[CIBC Investor's Edge Options Fundamentals]
[We will start momentarily]
Hello, everyone. Thank you for taking the time to join us today. On behalf of CIBC Investor's Edge, I would like to welcome everyone to the webinar with Jason Ayres. My name is Omar and I will be your host for this event.
Now just a few things to note before we get started, CIBC Investor Services Inc. does not provide investment or tax advice or recommendation, so everything we share today is for education purpose only. We are recording today's session and a replay will be available on our website. You will find the link to the replay on our homepage.
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[SPEAKER Jason Ayres, Montreal Exchange Instructor]
We are very excited to present Options Fundamentals Webinar where we will provide an introduction to options including basic option strategies and practical examples that show risk and reward profiles. We are delighted to have Jason Ayres as our speaker. Jason is a director at R.N. Croft Financial Group and a derivative market specialist who is one of the lead instructors for the Montreal Exchange. Jason regularly works with retail investors, advisors, brokerages, and financial service providers across Canada. With great pleasure, please join me in welcoming Jason Ayres. All right. Well, thanks very much. It's an absolute pleasure to be here and I am, of course,
very much looking forward to presenting on options fundamentals.
Just to echo the earlier disclaimer, we just want to make sure that everybody understands that the information that I'll be sharing here today is for educational purposes only. You know, the options market is not unlike any other financial securities market in that there are risks that we need to consider, so we just encourage you to make sure that you understand those risks before you take advantage of the strategies in your real portfolios.
So with that in mind, we've got a lot to cover over the next hour and, of course, I am looking forward also to answering any questions that may come up as a result of the content that I will be presenting. I want to first make sure everybody understands what an option is. We'll talk a little bit about how options are presented and priced. We'll discuss the two components of an options premium which is intrinsic in time value, and we'll also discuss exercise and assignment considerations as well.
[What is an Option?]
So let's jump right into it, the first thing that we really want to understand is that the options market is what's referred to as a derivatives market. Now that is a very broad-based market in that it applies to a number of different types of financial securities. But really in essence, a derivative is simply a financial instrument that acquires its value from an underlying security. And an option represents contractual rights and obligations associated with different characteristics.
[Two Types of Options]
So when we are looking at considering the utilization of options, there are actually two types of options that we can choose from depending upon what we're trying to accomplish. So we could look at buying or selling a call option or we could look at buying or selling a put option. And the rights and obligations associated with each contract will depend on which type we choose whether it's a call or a put, and whether or not we are the buyer or the seller of that particular contract.
[Option Contract Specifications]
So as far as sort of some general considerations, we want to understand that each option contract controls 100 shares of the underlying security and the price when you look at what's referred to the options chain which is essentially a list of all of the available option contracts that we can buy and sell, so the price as it's displayed within the options chain is based on a per share representation. So when we look at the quote, we need to multiply that quote by 100 to come up with the actual value. So, for example, when you're looking at the options chain within your trading platform, you may see a particular contract quoted at $1.25, we would multiply that by 100 and the cost of that contract would be... Or the value of that contract, of course, depending upon whether we're buying or selling, would be $125.
So if we break it down and take a closer look at each of these different types of options, first focusing on a call option, the call option buyer pays a premium and secures the right to buy or own or purchase, however you want to look at it, the underlying security at a specific price and that right is valid for a specific time frame. Now we have the choice of that specific price and we have the choice as a buyer of that specific time frame. Now the option buyer pays a premium and the call option seller or writer, as you'll sometime hear it referred to... Accepts that premium and takes on an obligation to sell or deliver the underlying security at the agreed upon specific price and that obligation is valid for a specific time frame. So what we have are two different sides of the trade and buyers and sellers are coming together essentially to meet their specific own objectives.
