna be discussing what I think, and hopefully you guys this is a relatively timely topic, which is really a focus on minimizing losses and profiting from a recession utilizing options. 

[DISCLAIMER] 

[Jason Ayres] : 

And so with that in mind I just want to make sure that everybody recognizes that this is for educational purposes only, the information that we're gonna share here today is really meant for you to just digest and sort of move forward with and educate yourself on, and then subsequently apply, let's say, in a trading simulator first, and the subsequently into your live trading account and so remember that the options market, not unlike any financial security, does carry with it risks, and you just gotta make sure that you know what those risks are before you start trading. 

[AGENDA] 

So that being said, let's take a look at what we want to accomplish for the next little bit, so I want to first touch on what exactly a Recession is, for those of you that have seen that across the headlines but maybe not 100% sure how that's going to conceivably impact the markets. We wanna just help you understand that a little bit more effectively. 

What can we possibly expect? And then we'll tie that into just what an option is, and how can we use them to manage through a recessionary period. We'll look at trading a directional view utilizing options, and we'll look at risk management and hedging utilizing options, then we'll try to tie it all together. 

[WHAT'S A RECESSION?] 

So to get things started here, let's take a look at what's a recession is. 

[DECLINE IN ECONOMIC ACTIVITY THAT LASTS FOR AT LEAST 6 MONTHS] 

So, really a recession by definition, is simply a decline in economic activity that lasts for at least 6 months. Now, many of you would agree that apart from fourth quarter last year, investors, since 2008, although there have been a few hiccups along the way, have seen some fairly robust periods within the market, and returns have been fairly attractive because we've been in a period that has been really supportive of business growth and development, and of course, a lot of it has to do with being in a low interest rate environment. 

When the powers that be, economists are really looking at determining whether or not we are in a recession, or heading towards a recession, they look at several economic indicators. So one is real GDP so, Gross Domestic Product, what is a company producing and ultimately exporting, income for people in the work force. Are people's incomes increasing or decreasing, or staying the same based on the cost of living? Employment. 

So what do the employment numbers look like? Are more individuals working or are people out of work, that sort of thing, and then manufacturing. So, are companies running at peak capacity? Is there a large demand for the products that are being manufactured so the products that go into the manufacturing of certain things are in high demand and then retail sales. Are people spending their money? 

So basically economists are watching these numbers on a month over month basis, and then using those numbers to ultimately determine whether or not the economy is running on all cylinders and whether or not it's slowing down. Of course the concern is that the economy is cyclical and a recession is actually a part of a normal business cycle that although is unpleasant, is something that we have seen in the past it's something that we'll most certainly see in the future. 

So the business cycle generally follows a fairly simple path. You have your expansion, you have your peak, you have your recession, depression, trough, recovery, expansion, peak, recession, and so on. And so this is something that historically economists have been able to track, now the timeframe for which each of these lasts can be different of course, but ultimately, where we need to be somewhat considerate, is at what point on the business cycle are we at presently, and that if one assumes that we've seen a peak, then we need to be prepared conceivably to deal with a recession. 

[POSSIBLE CHALLENGES] 

So, with all that in mind, what a recessionary period brings forward as far as challenges, is the risk of a rise in unemployment. So companies slowing down production, being concerned about their expenses, laying off people in order to stay in business. People lose their jobs unfortunately, and then have less money to spend and put back into the economy and so on. 

To tie that in, consumer purchases drop so people again, lose their jobs they're concerned about the economy, they stop spending money so consumer purchases drop, that impacts businesses, so businesses conceivably have the risk of going bankrupt, it's tough to find jobs out of school. It's hard to do that as it is right now, but if there is a hiring freeze, because companies are shuttering themselves because there's a risk of a slowing economy, they're not going to be hiring people out of school, and then ultimately housing prices fall. 

So what you see is a situation where that impacts the stock market. Growth prospects slow, so what are the things that we look for when reviewing company fundamentals and analysis reports, earnings reports, not so much what has a particular company done, quarter over quarter, but what are the forecasts moving forward? 

Is there an expectation that things are gonna slow for the business, or is it business as usual. So what ultimately ends up happening is forward guidance lowers. Remember the stock market is priced based on the future. So forward guidance is a mechanism by which CFOs of companies will actually try to communicate their expectations so we watch publicly-traded companies very closely when it comes to their earnings reports as to how they're issuing their forward guidance and again, markets will move, based on that consideration. 

The other important consideration is that as an investor who has participated in a market where it’s been onward and upward for an extended period of time, as soon as there's a bit of concern that things are gonna slow down, profits get taken and one of the things that we've seen in the past is that the more people take profits ...the more people take profits.

