Transcript: Options as an Income Strategy

Options as an Income Strategy
Jason Ayres
Nov 14, 2018, 12:00 pm to 1:00 pm ET

[Peter:]

Good afternoon everyone and thank you for joining us today. On behalf of CIBC Investor's Edge I would like to welcome you to this webinar. My name is Peter Campbell and I'll be your host for this event. Now, a few things before we get started.

[DISCLAIMER]

CIBC Investor Services Inc., does not provide investment or tax advice or recommendations. So, everything we share with you today is for education purposes only. We are recording today's session and a link will be emailed to any that registered online.

[FULL SCREEN CONTROL Q & A WINDOW]

To view this webinar in full screen please click on the expander arrows located on the top right-hand corner of your screen. And if you have any questions during the presentation, please kindly take a note and you will have the opportunity to submit your question after the presentation.

[JASON AYRES]

Our topic for today's webinar is going to focus on income generation strategies using options. To present this today we are very excited to have Jason Ayres here to share his expertise in this subject matter. Jason is a Derivative Market Specialist by designation, Director at R.N. Croft Financial Group and Educational Consultant for learntotradeglobal.com. As a member of the Investment Review Committee at R.N. Croft Financial Group, Jason contributes as a Market Technician and Derivative Strategist. With great pleasure, please join me in welcoming Jason for today's presentation.

[Jason:]

Hi there! Thanks very much Peter. I'm very excited to be with you guys this afternoon. I'm looking forward to obviously sharing what I know with respect to generating income utilizing options. So, just waiting for the presentation to load here and we'll be able to get moving forward shortly. But I guess confirmation that of course the audio is working would be fantastic. Just an indication would be much appreciated.

[Peter:]

Thank you Jason.

[Jason:]

Perfect! Good stuff. All right, thanks everybody for joining in and as I mentioned, we're just in the process of loading up the presentation and we'll get started from there. We sort of indicated in the information panel there, with respect to questions— If you do have questions as we move forward throughout the presentation, by all means as they're fresh in your mind, please feel free to type them in.

I may not have an opportunity to get to them immediately as we are transitioning through the slides, but certainly we're going to take a look at them at the end of the presentation and make sure that any questions that are outstanding we're able to address. Looks like we've got a fantastic crowd here this afternoon so again, thanks very much for joining in. I'm just going to hang tight here for a moment and we should be getting started with the slides here shortly. Thanks. Okay, so it looks like I'm seeing the title slide for today's presentation. I guess maybe a confirmation again that we are good to go. Peter, do you want to let me know?

[Peter:]

All is good to go Jason. Thank you very much.

[Jason:]

Awesome. Okay, thanks everybody for your patience and again, I really appreciate you joining in this afternoon.

[GENERATING INCOME USING OPTIONS]

As Peter mentioned, my name is Jason Ayers. I'm a Derivatives Market Specialist by designation. I've been a Montreal Exchange Instructor for about 10 years. I'm currently working as a Derivatives Specialist and Director of Business Development with R.N. Croft Financial Group. And I also work very closely with Learn to Trade as well from an educational standpoint. One of the—I think one of the most significant utilizations of the options market is the approach to generating income within a portfolio.

Many investors who sort of focus on the typical approach are usually really focused on some sort of a dividend paying portfolio or some sort of a fixed income portfolio. So I really feel that the introduction of options helps add, what I call "another dimension" to investing Again, not only through just the approach to generating income but also, the idea that as you're generating income and cash flow, you're also, to a certain extent, helping to mitigate volatility. And, as the most recent markets have shown, markets do from time to time get volatile.

[LIMITATION OF LIABILITY]

So, to echo Peter's sentiments, we want to make sure that everybody understands that the information presented here today is for educational purposes only. The options market, not unlike any financials security market, does carry with it some risks so we just want to make sure that you understand the strategies before you actually go in and start executing them in your live trading account.

[AGENDA]

So, we're going to cover quite a bit here over the next 50 minutes or so. The first approach is going to be really just helping everybody online understand what a covered call is and what covered call writing is all about. And I want to also try to illustrate just the difference between the traditional buy and hold approach that most investors still sort of cling to, versus the integration of the covered call strategy.

I'm going to try and give you a covered call example to help put things into perspective from a real-world standpoint. We'll also look at the comparison of the covered call strategy to another income generating strategy known as put writing. We'll talk about utilizing weekly options which are available on a number of Canadian securities and how that can help with increasing your annualized rate of return through being a little bit more active with your writing strategies. And then of course we're going to wrap things up and try to answer as many questions as we possibly can.

[HOW TO GENERATE INCOME WITH OPTIONS]

So, how to generate income with options starting with what the heck is an option essentially and how are we looking to utilize options to generate cash flow.