So if we take a look at just a real simple example here. Let's assume we have Jackie who is a... We'll refer to her as the call buyer. Now Jackie might have an expectation that CN, for example, is bullish and that the price is going to move higher over a certain period of time. Now Jackie may not own the stock and is looking for a risk managed way to participate in that upside potential that she is anticipating. So Jackie has a specific objective that she is looking to accomplish and believes that the purchase of a call option is a good approach to replacing the ownership of the underlying security. Now somewhere else, we might have Peter, who we'll refer to as the call seller. Now Peter may own shares of CNR and has a completely different outlook on the stock than what Jackie does. Now Peter might believe that there is only limited upside to the stock on the short term. Peter has maybe owned the stock for, you know, several years and thinks that, "Hey, you know, the stock's had a great run. And how can I look at generating some additional cash flow if I believe that the stock isn't going to move any higher? Right? So Jackie is the call option buyer, and in this example, Peter would be the call option seller or writer. Now they come together in the market and they essentially agree on the contract specifications. Jackie pays a premium and secures the right to own CNR. Peter collects that premium and assumes the obligation to deliver CNR. Both of them have two completely different considerations for the stock, but they're using the options market to essentially play out their outlook and achieve their goals and objectives.
[CNR Call Option]
So let's take a look at some sort of general pricing numbers here. So let's assume that CNR's sitting at $105, and we have a one month $105 call option that's trading at $1.40. So what does that mean? Well, what that means is that the call option is valid for one month and the rights and obligations associated with that particular contract are based on the stock, a strike price or a price of $105 per share. Okay, so just to reiterate, CNR is trading at $105 per share, Jackie is looking at $105 strike call option that is trading at a $140 per share. So Jackie would pay $140 for the call and has secured the right to purchase the shares at $105 regardless of how far that particular stock moves higher. Peter receives $140 of income and assumes an obligation and is in essence obligated to deliver those shares at $105 regardless of how high the shares trade within that particular time frame.
Now we can also look at purchasing a put option or selling a put option depending upon what it is that we're looking to accomplish. So in general the put option buyer is going to pay a premium and secure the right to sell the underlying security at a specific price and that right is valid for a specific time frame. Now the put option buyer is going to pay a premium to the put option seller, or writer as we would sometimes refer to them as, and that put option writer is going to assume an obligation to buy or purchase the underlying shares once again at that specific price, and that obligation is valid within that specific time frame. So if we take a look at a couple of investors here, let's assume that Doug is bearish on Barrick or ABX. Now Doug instead of short selling the stock is going to buy or purchase the right to sell the stock at a specific price through the purchase of a put option. So Doug doesn't have a position in the stock but is looking for a short stock replacement strategy. Now the benefit of doing this is that, again, because Doug is purchasing this put option... His risk is limited to the premium that he's paying. On the other side of it, again, we've got Amy who has a completely different outlook on ABX and believes that maybe the stock's trading a little high right now, but there's a price at which she would want to own the shares if they happen to drop. So believing that there's only a limited downside, what Amy is looking to do is sell a put option, collect a premium, and take on the obligation to buy the shares at a specific price. Now recognize that, that specific price that she's going to choose is a price at which she is comfortable owning the shares at. So in essence, Amy can get paid to wait for the shares to drop down to a price at which she is prepared to pay. So once again, you have two investors utilizing the options market to essentially meet their objectives. Doug is the put buyer is bearish and wants to capitalize on a move to the downside. As the shares drop in value, the put option contract will increase in value and subsequently Doug will ideally profit. On the other side, Amy as the put option seller wants to own the shares and is willing to take possession of those shares at the agreed upon strike price and is going to get paid to take on that obligation. Again, two different investment objectives coming together and utilizing the same option contract, one is the buyer, one is the seller, to meet their own individual objectives.
[ABX Put Option]
If we put some numbers around this, if ABX is trading at $22, a put option that is trading... Sorry, a put option that is expiring in one month at a $22 strike price is trading at 20 cents per share. Again, we need to multiply that by 100, so Doug as the put option buyer will pay $20 per contract for the put and has the right to short or sell the shares at the $22 strike price. Amy, pardon me, has taken on an income or has accepted the premium of $20 per contract and takes on an obligation to potentially buy the shares at $22 if they are trading at or below that level on expiration.