So in other words, as markets and share prices begin to drop in value, that creates a self-fulfilling prophecy in the sense that the lower the market goes, the more people sell, the lower the market goes and so on. What happens is investors start raising cash out of fear of necessity. So somebody loses their job for example, they've been saving, they've got an RRSP, TFSA, what have you, they've been investing in when they were gainfully employed, then all of a sudden they're out of work. 

Well, they need to draw on those savings in order to maintain their ability to pay the bills. So it's not because they want to get out of the market, but it's because they have to get out of the market and finally, what you'll see is stocks become volatile due to the uncertainty, and I think it's safe to say it's what we've been seeing since the beginning of fourth quarter last year it's just that volatile day to day price action, where one day you're down significantly, the next day you're up significantly and so on and so forth. 

So that volatility is in fact a byproduct of uncertainty, and you can kind of see how all of these observations, concerns and considerations tie in to one another and ultimately influence our behavior and subsequently how that behavior influences the stock market. 

[WHY THE CONCERN NOW?] 

And so why are we concerned now? Again, anybody that has been following the media and it's pretty hard not to. Every time you turn on the TV or you open up twitter, or any of the media outlets you're seeing headlines, and again it's probably safe to say that a lot of the market volatility that we have been seeing has been based on headlines, whether it's Trump tweeting out of the Whitehouse, or whether it's economists forecasting a slowdown, but ultimately what we've been seeing are headlines around trade and tariff concerns. I think it's pretty safe to say that this trade and tariff concern is probably continue for a while, given the fact that you haven't really seen concessions on either side between Trump and Xi over the last while. A general concern for the global economy at the end of the day nothing lasts forever. Markets go up and markets go down and at some point I use the analogy of an elastic band you can stretch it so far, but at some point, the pressure to come back is overwhelming. 

The final point here is the yield curve inversion that we've seen in both the Canadian and US bond markets. That's probably been one of the more recent concerns that investors have been trying to digest over the last couple of months. I think that first inversion was back in March and we've seen interest rates taken other twists today, which is another reason why US markets are down. 

[WHAT'S A "YIELD CURVE"] 

What the heck is a yield curve? Many of you may already be aware of how this why people are concerned about this, it does still amaze me, you see this in headlines so much, but how so few investors understand the implications of the yield curve and why investors and money managers are watching it. The yield curve tracks the difference between interest paid or the "yield" on short term bonds versus longer-term bonds. What happens is normally longer term bonds pay investors more for tying up their money for longer. 

That makes sense. The idea is if you expect an investor to lock their money in, you need to make it worth their while. So those longer term bonds will pay a higher interest to encourage investors to lock in for a longer period of time. Because of this, longer term bond yields are typically higher than shorter term, right? So a shorter term bond is gonna pay interest, but because the investor can get out of it in a reasonably short period of time and move that money into something that may be a little more attractive it doesn't pay as high. Because of this, longer term bonds yield a higher premium or interest than shorter term. 

[WHAT IS A "YIELD CURVE INVERSION" AND WHY DOES IT MATTER?] 

Now, what is a yield curve inversion and why does it matter? Well, when investors are concerned about future economic growth, particularly in the stock markets, they'll pull their money from stocks and they'll buy longer term bonds. This is where that concept of supply and demand comes into play. If there is a greater demand for a certain product, the value of that product will increase in bond market, what happens is when the demand for these longer term bonds increases, it actually decreases the yield. So the face value of the bond increases, and the yield it's paying decreases. When more money flows into longer term bonds, the bond price increases, and the yield on that bond decreases. 

[WHEN THE YIELD ON THE LONGER TERM BOND DROPS BELOW THE YIELD OF THE SHORTER TERM BOND THE CURVE IS SAID TO BE INVERTED] 

So what you ultimately have happen, this is a snapshot of the yield curve inversion in the Canadian markets back on March 26, you'll see in the blue we have our longer term 10 year government bond the 10 year note, and in the black, you'll see the Canadian government bond, which is the 3 month bill. So you've got your longer 10 year note, you've got your shorter 3 month bill, and what you'll notice here, is that you have a spread differential between each. 

And that spread that you see there, is reflecting the difference between the yields. And so the idea is that the longer term 10 year note yield should always be in a strong healthy economy, higher than the shorter term. You'll notice here on the 26th, you've got that inversion. You can see that dip below that black line there and that black line is in fact the inversion. 

So this is where investors and money managers were watching this and saying, "oh no, you've got more money moving into longer term bonds, so ultimately coming out of the equity market because the risk of a decline there is significant and moving into longer term bonds where it's safe". 