[CALL OPTIONS]

Options are a part of a derivatives market and essentially, an option contract will derive its value from that of an underlying security. There are two types of options that we would look at utilizing. One is a call option and one is a put option. So we're going to talk about put options towards the end of the presentation. But focusing more in on a call option, what we need to recognize is that there are two sides to every transaction in the options market. Not unlike the stock market, there's a buyer and there's a seller.

And so for the option buyer— The option buyer is actually paying a premium and they are securing the right to own the stock, or the underlying security, at a specific price, and that right is valid for a specific period of time. Now, as the option buyer, there are a number of reasons why you would want to take on that position and there are also a number of different approaches to choosing the appropriate option contract based on what it is that you're trying to accomplish. But for the purposes of our presentation today, we want to look at the right side of the presentation and focus more exclusively on being the call option seller or writer. The call option writer is actually getting paid a premium to take on an obligation. And again, that obligation is going to come with a specific price point at which that obligation is valid, as well as a time frame during which that obligation is held by the option seller or the option writer. So again, the call option buyer pays a premium, call option seller or call option writer gets paid to take on an obligation.

[CONTRACT TERMS]

So, important to understand the contractual terms associated with any equity or ETF option contract. One contract controls 100 shares of the underlying security. When you're looking at your Investor's Edge trading platform, and when you are looking for the options contract and how they're listed, they're actually listed in what's referred to as an options chain. That option chain then will provide to you all of the different contracts, the different strike prices, and the different expiration dates associated with the options trading specific to that underlying security.

You're going to see a bid and an ask price and those prices are essentially listed on a per share basis. So, what that means essentially is that if you are looking at the price of the option contract, you need to multiply that by 100 because that contract is in fact representing the cost per 100 shares of the underlying security. So for example, if you are looking at a quote for a contract of $1.25 you're actually going to pay $125 per contract. It's really important to understand the underlying share obligations of an options contract.

The covered call strategy is essentially based on the fact that the investor holds the obligated shares, or the appropriate number of obligated shares, for every call option that they sell. So in other words, if I sell one call contract as part of a covered call strategy, then my obligations that I've been paid for based on the premium that I've collected essentially are that I need to deliver 100 shares of the underlying security. So, this is where the term covered call comes in is that the obligations associated with the calls that you've written are covered by the number of underlying shares that you in fact own.

[WHAT IS COVERED CALL WRITING?]

So what is covered call writing? Basically, you buy or already own the shares of an underlying security. So it could be an options eligible stock or it could be an exchange traded fund, and you're basically getting paid a premium up front for assuming the obligation to deliver the shares at a specific price and that obligation is valid over a specific period of time.

So the way I kind of look at this as more of a simplistic analogy is you're essentially renting out your stock at a certain price and you're getting paid while you're doing so. Now again, it's important to understand that the call option is a contractual obligation so as long as you have sold that contract, you are obligated to deliver those underlying securities. That's in fact what you're getting paid to do.

[COVERED CALL EXAMPLE]

So, if we look at an example here, right? So let's assume we're going to buy 1,000 shares of XYZ and those shares are trading at $12 per share. So we're going to put up $12,000. We're not talking margin, we're not talking leverage, we're just looking at us having $12,000 in our account and we're going to allocate that to buying shares of the underlying security. So we can look out to the options expiring in six months and to a strike price of $13 and we can see that there's a bid price of 85 cents.

So what is this telling us? Well basically, what this is suggesting is that if we sold that $13 strike call, we have an obligation to deliver the shares at $13 over the next six months and we're going to get paid 85 cents per share to take on that obligation. Now, one thing that I'll just reinforce here is that I'm using six months as an example. You could go out and you could sell a one-month call option, a three month, a five-month, whatever time frame that you feel is appropriate to the strategy that you're looking to implement as well as to your comfort level as far as how active you want to be.

You can make that decision yourself. You can also choose a strike price different from what I used here as an example. So, you may choose to sell a $12 strike call. You'll get paid more but you'll have no upside on the shares. Or you may choose to sell a $15 strike call option. It'll give you more upside opportunity on the stock but you're going to get paid a little less for the premium.

So you're going to build out a strategy that makes sense to you. In this case, we are comfortable selling our shares over the next 6 months at $13 and we're going to collect 85 cents per share in order to take on that obligation. So, because we hold 1,000 shares, what we can in fact due is sell ten covered calls. Right? Because remember, each contract represents 100 shares of the underlying security.

So we can sell ten calls and we know that our 1,000 shares will cover the obligation associated with selling those ten call contracts. Now we're going to collect 85 cents per share but that works out to be about $850 over the next six months to take on that obligation. So, when we look at this from the perspective of a return, that's about 7.08% in premium over the next six months.

So again, a lot of investors look at the necessity for share appreciation as a means by which they are going to profit. But, understand that when you're looking at implementing an options writing strategy, not only can you benefit from an outside move in the underlying shares, but you can also benefit from the revenue generated through option writing.