Now you've heard me talk about and reference strike price and maybe jumped ahead a little bit, but the idea is that each option contract has a specific price at which the shares have a right to be transacted at, in which the shares are going to be transacted at. So the strike price is the price at which the option buyer has the right to transact the security. As the call option buyer, it's the right to purchase the shares at that specific price. As the call option seller, it's the obligation to deliver at that specific price. For the put option buyer, it's the right to sell at that strike price. And for the put option writer, it's the obligation to buy at that strike price. Now once again, those rights and obligations are based on a specific time frame. So when we refer to the expiration month, it's the month in which the option expires. Now as we talk more about some of the different strategies we can utilize in our upcoming webinars, you'll recognize that our strike price and expiration month selection become very, very important in actually being able to meet our objectives. And we'll go into much greater detail when we talk about specific strategies. Important general consideration, we're going to review this as we move forward through the presentation, but important consideration is that the expiration or the options always expire on the third Friday of the month, of the expiration month, unless the stock has weekly options which essentially expire the Friday of the expiration week.
Now just a touch on weekly options, weekly options are only available on the most liquid option chains. There are investors that want to be more active with their trading and investing and perhaps take advantage of short term price fluctuations in the underlying security or maybe look to generate income or cash flow on a very short time frame or perhaps they're looking at utilizing options to hedge around a specific event and, you know, in that case they only need a very short time frame. So in order to accommodate that particular objective, weekly options were listed. And what happens is they're typically listed on the Thursday the week before the expiration Friday. And again, very important to understand that weekly options are really designed for individuals that are prepared to be more active in managing their portfolio. So you have to take that into consideration when you're, you know, making your expiration date selection.
[Time & Expiration]
That said, in general, all options listed will have the front month or one month expiry available. So, for example, we'd be able to look at the monthly option, sorry, the July options as what we'd refer to as the front month. And then typically we have additional months listed that fall within one of the three expiration cycles available. Now what I always like to reinforce is that as an investor we only have the selection to choose from that's made available to us through our trading platforms. It's the Canadian Derivatives Clearing Corporation that essentially decides what expiration dates and what strike prices are available. And that's based on market capitalization, liquidity, when earnings reports fall, all sorts of different characteristics, but what we have to understand is essentially what you see is what you get. And we have to build our strategies around the strike prices and expiration dates made available to us, and it is again up to the Canadian Derivatives Clearing Corporation to determine what is the most effective and marketable set of expiration dates and strike prices for the underlying security.
[Type of Options - American Style]
Now there are actually two types of options that are available to us when we're looking at what we refer to as exercise and assignment. Now the typical ETF or equity option is what we refer to as American style, and what that really means is that there is an underlying security that has shares that can exchange hands. So, for example, when we buy or sell an option on an ETF or on a stock, that option represents rights and obligations to buy and sell underlying shares. Now we don't necessarily have to take possession or necessarily have to deliver those underlying shares. We can manage out of those positions if we are not inclined to take on that responsibility. But the bottom line is the underlying security is what's referred to as the "deliverable." Now what happens with this style of option, is that they can be exercised at any time prior to expiration. So, for example, if I owned a call option on CNR or if I owned a put option on Barrick, I could decide at any point before expiration that I want to exercise my right to buy or sell those underlying securities. Now it's not typically done early because as the buyer, as soon as you decide to exercise, you give up the entire premium, any time value which we're going to discuss in a few moments, but you give up any time value remaining in that option. So there has to be a really significant financial benefit to doing so. So what you'll find is that, you know, it's not typically done on a regular basis, but it does happen. Now what this means is because the buyer can exercise any time, when you're the option writer let's say as part of a covered call strategy, or when you're a put writer as part of an income generating strategy, you can possibly get assigned to deliver the underlying shares before expiration. So that's something that you need to be aware of. Now what that means is you get to keep the premium, so you get to essentially recognize the profit from the premium earlier than if you had to wait till expiration, but it's something that you need to consider. Now this typically won't happen unless, as I mentioned, there is a definite financial benefit to the option buyer in doing so.