So from a psychological standpoint, investors are more comfortable in the longer term bond getting less return, because that lower return is still a return, versus the expectation in the stock market, there may be a lower return to even a potential loss. So therein lies the yield curve inversion. 

[IS A RECESSION GUARANTEED?] 

Now, is a recession guaranteed? Well, absolutely not. While the inversion is seen to reflect the investors lack of confidence in the economy, it historically has preceded a recession, it doesn't mean necessarily that that is going to happen. The last yield curve inversion, and this is why the markets are spooked, was back in 2007, and I probably don't have to share with you what happened a year later, the big global stock market crash. 

So psychologically, investors and money managers step back and look at that yield curve inversion, they look at what the economy has done historically after that inversion, and they begin to get concerned. and it comes down to a chicken and the egg scenario, is it the yield curve inversion signals a recession, or is it the risk of a recession that signals that yield curve inversion and subsequently, it's a psychological consideration a self-fulfilling prophecy so to speak. 

At the end of the day, it doesn't matter. What we want to recognize, is that there is a risk, there's uncertainty, there's concern, and what can we do with our portfolios to manage that. Now, to tie this back in again, is a recession guaranteed? With central bankers controlling interest rates, which is a key driver to growth, a recession is not necessarily guaranteed. 

So you've got central bankers both US and Canadian and European that have the ability to maintain low interest rate environment. What we want to recognize is that cheap money can go a long way in driving growth in an economy. So there are some outside influencers that can help mitigate or help offset the risk of a recession but at the end of the day, it's still something we want to recognize is a concern. 

[HOW CAN THE OPTIONS MARKET HELP MANAGE THE UNCERTAINTY?] 

So, how can the options market help us manage the uncertainty? Really at the end of the day, that's what options are all about. It's really about being able to build strategies that help us mange for uncertainty, or take advantage of uncertainty. 

[WHAT'S AND OPTION?] 

So a couple of key points around the options market. First of all, the options market is a derivatives market, which means that the option price is derived from, among other things they value of an underlying security. It is a contract that represents a rights and obligations, and so we have an opportunity as the user of the options market, to determine what our objectives are, and ultimately what strategies are going to make the most sense for us to implement and ultimately decide, do we want to secure the right associated with buying or selling a particular stock, or are we interested in getting paid to assume an obligation? So these are choices we can ultimately make once we have an idea as to what we think an underlying security is going to do. 

[PUT OPTIONS] 

Now just to give you guys a bit of a high level outline of the difference between option and contracts we can use Two types we can use to trade our directional views to meet our objectives. We can use put options, and you can be the buyer of a put option or you could be a seller of a put option depending upon what your objectives are. For the purposes of todays' presentation, what we're going to be focused on, is the idea of being an option buyer. 

The put option buyer pays a premium and secures a right and that right is to sell 100 shares of the underlying security for each contract that is purchased. So the key take away here is the put buyer has the right to sell 100 shares for each contract purchased. So each contract has a 100 unit multiplier and the buyer of a put option has a right to sell those shares at a specific price. We get to choose the strike price which is the price at which the shares can be sold and we get to choose the duration at which this contract is valid. 

[CALL OPTIONS] 

Now, the second option contract that we're gonna be looking at is the call option. Now the call option buyer pays a premium and secures a right, but that right is to buy 100 shares for each contract that's purchased. So again, the call buyer pays a premium secures the right to own 100 shares at a specific price, and that right is limited for a specific period of time. 

So the underlying characteristics of each contract involves selecting a strike price, which is the price at which the shares can be bought or sold, and it also involves selecting an expiration date which is the date until the contract rights and obligations are valid. 

Now this is where things may be starting to get a little complex, but the main take away here is that we are buying contracts, those contract have a specific set of criteria, and we choose what that criteria is based on what we’re trying to accomplish. 

That is, where do our rights lie, as far as the underlying stock, and also, how long are those rights valid for. To reinforce once again, the contract multiplier is 100. So if you're looking at an options prices, as presented in what's referred to as an options chain, you might see that that's price listed as 1.25 or 1 dollar and 25 cents. Well that's per share, and because we have a 100 unit multiplier, that means that the cost is going to be $125 and so on and so forth as you can see in the table here. 

[HOW CAN I USE THEM?] 

So let's look at how we can use them and this ties into going into an environment, where there may be risk and uncertainty. So as the option buyer, we actually can trade a directional view with a limited and identifiable risk exposure. No I'm going to give you some examples as we move forward. We can use options to generate income. So if we are in a market environment, where the stocks are going sideways, the options market can be used to generate cash flow when capital appreciation is limited or non-existent because things are slowing down. 