[CALL OPTIONS]

So, when we think about how this transaction takes place, I always like to make it very clear that it really does not matter what the objectives are of the person on the other side of the transactions. So, if we've got Jackie the call buyer here— Jackie may in fact be bullish on the stock and wants to buy a call option as a stock replacement strategy. And that's based on what she's trying to accomplish with her portfolio.

So, she's going to go to the market and she's going to want to buy that call option. And we can have Peter on the other side here and Peter essentially has been holding these shares and if we use the XYZ shares as an example— Maybe Peter bought these shares at $6 and he's now thinking that, "You know what? There's probably not a lot more upside. Why don't I get paid over the next six months to lock in some profits on the position?"

So you've got two investors essentially meeting in the market to trade, essentially, the same contract but both have completely separate objectives. And that's important for you to keep in mind as well, is that, you know, whether it's the equity markets or whether it's the options market, these markets function based on people having different ideas and objectives and then going to the market and trading back and forth the contracts and the different positions to meet those objectives.

[COVERED CALL EXAMPLE]

So, as we move forward here, let's break down this position from the perspective of whether or not the stock was up a little, up a lot, stays the same, down a little or down a lot. Now, remember that we were looking at the shares trading at $12, and we were looking at selling a $13 strike call option which meant that we were getting paid to sell those shares at $13 over the next six months, and we are going to collect 7.08% in premium or basically 85 cents per share for taking on that obligation.

So as we work through the different considerations here, recognize that if we look specifically at the covered call return in total, if the shares go to 18, important to understand that as the covered call writer, you've capped your profit potential at 13. And what you've done by selling that call option to Jackie, is you've said to Jackie, "Hey, I'm going to make more money on the stock up to 13, but I'm going to sell you the right to benefit in the share appreciation anything above 13." And so this is why when in this case we've written the call at 13, we are limited to the premium that we've collected, and the difference between where we purchased the shares, and the strike price that we've obligated to deliver them at. So in total, the covered call return if the shares go up to 18, as a sort of indiscriminate higher number, is about 15.41%. You've got $1 upside on the shares and you've got that additional which is just over 7%, and then you've got the premium which you've collected which is essentially just at that 7% level. Now, if the stock was up a little, let's say it just hits that strike price at expiration, you're still only going to make that 15.41%.

You collect the difference between the $12 and the $13, which is your share appreciation, and you get to keep the premium. Now if the stock stays the same, this is where things get pretty interesting. In a market that is relatively neutral or sort of chopping about, the typical investor really is only going to generate a return or what you would call an unrealized return, if the shares are higher than where they bought it.

But, if you overlay a covered call strategy, even though the shares may be chopping around a little bit, on that expiration date the shares could have just essentially stayed at the same price that you bought it at, so $12, but that call option that you sold is going to expire worthless. So that becomes your profit and ultimately you've collected that 7.8% within that time frame. Now as I mentioned, again, you're going to choose the time frame that makes sense to you and you're also going to choose the strike price at which your obligation becomes something that you are going to be responsible for.

So we can go shorter in our time frame or we could go further out, or we could go closer with our strike price selection that we're selling or we could go further out, it's completely up to us. Now, the interesting consideration here, as I referenced at the beginning of the presentation is that you can actually use this strategy to help offset volatility to a certain extent. Because if you look at the stock being down a little bit, let's say it goes down from $12 to $11.50, well you still actually collect that 2.91% in premium.

So even though the stock has gone down, you get to keep the premium you've collected which results in a modest return within that six months. Now if the stock goes down a lot, you're still going to be down so an important consideration to remember is that as in investor, your risk is still based on the fluctuation of the underlying shares.

You're just offsetting that risk to a certain extent by the amount of premium that you've collected. But what I will suggest is if you can collect that premium on an active basis month over month over month, you're actually going to lower essentially your cost basis of the shares and subsequently lower the impact of any selloff that make take place to your overall portfolio. Now, if we in fact compare that same position as just a stock position only— Well, if that stock was up a lot, man, you made 50%. So that's fantastic. So that's something that you've got to really wrap your head around as an investor.

If you really think that stock is going to go up a lot, you may want to decide not to sell the call option against those shares or you may want to decide to choose a strike price that is further out. So in other words, instead of 13 you might choose 15. It's going to be dependent on what your outlook is. But what's interesting is once again, if the shares go up a little— If they just go up to $13, the average investor is going to be sitting at around an $8.30 return, unrealized of course until you sell those shares. Whereas, comparatively, with the upside plus the option right, you're sitting at 15.4%. If the stock stays the same, no surprise, they typical investor doesn't make anything but the covered call writer still generates that return. Finally and again, what I find appealing as well is that if the stock goes down a little, the stock position is down from the price point at which you bought those shares or where they're at on that particular day before the selloff to where they're currently sitting at the point of the selloff. So in this case, dropping from $12 down to $11.50— Typical investors down 4.16%.