[CNR Call Option]
So if we go back to sort of a simple example of an American style exercise and assignment process, let's say Jackie originally bought the $105 strike call options for a $1.40, and CNR proceeds to rally above $105 into expiration. Well, Jackie can step back and say, "Well, I bought the call at $1.40 when the shares were trading around $105, now the shares are trading at $110." So the call option has appreciated in value along with the stock. So Jackie could sell that call option for a profit and just simply walk away so benefiting from the move in the call option as a derivative of the underlying security. Or Jackie might say, "You know what, I actually want to own those shares of CNR." So Jackie could exercise her right and take possession of the shares and assume ownership of the stock.
[CNR Call Options Exercise]
All right, so if we take a look at what this means. If Jackie decides to exercise her right to own the shares at $105 instead of just selling the call option back to the market, Jackie will pay $105 per share to Peter who has taken on the obligation to deliver the shares at $105, and Peter will subsequently deliver the shares to Jackie. Now what we want to recognize is that as the call option writer, Peter does not get to benefit from any appreciation in share value above the strike price that he sold. So even though the shares may have traded up to $110, Peter has taken on the obligation to deliver at $105. Now what we want to understand is that if at any point during the expiration cycle Peter feels that the shares are going to continue to move higher and does not want to limit that upside opportunity, he can simply buy back the call option that he's written, and absolve himself of the obligation to deliver at $105, and then could conceivably sell a call option at $107 or at $110 in order to benefit from further upside in the stock. So this is what we would refer to as rolling the option, and important to understand that even though both Jackie and Peter have entered into a contractual arrangement, both investors have the opportunity to manage out of the position to, you know, manage their risk exposure or to monetize profits or to reestablish a position if they feel that it's appropriate. So neither one of these investors is in fact 100% tied to the position, they can manage out of it if they feel that it's appropriate.
Now if Jackie, for example, holds that contract into expiration, what will ultimately happen is the automatic exercise rule will be implemented. Now this occurs if an option contract is $0.01 in-the-money. So what do we mean by in-the-money? Well, if I own a call option and the stock is trading at $0.01 above the strike price, that's referred to being in-the-money. If I own a put option and the stock is trading $0.01 below the strike price, that put is considered to be in-the-money. So what happens is that at the market close on the expiration date if the option is in-the-money, the Canadian Derivatives Clearing Corporation or CDCC assumes the option holder wishes to exercise their right. So remember, when we buy the call or when we buy the put, we purchase the contract, we have a right. And so the clearing corporation assumes that because you still hold this position into expiration, you want to buy or sell the underlying shares at the specifications of the contract.
Now as the call option buyer, the underlying will be purchased at the strike price. So you want to understand that you will be required to come up with the capital associated with buying the underlying shares. As the put option buyer, the underlying shares will be sold at the strike price. Now if the put option holder does not already own the underlying, a short position will be created. So really important to understand the outcome should you decide to hold your positions through the expiration date and into the close of the day. There will be an exchange of shares, and you will have the essentially appropriate capital removed from your account, and that underlying position will be taken on. So you really just want to make sure you're managing your positions accordingly into expiration. And with that in mind, remember that you can close your position any time before the expiration date. So as the option buyer, you can sell your options back into the market, as the option writer or seller, you can buy them back from the market as well, so you can always manage out of the position before expiration.
[Types of Options - European Style]
Now in comparison, you know, what we've been talking about up until this point are American style exercise and assignment. And again, the American style approach is what we will be looking at for the most part in any of our upcoming webinars. And again, American style means that there are underlying shares that are deliverable and that can exchange hands. With the European style which refers to let's say index option such as the SXO which are options on the S&P TSX60, they're European style. All that simply means is that there is really no underlying that can exchange hands. They're only exercised on expiration. Now they can be bought and sold freely on any given day on the exchange right up until the expiration date, but they're referred to as being cash settled. So no shares exchange hands, all that happens is cash is either credited or debited from an account based on the difference between the strike price and the settlement value of the underlying index or of the underlying security. So, you know, there is some, you know, significant value to this as we'll take a look at again in one of our upcoming webinars when we talk about index options, but the idea of the options being cash settled just means that there's some flexibility in terms of what you can do with them within your portfolio, particularly from a hedging perspective.