And then finally, and most importantly, for the topic of today is risk management and hedging, and that risk management actually ties into trading our directional view with a limited and identifiable risk exposure. But we can actually build strategies into our portfolio that will help us identify and manage risk effectively and hedge against the uncertainty that may accompany a recessionary period. 

[TRADING A DIRECTIONAL VIEW] 

So let's look first are trading a directional view. 

[TWO WAYS TO PARTICIPATE IN A BULLISH OUTLOOK] 

So when we are considering trading a directional view, let's first consider the idea of a bullish outlook. We've talked a lot about how a recession tends to be negative for the stock market, in which case, we only expect that the only direction is sideways to then down. 

Recognize that there may be opportunities within that environment that have the potential to go up. They may be outliers, they may be inversely related to the broader market and you want to be bullish, you want to be an owner of those stocks or you may feel we're coming out of a recessionary period and you want to be confident in perhaps picking what you think is maybe the bottom of a stock that has been selling off. 

So let's look at a couple of examples here. The first one we're gonna look at buying the stocks. Let's assume that we're looking at XYZ, it's trading at $45 per share, and we're gonna buy 1000 shares of that particular stock. Now recognize that we're gonna pay out $45 000 for that and let's not consider margin, or any of that stuff, let's just recognize that if you wanna buy 1000 shares of a stock that's trading at 45 bucks, you're going to put up $45 000. 

An alternative to that as an example, would be we could go to the options market and instead of buying the shares, we could buy a call option that gives us the right to buy those shares. The consideration here, is we have to choose a strike price. So we're gonna look at the stock trading at $45 we're gonna look at what's available on this option chain as far as strike prices, we're gonna see there's not a 45, but there's a 46, which is relatively close. We're also gonna look at the expiration months available. We're gonna stare back and say, "Okay, I think that these shares are gonna go up in the next 3 months, so that's the timeframe I want to trade within." 

So I'm gonna reinforce the importance that that 3 month expiration selection, is an example. When you're looking to choose the expiration date of an option contract, it has to be based on what your expectations are for the underlying stock. It could be 1 month, it could be 3 months, it could be 6 months, it could be a year. 

That's something that you'll have to make that determination based on the characteristics of that underlying stock. Now in this particular example, this option contract is based at $3 per share, but we know that each contract give us exposure to 100 shares, so that's $300 per contract and we're gonna buy 10 contracts because we know each contract representing 100 shares, we would need to buy 10 of those contracts to simulate a similar exposure to this share position. So 10 contracts gives us exposure to 1000 shares, that gives us the right to buy 1000 shares at $46 over the next 3 months. 

So what we really want to see happen, is we want to see this stock take off and move higher so maybe it goes to 47, maybe it goes to 48, 49, 52, 55, so that the value of the call option appreciates and we can close that out at a profit. So we're gonna pay out $3000. Now the first thing you want to consider is the stock position has us putting up $45 000. The options has us putting out $3000. 

[ABC SHARES HIT $55.00 TARGET BEFORE EXPIRATION] 

Now, let's compare the two positions. I'm gonna assume we have a target at 55 and it hits that target before expiration. So remember the stock investors bought 1000 shares paid out $45. Now the risk on that position is $45 per share. It's based on the total price paid. That's assuming this stock just keeps going down down, down, down, down and goes to zero which may or may not happen, but recognize you have an unlimited risk exposure when you buy these stock positions. Now on the upside, if these shares hit the target, you actually make $10 per share. 

So for that $45 000 initial investment, if the shares hit that target within that timeframe, you've made $10 per share, or a $10 000 profit. On the other side with the call option purchase, again we bought ten 3 month calls with a 46 strike, we paid $3. So you want to recognize our maximum risk is limited to $3 per share. And we calculate the actual cash allocation as the premuim, which is $3, times the 100 share multiplier, times the number of contracts. So $3 times the 100 share multiplier, times 10 contracts, gives us $3000. So that $3000 in this example gives us out maximum risk. 

So the consideration for using call options as a bullish stock replacement strategy in a recessionary environment is that you can take a decisive position stock in a market that may in fact be bearish and you can do that with a limited and identifiable risk exposure. So you know what risks you're taking before you go into the trade. Now if the shares go up as anticipated, we as the call option buyer are up $6. Now you're saying, "Well why the heck are we only up $6?" Well, what we want to recognize is that the stock is trading at $55. We have the right to own it at $46. So the intrinsic value of that option contract is $9. 