The covered call writer is still sitting positive at about 2.9. Again, stock is down a lot, you still, as the covered call writer incurring some unrealized loss at 17.9% but the stock position only as you can see is down about 25%. So, what we've done here effectively is we mitigated or offset that downside to a certain extent with just this one covered call right here. Again, risk is always on the underlying security so regardless of whether or not you're utilizing the covered call strategy or you just hold the stock position by itself, you always got to make sure that first and foremost, you're invested in a company that you think is going to go up and you're confident in holding that position through what might look like a bit of a volatile period.

[COVERED CALL CALCULATOR]

So, just a couple of interesting tools available on the Montreal Exchange site here at www.m-x.ca. You can actually go in and kind of play around with some of the different stocks that are trading in Canada that are options eligible and essentially do a bit of a search to come up with some interesting ideas. Now remember, it's important for you to kind of go through your own due diligence and make sure you realize these are just suggestions, they are not recommendations. This is a pretty interesting tool to be able to utilize to just generate some ideas. Tying in the stocks that trade in Canada that are options eligible and the options that are trading on the Montreal Exchange site presently.

[WWW.M-X.CA/OPTIONSPLAY]

The other interesting tool that's available as I've identified here is the options play tool which is again, a really interesting bit of software where you can actually type in the stock that you might be interested in. So here, at the time I was using Agnico Eagle as an example. And you'll notice that I've selected income and it's actually come up with some pretty interesting strategies here that I might consider looking at utilizing. Whereby there's a suggested contract, it's giving me maximum risk on the position, maximum return, annualized return, all that sort of fun stuff, break-even point.

Everything you really need to make an educated decision as to whether or not you want to add the position to your portfolio. So, I really do encourage folks to play around with that as well because there's some pretty interesting— beyond even just the options for income application. There's some really neat strategies that you can be introduced to through this little software.

[SCENARIOS AT EXPIRATION]

None the less, as we carry on and we take a look at the covered call strategy that we've just been discussing as an example and we look at some of the different scenario's at expiration, what you'll realize is that you're not trapped in the position.

[SCENARIOS AT EXPIRATION]

So there's always an exit strategy that you can look at depending upon what you're trying to accomplish. So first of all, we're going to look at the in-the-money scenario. Well, what do I mean by that? Basically, what that means is that if I own the stock at 12 and I sell a 13 strike call option, I have created an obligation to deliver the shares at 13. If the shares are below 13, the option expires and I no longer have an obligation and I get to keep the premium. If the shares go above the written strike price, in this case the 13 strike call, I do have an obligation and I can essentially allow my obligation to be assigned. So in other words, I can basically just let the stock get taken away from me at 13.

I get paid $13 per share. So, I get paid the amount that the strike price has defined and the option contract expires profitably because I've fulfilled my end of the bargain. I have delivered the shares at the strike price. That's what the call option buyer has paid me to do. And so as a result, the option is assigned and I get to keep the premium. So that would be a situation where you're okay getting rid of those shares out of your portfolio and you're going to move on and find another opportunity. Now, with the in-the-money scenario two, you may want to keep the shares.

So, you may love the stock and you may think that there's further upside and so what you may want to do is what we refer to as toll the option contract or close the option contract before expiration. So, what do I mean by that? Well basically, when we refer to rolling a contract, really all we're suggesting is that we buy back to contract so that we eliminate the obligations around that specific contract and then we subsequently roll the position up to a higher strike price and out to a further dated expiration or further out expiration date.

So, what that does is as I mentioned, it eliminates our obligations to sell that stock at the present strike price and at that specific time and it just gives us a little bit more upside on the shares and gives us a little bit more time to participate. So that would be what we refer to as "rolling". You can also just simply close the position out before expiration. So, you sold to open a position the market, you're going to simply buy that back to close the position within the market.

As soon as you buy that contract back, you eliminate your obligation to deliver the shares and you are free to participate in any further upside beyond the strike price that you were limited to prior to you closing the position. So two different considerations there if the shares do happen to trade above your strike price.

And you can make that decision at your discretion based on what you're trying to accomplish. Now, in the out-of-the-money scenario, this is where it's a really neat strategy because even if the shares have gone up a little bit, you, on expiration, provided that those shares are still below the strike price then the auction is going to expire. You've essentially, you know— you've fulfilled your end of the bargain.

You held on to that obligation to deliver at, in the case of our example, 13. It just so happens that the shares didn't trade above that $13 level. As such, there is nothing for you to be assigned on and that options contract expires worthless. Think about that scenario— Again, I'll use another little bit of an analogy. Think about your car insurance broker and your car insurance. If you don't get into an accident during the month, then the car insurance broker has no obligation to deliver on the policy.

And as such, they get to keep your premium for that month. So, in the case of the out-of-the-money option contract in scenario three there, you're essentially the insurance broker. You sold the contract, the stock didn't do what the call option thought it was going to do, as such the option expires worthless and you keep the premium. So again, three different considerations or three different outcomes. For scenario one and two, you are going to decide what makes the most sense as far as managing your positions.