[Options Pricing Variables]
Now all options regardless of whether or not they're American style or European style are priced based on a specific set of variables. And this is what really makes this market unique comparative to any other market out there. The first consideration is the price of the underlying security. So no surprise as a derivative the value of an option contract will fluctuate up and down, you know, based on the price fluctuation of the underlying security. Now depending upon the strike price of the option contract, as the price of the underlying moves, its relationship to the strike price of the option contract will also influence the value of the contract. So how close the underlying stock price is to the strike price of the contract will have an influence on the price of the option. Time until expiration, which we'll take a closer look at in a few moments, but how long before the option expires will also be a determining factor in the value of the contract. Volatility of the underlying, so what this means is how fast is the share price moving and how far is it moving. So think about it like car insurance, you know, the car insurance on a minivan is significantly less than car insurance on a sports car. So again, you know, the more volatile, the more unpredictable a stock is, the higher price the option contract is going to be. Dividends are also factored in as well as interest rates, so what happens is a market maker who is in charge of pricing an option contract will plug in all of these variables and come up with what is referred to as a theoretical value, and then they'll post a bid and ask based on the theoretical value that's been derived from the equation that calculates this, and subsequently that bid and ask price as I mentioned is posted and buyers and sellers will review and determine whether or not the numbers make sense, and subsequently prices will adjust according to supply and demand. Now it's important to understand that option prices will fluctuate minute by minute throughout the day as all of these different variables adjust.
[Strike Price and Stock Price]
Now when we look at specifically the price of the underlying and how it relates to the strike price of the option contract, that fluctuation in share price will influence an option contract in and out of three different categories. So the first to consider is in-the-money, and I kind of referenced this... I didn't kind of, I referenced this earlier on. So as the share price for example trades $0.01 above the strike price of a call option, it would be considered $0.01 in-the-money. If it's $2 above the strike price of the option contract, then it's considered $2 in-the-money. For a put option, it's the opposite. If the shares trade $0.01 below the put option strike, it's considered to be $0.01 in-the-money. If it's $2 below the strike, it's considered $2 in-the-money. So as share prices fluctuate, if the share price is sitting exactly at the strike price or very close to the strike price of the option contract, it's considered to be at the money. And if the share price is trading a fair distance away from or any distance away from the strike price, it's considered to be out-of-the-money. And the option contract value will adjust depending upon whether or not it's in-the-money, at-the-money, and out-of-the-money. Now utilizing each of these categories has advantages and disadvantages, we'll actually address a lot of those as they pertain to some of the strategies that we'll cover in future webinars. But important to consider that when we're selecting a particular option contract to utilize, the way that it will behave based on market conditions will change depending upon what category
[Components of an Option]
we choose in as part of the strategy selection process. Now if we focus on an in-the-money option for a moment here, the in-the-money option has what's referred to as intrinsic value. And all that intrinsic value is referring to is that one $0.01 or that $0.05 or that $2 that that contract or the stock is trading above or below that strike price. So again, if we take a call option and we take the current stock price and we subtract the strike price, if there is a value to that calculation, that value would represent the options intrinsic value. If we are looking at calculating intrinsic value for a put option, we would take the strike price and subtract the current stock price, and again, if there's a value, that value would represent the intrinsic value of the put option. Now, the option premium is going to be, if there is time left until expiration, it's going to be priced likely higher than that intrinsic value component. So if we take the option premium and we subtract the intrinsic value that we've calculated, what we're left with is time value. What you want to recognize is time is money. So the more time left until expiration, the higher that time value component is going to be, but as we get closer and closer and closer to that expiration date, that time value diminishes. So what we really want to be as the option buyer, what we really want to be aware of is that we need to be confident that the stock or the shares of the stock or the price of the stock has the potential to move and do what we expect it's going to do within the time frame that we've allocated, right? Because if it doesn't, and if the shares don't move, and there is only time value associated with the option contract, if there is no intrinsic value, then time value erodes to zero and the option expires worthless.