But we actually paid $3. We paid the option seller three dollars. That $3 is time value. So on expiration, that time value is gone, that goes to the option writer. What that leaves to us as a profit, is the $6000, or $6 per contract. So when we compare the rate of return, for the stock investor, you've got a 22% rate or return on your risk, so you've made more. You've made about $4000 more as a stock investor but based on the risk that you've taken on, it's about 22% the return rate of risk. Whereas the call investor has made less, but the return on risk has about 200%, alright? So you're able to leverage your capital with a limited and identifiable risk exposure you're making less based on a similar move by a stock investor, but you've done so in a much more attractive way based on the fact that you're putting out less capital and risking less capital if your stock moves in the opposite direction. 

[TWO WAYS TO PARTICIPATE IN A BEARISH OUTLOOK] 

Let's move on, we're gonna have enough time for questions at the end of this, so let's move on and take a look at the bearish market environment. Most investors are preconditioned to participate in a bullish environment when stocks are going up, so everybody thinks the only way I can profit is if shares are appreciating. But more sophisticated investors realize that they can short sell stock and in fact make a profit when the market goes down.

So let's compare two ways to participate in a bearish outlook The first is we're gonna short 1000 shares of our stock XYZ at $42. Now, we're gonna bring in $42 000 we're adding a credit to our portfolio, but keep in mind, we have a margin requirement. So basically, at any point in time, if we're on the wrong side of this trade, if shares go up in value as we're gonna see in the example, we gotta give that money back and then some, to close the position. The brokers are gonna watch very closely as to what's happening in your portfolio. 

And the other thing that I would reinforce, is you can't short sell stocks in a registered account. But you can buy put options. So the alternative to short selling shares, 1000 shares at $42, is we could actually go to the options market. We could give us an option that gives us the right to short those shares at $42 and as the share value drops, the right to sell them at that higher price, becomes more attractive to the market, and that's ultimately where we can generate our return. 

So in this case, we're gonna look at a 3 month $42 strike option. Again, the expiration month selection is based on the expectation on the underlying stock. How long do you think you need to get that stock to move sufficiently enough for you to profit? Some stock move very quickly, others not so much. You wanna make sure you give yourself enough time. In this case the option price of that contract is $2.20 per share times the 100 unit multiplier is $220 and because we're looking to mimic 100 shares of the underlying we're gonna buy 10 contracts. 

So what we've done is bought 10 put contracts that expire in 3 months that give us the right to sell, or short that stock at $42. We're gonna pay out $2200. 

[XYZ SHARES HIT $37.00 TARGET BEFORE EXPIRATION] 

Now, when we compare the two positions, the stock investor has truly an undefined risk. That stock keeps going higher, our responsibility as the short seller is that we have to buy to cover. So the higher that stock goes, the more it's gonna cost us to cover the position. So again, just a quick example, if we short sold the stock at $42, and those shares go up to $45, we have to give those shares back to the rightful owner at the market value. 

So we collected $42, but we have to give them back $45 or $48 or $50, or $55, whatever the stock is trading at we have to cover, so either we're gonna have enough money in our account to cover our margin requirements, to cover that risk, or the broker's gonna say, time to shut down this position because you don't have enough money to cover your obligations to return those shares. 

So undefined risk, but if those shares drop as anticipated, and XYZ hits $37 before expiration, the short seller makes $5 or $5000. Well how's that possible? Well, they shorted the stock at $42, they buy cover, the buy it back to cover at $37, they keep the difference, right? They bought it for $42 000 they send back out $37 000, and they get to keep that difference, that $5 per share, or that $5000. Now on the put buyer, again 10 contracts, 3 month expiration, $42 strike puts, paid $2.20 per share, or $2200, their risk is limited to $2.20 per share. 

Once again, it's the premium that they paid, it's $2.20 per share times 100 share multiplier, times the number of contracts, so that's $2.20 x 100 is $220 x 10 contracts, is $2200. Now, again, they have the right to short the stock at $42 and in the market, those shares are now trading at $37. So there's a $5 intrinsic value associated with that put contract. But the put buyer paid $2.20. 

So the put option seller gets to keep that $2.20 because "hey, they're gonna fulfill their obligations, that's what they signed up for, so they get to keep that premium." When you take that out of the overall value of the option contract, the net profit to the put investor is $2.80 per share. 

Once again, you'll recognize that the short seller has generated a greater return, however, the risk adjusted return on the short seller is 12% vs 127% for the put option seller. So two different ways to participate in a directional bias and one might yield a higher monetary return, in the event that you're right about the direction however the other offers a limited and identifiable risk exposure and a higher percentage rate of return within a time frame selected. 