[CONTRACT SELECTION]

Now contract selection. I've been talking about the idea that we can make some choices.

[STRIKE PRICE SELECTION]

So, the thing about the options market is again, you have choices. You are in control of the contracts that you're buying and selling, the strike prices and the expiration dates. So you're going to know going in, before you actually click the trade button, what it is that you're trying to accomplish. So, we can actually sell what's referred to as an in-the-money option contract. Now that gives no upside whatsoever. It in fact obligates you to sell the stock at a lower price than what it currently may be trading at. But that difference is actually already factored into the option contract. So, what you're essentially doing is you are selling intrinsic value and that is really helping to buffer more significantly the downside risk on the stock. Now you're going to get less time premium which is what we really do benefit from as the option writer. But, you've effectively lowered the break-even point on the stock and you've created a much more conservative position in the markets.

So if you think there's no further upside in the stock, you want to collect a little bit of premium for the period, and you're really more concerned about buffering significant down side, that in-the-money option write is where you'd want to go. Now, at-the-money is referring to options contracts that are very close to where the underlying shares are trading at presently.

So, in the case of our example with XYZ— you've got shares trading at $12 and you're going to sell a $12 strike call option. So there's no upside on the shares but you're getting a good chunk of time value. And the one thing that we need to understand about options, is time value always erodes to zero on expiration. So for the investor that is more focused on generating cash flow, you sell the at-the-money call option.

You're giving up the upside but you're collecting a lot of time value which at the end of the month is going to be zero which means that that's a zero for the option buyer. But as the option writer in the case of the covered call writer, that's yours to keep. So, no upside but greater time value for more cash flow. Now, out-of-the-money option contract selection is for investors that feel that there is upside on the shares. So, what this means is that you are more focused on looking at profiting from a move higher in the stock but you just want to be able to generate a little additional cash flow.

You're essentially creating a target for yourself and ultimately, you're going to get paid conceivably to sell those shares when it hits that target. You're going to get a lower premium. So it's important to understand that the further away the strike price of the option is from the current stock price, the lower the premium is. But, you're going to make up for that ideally by being right on the stock and you're going to benefit from the capital appreciation of the shares.

So, if we can more or less summarize each of these different approaches; your in-the-money is the most conservative. It's going to give you more down side risk protection. The at-the-money is more for the income focused investor who just wants that cash flow on a monthly basis. And the out-of-the-money option contract is for the investor who wants to benefit from upside on the stock, who feels there is an opportunity to capture or more higher but wants to generate a little bit of additional returns while they're managing their stock position.

[EXPIRATION MONTH SELECTION]

Now as far as expiration month selection, as I mentioned— You know, I used a six-month option contract in our example today but we can choose a shorter term option contract such as we refer to as the front month contract. Now, the front month contract is really just the option contract that's expiring the closest to where today's date is. So for example, November contracts are going to expire next week, next Friday.

So ultimately, we would be looking at that being the expiration date that--sorry— We would look at that being more or less the front month option contract. Very short term in duration. What that does is it allows for a higher annualized cash flow but tends to be more transactional.

So, if you're somebody that's a very active trader, you're not concerned about commissions, and you're looking to be able to adjust your positions on a month to month basis, then utilizing the shorter term expiration dates makes more sense. The further out you go, you're going to get more premium up front because you're collecting more time. That's why we were able to collect in that XYZ example there.

We were able to collect about 7% in premium because we were going out six months. And that's a lot less transactional. So if you step back as an investor and you say, "Okay, over the next six months, if I was able to collect roughly 7% upside on the stock plus another 7% in premium, to the tune of in the case of the example of around 15%, would I be happy with that over the next 15 months?" And if your answer is "Yes", then that's the great strategy. If you step back and you say, "You know what? I think that this stock has greater upside potential.

Why don't I just sell the short term 13 strike call? I'll collect less premium but if the shares go up a little bit, next month I'll maybe write the 14. The following month I might write the 15." So you can subsequently adjust your position by using those shorter term contracts. You've got to select the approach that really makes the most sense for you and meets your objectives taking into consideration what you do on a day to day basis. Are you at your computer? Do you have access to your trading account? Can you make adjustments that actively?

Would you prefer to just build out your portfolio and from time to time just take a look at what's happening? I do recommend you spend more time if you're a retail investor, monitoring your portfolio but you may not necessarily want to be transacting all that actively. So, you've got to figure that out for yourself.

[WHICH APPROACH?]

Again, which approach? What are you trying to accomplish within your portfolio? I want to just reinforce as well that these are not mutually exclusive to one another. So, the approach that we typically take is we build out sleeves. So one sleeve may be for shorter term active opportunities. Another sleeve may be for more income generating strategies. At the end of the day, you can step back and determine how you want to manage your portfolio.