[CONSIDER] 

Now, a couple of really important considerations here. The stock buyer and the short seller do not have a time limit. So provided you're able to maintain your margin requirements or maintain your position, you can hold that stock as long as it stays in business. So as long as you think it's a good trade, or until you can't meet your margin requirement, you can go as long as you want. 

However, the option buyer has a time limit and risks a loss on the expiration date if the share price does not move sufficiently. So what this basically means, is that if you as the option buyer haven't given yourself enough time to participate in the opportunity well, you may have to incur a loss on that position and reassess and reevaluate and ultimately determine whether or not you want to try again or find another opportunity. So there's a couple of really important differences to consider. You have to manage for the time depreciation associated with utilizing the option as the option buyer. 

[RISK MANAGEMENT AND HEDGING] [THE STRATEGY] 

So here's the strategy, you buy or already own the shares. So you may have a basket of stocks within your portfolio What you're gonna do is you're gonna buy a put to secure the right to sell the shares and what happens is as the shares decrease in value, that put option increases in value, offsetting a portion of the loss. So it kind of like stock insurance. And this means you are fundamentally bullish on the stock, and you're just looking to add a little insurance as a precaution. 

[EXAMPLE] 

So let's take a look at an example of an investor, who's bullish on the stock, but wants to participate with limited risk exposure. So again, where this may come into play, is we're entering into an uncertain recessionary period you still think at stock looks good to the upside, but you're just not sure, you're gonna add a little insurance policy and this is the strategy that you could use. So the stock XYZ, the share price is $80, you think it's gonna go up to $90 over the next 4 months. 

[STOCK PLUS PUT OPTION] 

So you are going to buy the stock, buy 300 shares at 80 bucks, you're gonna put up $24 000. Now you're the shareholder. You're gonna then go to the options market, and you're gonna buy a put option that's gonna hedge your risk in the next 4 months, and it's gonna give you the right to sell those shares at $80, so the price you pay regardless of how low it goes, so you're gonna pay $2.50 for this put insurance, right? So there's your premium, just like your car insurance. 

You wanna manage your risk as a driver you're gonna pay a premium, so that put option premium is your insurance policy premium. you're gonna buy 3 contracts, right? Because that basically covers you for 300 shares, and you're gonna pay $750. So that is the cost of insuring your position over the next 3 months and the rationale here is that you feel the risk on the position is much greater than the cost of the insurance policy. And again, here just think of it like you're a driver. 

The risk of what you would have to pay if you get into an accident is far greater than that premium you pay on a monthly basis so that's the rationale for the put buyer you think your risk is greater than the cost of the put. But you still think there's a possible benefit to the upside. 

[MAXIMUM RISK] 

So, what is your maximum risk? It's the premium you pay for your put option that is what you would call a sunk cost, plus the difference of the strike price of the put, and the purchase price of the stock. In other words, in our example, because we bought the stock at $80, and the strike price is $80, our maximum risk is the premium we're paying for the put option. But if we bought the stock for $80 and we bought the put option at the $75 strike, then the difference would be between the strike price and the purchase price of the stock, $80 minus $75 strike gives you $5 plus the put option, which is the $2.50 so your maximum risk would be the $7.50 and we have a choice of what we select here, and again, it's just depending on what our concern is for the market. 

If we're really concerned, we might buy a put strike that is close to where the stock is trading. If we're moderately concerned, we may go lower, in what's referred to money and pay less because we don't think the risk is as significant as it could be. 

[THE TRADE] 

So, let's look at the trade here. We paid 3.13% premium for a guaranteed sale price of $80 over the next 4 months. So when you think about that, our maximum risk, in taking this position over the next 4 months is 3.13% We actually have all of the upside for that stock, plus dividends so we've got a defined worst case scenario.

So think about that, we're going into recession, we still want to take a decisive stance on a stock that we really like We can actually build this hedging strategy around it and benefit from the upside, but we can sleep at night, knowing we have a defined risk exposure. 

[TYING IT ALL TOGETHER] 

Now, when we are looking to tie this all together again we got room for questions here, there's a few thing we wanna take into consideration. 

[A RECESSION IS NOT GUARANTEED BUT THE RISK RESULTS IN MARKET UNCERTAINTY AND VOLATILITY] 

We wanna make sure we recognize that a recession is not guaranteed, but the risk of a recession results in market uncertainty and volatility. And at the end of the day, that's really what we're trying to manage for It's the uncertainty and the volatility. 

So these options strategies that we've talked about here can actually help us define our risk and manage in a more volatile environment but the bottom line is, we wanna use these options as a tool along with a trading or investment plan we don't just wanna go into the options market and start indiscriminately using these strategies just for the sake of using them, we wanna step back and think where can we apply these strategies most effectively. 

That means that considering we can trade a directional view with a limited capital and an identifiable risk identifying your risk exposure in an uncertain environment is a powerful place to be. We can actually own stock with down side protection.

So that also means if you've enjoyed the upside on a stock for a period of time, rather than just closing that position outright, you can stay invested, but integrate a protective put lock in your profits to date, and ultimately if the market continues higher, well you're gonna keep profiting less the premium. 

If the market turns around and drops, well, you've locked in your profits less the premium and you've done a great job at managing your risk. Where I think this becomes another extremely important consideration is in helping you managing your emotions when you are invested in an uncertain environment and every day you are waking up and you've got headlines that are saying this and you've got markets that are doing that, it can be stressful. 

So when you start integration options as a way to define risk and manage risk, and as an alternative to participate in a market you sleep better at night. You feel better about being invested, because before you click the trade button, you already have your defined risk exposures set out, there should be no surprises. 

And the final point that I would make, before we look at answering some questions, is that these strategies that we've discussed here today as well as a few income generating strategies available to us are permissible in registered accounts. So those of you who are doing this in your tax free saving account who are doing this in registered accounts, that are managing actively, you can employ these strategies within those registered accounts to protect and preserve your capital and to trade a directional view on a stock, whether it's bullish or bearish in an uncertain market environment. 

[TO LEARN MORE] 

So on that note, just a couple of references here to check out that the Montreal Exchange provides. We've got optionmatters.ca, which is a blogspot, so you can read short and timely blogs on various strategies applied to current market conditions videos and webinars, trading guides & strategies option calculators covered call screeners options trading simulators, and a really cool screening tool called options play, which you can go in and put in a stock and take a look at some ideas that may be of interest as far as an options strategy overlay. 

And what's really neat about this, is you're trying to understand the implications of these strategies we've discussed is it actually will outline and refer to risk reward profiles so you can see, "Well, if I do this, what's my maximum risk? What's my maximum reward? Is this worthwhile executing on? So take some time and check that out. 

[THANK YOU] 

So, before we get to some question, I'll just thank everybody for joining in this afternoon. Again, I’m not sure, as I mentioned earlier on in the presentation we were having some challenges with the audio, I wasn't hearing the guys on their side, so maybe guys at home base, you wanna just do a quick check, and let's hear if you're back online [thanks for that, Jason, that was a very insightful presentation] [I just want to double check that we can hear the audio from this end] [Jason, are you there?] [Jason Ayres]: I am hearing you guys, yes, you guys thank you for the confirmation. 

[male moderator]: 

So we would like to answer questions from the audience. Please take the time to type in your questions on the lower right hand side of your screen. A last call participants to please keep all questions relevant to today's presentation as well as not ask questions about specific securities as recommendations cannot be provided. 

While we wait for the questions to come in, I'd like to point out that CIBC investors edge clients have access to our knowledge bank where they can take advantage of our free resources. You will find the knowledge bank tab on the left side of the screen once you have logged into your investor's edge account. 

The knowledge bank has videos, articles, and past webinars on a variety of subjects related to the economy, and the markets. You can also register for upcoming webinars as well as access and subscribe to our quarterly newsletter to get the latest up to date information on financial markets, the economy, and personal investing. Now I'll pass it back to you Jason, to answer any questions. 

[QUESTION & ANSWER] [Jason Ayres]: 

Right, yes, so first question that we've got rolling I think you're covered a couple of them that were asked about the presentation availability and such. But am I sure we can do put options in a tax free saving account. Absolutely. You may have to connect with your contact at CIBC to enable your account to access options which is something the guys can share a little bit more on, but you can buy puts, you can do protective puts, so you can buy puts to speculate on a bearish direction, you can buy puts to hedge against a stock position, you can buy calls to speculate on an upside opportunity, you can do covered calls to generate cash flow, and you can also do what is referred to as a caller's strategy, to generate cash flow and also hedge your downside risk on a stock within all of your stock registered accounts. 

So hopefully that helps answer that question on leap options, which are longer term options the duration you select as far as the expiration date of your option contract is gonna be based on your outlook. One strategy that is relatively common in non-registered accounts is, you buy a leap or a long term option contract on a stock that you wanna hold, but you don't wanna put up all the capital, and then you can sell short term options against that in what's referred to as a covered leap it's kind of like a covered call, only you're using a longer term contract to participate. 