You may be looking at your tax-free savings account which incidentally, this strategy is permissible in registered accounts— A very important consideration. But, you may be looking at being more active and focused on upside opportunities in your TFSA. So, you may be a little bit more short term with those strategies. Whereas your RRSP or your RIFF for example, you may be focused on retirement income and you're just looking at lowering volatility in your portfolio and subsequently collecting that paycheck on a monthly basis or every couple of months to help compensate you while you're retired.

So generating cash flow off of your investment portfolio. What you can do as well, as somebody who's got a little bit more of a time horizon and you're not looking to necessarily looking to be withdrawn from that portfolio, is you can consistently be compounding your growth. So in other words, you generate the cash flow. Cash flow from those option contracts get reinvested, used to buy more shares, write more contracts. And subsequently, try to take advantage of that additional cash flow to compound your returns. The objective of this strategy is really to be able to generate stock market style returns with less risk. So in other words, if we do better than what the stock market is doing on a month to month, year to year annual basis, but we can actually lower the volatility of our portfolio, then we've actually added value by introducing this strategy to the portfolio.

And that really at the end of the day is what using this strategy is all about. It's not a get rich quick approach. You're not looking for triple digit returns. You're not leveraging your capitol. What you're trying to do is take your traditional approach to managing your own portfolio and just enhancing it to the point where you are increasing your revenue stream and your returns but you're also mitigating the downside and lowering the volatility.

[CONSIDERATIONS: DIVIDENDS]

Some considerations. When you're building out your portfolio, what's really cool about this strategy as well— If you've overlaid an option writing strategy on top of dividend paying stocks, is that you're also going to receive a dividend as well. So again, for those of you that have built out a portfolio where dividends are essentially your main source of income other than maybe drawing down your principal investment, you can overlay the covered call strategy on top of these dividend paying stocks and enhance the cash flow that you're generating off of those holdings. The only consideration, and it's referenced here as a risk but I wouldn't suggest that it is a risk, is that you may get a sign on the ex-dividend day, so the day that the dividend is being paid out if the premium left in the option is less than the dividend. So the reason being is let's say for example the option that I sold over top of my stock position is in-the-money.

And let's say it has a market value or an ask price of 20 cents. Well, if those shares are paying out a 40 cent dividend, a call option buyer may swoop in and say, "Hey, I can buy this call for 20 cents and I could exercise my right to own the shares. I'll take these shares from the shareholder, I'll hold them in my account so that I'm shareholder on record and I'll get paid the dividend. So my 20 cent premium ultimately has generated me a 40 cent dividend. Now, it doesn't happen all the time so don't think this is something that you're going to have to be dealing with all the time.

But it's important to understand that this may be a possibility. But, in saying that, you still are going to get paid per share based on the strike price that you've selected and you're still going to get to keep the premium that you've collected when you sold that option contract. So you may just get assigned early, it's called early assignment, and you'll collect ideally your returns from the stock appreciation as well as the premium from the option write earlier than you anticipated. You just don't get to keep that dividend.

[CASH FLOW VS. RETURNS]

So, something to keep in mind as you're building this strategy into your portfolio. The other thing to consider is cash flow versus returns. When we talk cash flow, we're talking about the total premium collected. Your returns are going to reflect any changes in your capital gain or loss on the underlying shares, plus the premium, plus the dividends. And so your returns are going to vary depending on what kind of market environment that we are in. So just keep that in mind. There's cash flow and then there's returns and returns are a combination of everything that you're doing in order to generate profits on the position that you're holding.

[COVERED CALL VS. PUT WRITING]

Now, another strategy that's available to us, albeit outside of our registered accounts is put writing.

[PUT OPTIONS]

So, what is put writing? Well, we've got to understand what a put option is. Put option buyers pay a premium and they secure the right to sell the underlying security at a specific price. So they may be doing that because they're bearish and they're speculating on the stock dropping or they may be doing it because they own the stock and they're buying the put as protection. But regardless, as the put option writer, we want to get paid to take on those underlying shares.

We are looking to get paid to take on the obligation to buy those shares at a specific price and for a specific period of time. So the way that that strategy would work, once again, no different than the mechanics behind the call option buyer and the call option writer. We've got Doug the put buyer.

Doug is buying puts because he's bearish or Doug is buying puts because he's trying to build a protective strategy around his portfolio. That's his objective. Amy may like the stock that Doug is currently holding, think that it would be a great opportunity to own it at a certain price, and ultimately wants to get paid to wait for it to come to that price so that she can buy it.

Two different investors with two different objectives coming together. One is buying that put, the other selling that put and a deal has struck and they're both happy because they are actually doing what they set out to do for their own individual portfolio.

[PUT OPTION WRITING]

So, with put option writing you don't own the underlying shares. You're basically getting paid a premium up front for taking on the obligation to purchase the underlying shares at a specific price over a specific period of time. Again, where this becomes a really interesting strategy, and unfortunately, it's not permissible to your registered accounts, but you may like shares of XYZ which are trading at 22 but you may think that it's a better buy down at 20.

And rather than sitting and waiting for those shares to drop down to 20, you basically can sell a 20 strike put option and get paid to wait for those shares to drop down to that level for you to buy them. In that case, you buy the shares at 20, you collect that premium and your cost basis has been essentially reduced by the amount of premium you collected. Or, the shares stay the same, they don't crop, you collect the premium and you've just generated cash flow for the month while still having a portion of your portfolio in cash.

[PUT WRITING VS. COVERED CALLS]

So, when we look at a very simple comparison, let's consider the idea of selling that call option on shares trading at $12 but doing that little shorter time frame and at the money. So in this case, we've got 1,000 shares of XYZ. We're going to put out $12,000. We're going to sell 10 three month call options and obligate ourselves to essentially deliver those shares at $12. So we're going to collect 50 cents or $500. That's a pretty decent return for that particular period of time, right? So that's the covered call side.

Well the put write side, you've got $12,000 in cash, you're going to sell 10 three month put options, you're going to collect 50 cents or $500. So in one case you own the shares, you sell call. In the other case you just have cash and you sell the put. Now, three months later if the shares are trading above $12, for the covered call writer; the call is exercised, the shares are sold at 12, there's a net profit of 50 cents per share or $500. The put writer; the put expires profitably, no shares are ever transacted and there's a net profit of 50 cents or $500. What becomes interesting is if the shares are trading below $12.

For the covered call writer; the call expires profitably, the shares remain in the account, there's a net 50 cents per share realized in cash flow which ultimately adjusts your cost basis down to $11.50. So the original $12 cost minus the 50 cent premium. If you look at the put write position, what ultimately happens is because those shares have dropped below 12, that put option is in-the-money, you're assigned to buy those shares at 12. So you're obligated to buy 1,000 shares at $12.

There's a net 50 cent realized cash flow from the option write. You now own the shares at $11, which is the $12 purchase price minus the premium you've collected. So you can see in both cases the net result is essentially the same thing. Where you may want to consider selling put options is one of the characteristics of the options market when stocks begin to sell off, is put options premiums get inflated. It's a volatility adjustment which we'll talk about in another webinar. So you can actually as the put option writer take advantage of that inflation of volatility on stocks that you want to own as an alternative to actually going out and buying the underlying shares and doing the call option.

[INCOME WITH WEEKLY OPTIONS]

Now, just to add to this-- again with respect to frequency, you can actually be even more active with your call option and put option writing by utilizing weekly options. So, the characteristics of a weekly option are essentially the same as a standardized monthly contract. Really, the only difference is that there's eight trading days. So they're introduced on a Thursday and they trade through to the close of the following Friday. And so you can be much more active and generate more consistent cash flow on a weekly basis.

The thing about the weekly option contract is they have a really rapid time depreciation associated with it. And so again, that annualized rate of return can be conceivably enhanced because you're doing this more often. You can also adjust your written strike, so the strike that you've sold, to accommodate fluctuations in share prices for a week to week basis. But again, take into consideration the increased transaction cost. You want to make sure that that fits within your investment plan and that you're not imposing upon your returns so significantly that it doesn't make sense to the strategy. So, commissions count. There's no question about it, make sure that you factor that in.

[PUT WRITING WITH WEEKLIES]

Put writing on weeklies as well. Again, same consideration; enhanced annualized cash flow, short term strike adjustments, but you need to consider the increased transaction costs, there's no stock upside and this strategy is not permissible in your registered accounts.

[CONCLUSIONS]

So with all that in mind; Investors have the potential to reduce volatility in a portfolio while earning income beyond the traditional approach. I really truly believe that in this kind of market environment and what we're likely moving into here as we've seen over this last past year. We need to look beyond the traditional approach to help manage risk in our portfolio and help generate cash flow.

So this is one strategy utilizing options that can actually help you do that. Covered call writing is often stereotyped as risky, but if applied appropriately, it can also be a very conservative strategy. You essentially will define the risk based on the strike price and expiration dates and how you manage the position. And again, just to reinforce the important consideration, covered call writing can be executed in a registered account. So you can do this in a TFSA, an RESP, and RSP, a RRIF, a LIF, a LIRA, you name it.

Whatever you're managing for yourself, you can actually apply these strategies while put writing is only available within a margin account. And I should qualify that. Covered call writing and put writing are available in margin accounts as well. There's a lot more flexibility and option strategies in margin accounts such as spreads and such, but you are somewhat limited with your registered accounts as I said to covered call writing, buying calls, buying puts and the caller strategy, which is a protective strategy using both covered call writing and protective puts.

So, important to remember that when you're building out your approach to investing. I think it's very important that investors really understand that risk still lies with the stock positions. So in other words, we're mitigating risk. We're offsetting risk through the premiums that were collecting but you still are invested in the stock and you want to make sure that it's a position that you're comfortable with and that you're managing the risk on that position.