Your expiration selection is gonna be based on your expectations for the stock, and how you want to participate. Can you do options in a Lira? Options depending upon how your account is structured all registered accounts are options eligible, limited to those strategies that I mentioned. Lots of questions coming in, I love this guys, I'll trust the fellas back at CIBC to let me know when we`re running out of time.

Question from John, when purchasing options in the share price hits the target price, do you just keep the premium, or do you get the shares? Great question. 

You have the right, if you buy an option you have the right to either sell that option back to the market, since it's appreciated, or you have the right to exercise and take the shares. So it really depends on what you’re trying to accomplish. Most speculators using options just want to buy and sell the option contract, and as the shares move in your favor, and you see that you are generating a nice little profit on the position, you can close that position out at any time so if I bought the contract at $2.50 and can now be sold in the market for $4.25, just sell it back to the market, you never have to worry about exchanging hands as far as the stock is concerned. 

So again, it depends on what you’re trying to accomplish but when you're buying options, you have the right but not the obligation, and you close the position out at any time. What is short selling? Again I mentioned that more as sophisticated traders will sell stock, or short sell stock and it's a way that you can participate in a stock that you think is going to go down.

So you actually borrow the stock from somebody you sell it into the market for let say $50 You get $50 per share in your account. The objective is that you wanna return that stock back to its rightful owner at a lower price so if you get $50 in, you cover that stock position let's say at $45. You keep the difference. It's kind of like borrowing your neighbor’s lawnmower and returning it back broken. 

The idea is that you collect the higher amount and you give back the lower amount. It's a way to be bearish on a stock, but it's not permissible in your registered account. We got lots of questions here. Who sets the options price? There's a lot of things we couldn't cover here in today’s presentation because we had limited time but options are priced based on a number of different variables the underlying share price is one. 

Time to expiration is the other. Volatility, so anticipated movement of the underlying security is another and interest rates and dividends are the other two considerations. So there's actually a pricing model Black-Scholes model is the most popular, that's an equation that's used to derive a theoretical value so marker makers, which is exactly as it sounds it's a firm that's in place to make a market on a product. 

They're able to use this equation to come up with what the option contract should be priced at and then buyers and sellers of that option contract will then force that contract to move back and forth so there's a certain set of variables, then the market sets the price by simply buying and selling those contracts. 

Margaret asks, if I buy a put option, can I sell the shares even though I don't own the shares? So if you buy the put, the exercisable part to that if you don't own the underlying shares, is you would exercise to short the stock. You would take a short position and you underline. It all depends, you cannot do that in a registered account, but if you had the margin sufficient enough to cover that short position, you could exercise that long put that you own, and take a short position in the stock. 

Manjeet Dinder asks what is a put and call? Too much to dig into now, so I would suggest you maybe take a look at some of the other recordings available and we'll be digging into this at later events but just at a high level, the puts in calls are the two different types of contracts that we can use in the options world and you can refer back to my introductory slides on options which define the rights and obligations associated with each and I think that's gonna help you a lot. 

In general, Cray asks although risky, would you not consider a market downturn and sell stocks, I'm not gonna name any names, as an opportunity to buy low, and eventually sell high with the right timing That is in essence the nature in using a call option as a stock replacement strategy as we go into a period where we think, because remember, we don't know, It would be nice to say, "Hey, I think this stock is low, but I'd encourage you guys to read the analogy on Mr. Market if you've never read that personification of the market I find it very handy to draw on because there's one line in that says, "If you think Mr. Market is showing you a low price, buy that stock and Mr. Market will show you exactly what low means." 

So you ultimately just don't know. So when you use a call option as a replacement strategy, you define your risk. So you take that shot on a stock that you think is a great deal. And if it turns out to be a great deal, you can always exercise your right and buy those shares, or simply sell those call options back to the market. 

So it just gives you some choices. There's so much here. I see we're pushing beyond that 1 o'clock I'll just defer back to home base there, How are we doing on time, guys? Looks like that's all the time we have today, Jason. I apologize, we had some really great questions coming in thanks everybody for that, I appreciate all the input I'll put it to you guys to take us back home there. 

[THANK YOU] 

Thanks Jason, that was a very informative presentation It was easy to understand how to use puts and call options as a tool to limit risk and potentially profit in a bearish market. So thank you for the great presentation and demonstration. 

[MONTREAL EXCHANGE OPTIONS EDUCATION DAYS] 

CIBC's Investor's Edge is proud to sponsor the 2019 options education day hosted by the Montreal exchange. The options education days are full day training days designed to provide retail investors with the knowledge needed to successfully navigate the options market. Please see the information on the screen should you want to learn more about options and advanced option strategies. 

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