Potential loss on the position may be calculated by subtracting the premium that you've collected less the difference between the purchase price of the stock and the present market value. Point being is that as you're generating cash flow on the position, you're essentially lowering your cost basis. That is offsetting the downside risk exposure but there's still risk beyond that.

[TO LEARN MORE...]

To learn more, lots of information on the Montreal Exchange site. Blogs, videos, trading guides and strategies, calculators and other tools that I highlighted throughout the presentation. The OptionsPlay software can be actually accessed from the Montreal Exchange site as referenced here on the slide. And of course, you can always visit the MX site as well for more details. So on that note, let's move on to answering some questions. So I'll pass it back to Peter to maybe facilitate that part of the presentation. Thanks very much everybody for joining in.

[Peter:]

Thanks so much Jason for your insightful presentation. While Jason is reviewing some of the questions, I wanted our audience who joined in later to know you can type your questions in the Q & A panel located on the right-hand side of your screen. If you wish to review this webinar again, a link will be emailed to everyone that registered for this webinar. Also, I would like to request the audience to ask questions more explicit to today's topic on options and to avoid asking questions that are specific to a security or a company.

[Jason:]

All right, I think Sammy had a question there Peter. You can probably address this with respect to the execution of vertical strategies, vertical spreads at CIBC. So I'll leave that one to you if you want to touch on that. ...based on your platform there.

[Peter:]

Oh yes, absolutely. We do have a team to do specialized trading and we do have that opportunity. The best way to do that is not the online platform. We do have agents that can definitely handle complex strategies such as the straddles, the vertical spreads and so forth.

[Jason:]

Okay. There's some questions around transaction fees as well which I think maybe I'll let you touch on afterwards.

[QUESTION & ANSWER]

But I am seeing a few options related questions. So, Timothy has a question. So, where a stock is listed on both Canadian and US exchanges, are the options prices synchronized or is there typically better profit in one or the other? So, no, the option contracts are not synchronized in the sense that the stocks trade on different exchanges. There are different supply and demand factors associated with those contracts as well as of course the FX or currency considerations as well.

Really, again, to determine whether or not there's any increased profitability using one or the other, at the end of the day it's about the strategy that you're looking to implement. I think always you need to be considerate or currency risk as well. And so as a Canadian investor, any time that you convert your Canadian dollars to US dollars and then invest in US securities, whether they're stocks or options, and then subsequently have to reconvert, there is going to be some currency considerations there. So you have to decide which side of the border you want to trade on.

Oftentimes, when you're looking at using US options, there's lots of great opportunities out there as well but you've got to factor in the FX exposures. Quite often the dually listed securities often trade more actively on the Canadian markets than they do on the US market. It just depends on what stock you're looking at. Another one that I'll look at is, how would put and call options effect the underlying stock? Well, the put and call options are derivatives of the underlying stock.

So it's actually the underlying stock that's impacting the option contract value, as well as time depreciation and implied volatility, interest rates and dividends. All of that is actually used to determine the value of the put option and the call options. So, important to remember that options are derivatives of the underlying security so it's the underlying security that is impacting that. So, in my opinion, should a retail investor begin option writing with larger, more liquid holdings?

Yeah, you know, I think liquidity is very important. It doesn't necessarily apply to using options exclusively in the US versus Canada. A lot of very highly traded securities in the Canadian markets have very liquid options available as well. So I think it comes down to your exposures. Most investors will typically have a balance of Canadian and US securities within their portfolio.

You've got to consider the currency conversion and the exchange rates and the currency risk associated with trading in the US. So I think you can build out a very effective portfolio around highly traded options eligible stocks on the Canadian market. You just have to do a little bit of research and due diligence around that. [inaudible] with a large volume of call options push the price of the underlying stock up? No, not necessarily.

A large volume of call options will increase the value of the call option itself because you are essentially influencing the market. Depending upon the size of the position— Oftentimes, to get a little bit more detailed around just how the option market works, there are market makers that are buying and selling these option contracts to help provide liquidity. So, from time to time as they are hedging their portfolios, they may have to buy the underlying security or other option contracts or what have you.

There is still some modest influence. But at the end of the day, it's us as the traders that are essentially driving that and these options contracts are priced based on what's happening with the underlying security, not the other way around. Peter was just telling me this is the last question so I apologize if I haven't gotten to everybody. But, I'll let you take it from there.

[Peter:]

Great presentation. Thanks so much Jason. I'm sure I speak on behalf of the entire audience that I thoroughly enjoyed listening to your insights and thanks for such a great presentation.

[THANK YOU]

On behalf of CIBC Investor's Edge, I would like to thank the audience for attending today. Should you have any questions or comments, please visit the Investor's Edge website or please feel free to get in touch with us by phone, live chat or email. And thanks so much for joining us today and we are looking forward to our next session. >>Jason: Hey, thanks very much everybody for joining in as well. Thanks Peter.