[Impact of Time]
The more time until expiration, the higher the premium. So what we want to understand is time, time is a function of unpredictability. So if I'm a market maker and my job is essentially to price options, what I need to do and what I need to recognize as part of this calculation that I'm making, and it's of course done all by computer these days, but it's very difficult, like... The example that I like to give is, if I were to say that it's going to rain today by the end of the day, well, you know what, it's pretty easy for me to make that prediction because, you know, if it's sunny out right now and, you know, the forecast is suggesting no rain for the next few days, I can essentially be pretty confident that it's not going to rain. So I can price my probability relatively, you know, low in that I'm going to be right. Whereas if I'm looking at predicting over the next month that it's going to rain, it becomes much more difficult. So the market maker will price the option contract based on that level of unpredictability. Pardon me. So the more unpredictable the outcome is, the higher the option premium or the higher the contract. As uncertainty decreases, so as we get closer and closer to the expiration date and it's a little easier for, you know, the market to predict the outcome, that uncertainty premium diminishes, it shrinks.
[Call Option Time Value Example]
And so what we may have, for example, is... You know, let's say we've got one month until expiration, and the stock is trading at $20, right, and we own a $15 strike call option. Well, that call option may be priced at $6.50, but we can determine that out of that $6.50 there is $5 of intrinsic value, so the difference between my $15 strike call option and the stock trading at $20. But there's obviously a difference in the premium, so that difference represents the time value. So what the market is basically saying is, okay, there's a $5 intrinsic value in the stock based on where the stock's trading or in the option based on where the stock's trading presently, and there's $1.50 in time value because there's one month until expiration. If the stock stayed the same, you know, at $20, this $15 strike call option would be worth only $5 on expiration. Because what happens is the time value component is diminishing as we get closer to expiration leaving only the equity intrinsic value of the contract, the difference between my right to own the stock at $15, and my ability to sell it for $20 in the market. Now it's important to understand that as the underlying shares increase and decrease, this value, the equity intrinsic value, will increase and decrease as well. So the risk that we run into is if by expiration the shares drop all the way back down to $15, well, there's no intrinsic value, and there's no time value left, so we're left with zero, the option contract is worth zero. So it's important for us as the trader or investor to recognize, you know, "Maybe we'd better take our profits now versus running the risk of losing them if we hold all the way to expiration." Again, that's just a management strategy that you'll work out based on your own trading objectives.
[Put Option Time Value Example]
If we take a look at the put option, right, the put option might be trading at $5.95, but if we're looking at a $25 strike put option with the stock trading at $20, we need to understand that there is a $5 intrinsic value. So what does that mean? Well, what that means is $0.95 out of that $5.95 premium is time value and it's decaying as we get close to expiration, and there's $5 of intrinsic value that is fluctuating with the underlying value of the stock. Now in this example, if as we move towards expiration the shares start trading higher, so they start moving from $20 and start moving up towards $25, we are losing intrinsic value. So on expiration if the shares are trading at $20, there's no intrinsic value, and time value has disappeared, so that option contract will be worthless. So very, very important to understand that unlike the buyer or short seller of a stock, that expiration date is a very, very important consideration. Because on that expiration date, that option is either going to be worthless or it will have intrinsic value, and you'll have to decide whether or not you want to take on the position in the underlying security or if you want to sell it back in the market. But what I always say is that with options there's always a day of reckoning, there's always a day in which you're going to have to make that decision, and you also have to be sort of monitoring and managing that decision making process on a day-to-day basis leading into that option's expiration so that you're locking in profits or you're cutting risks
[Time Value vs. Intrinsic Value]
where you need to be doing so. So again, just to reinforce, time value erodes to zero as an option approaches expiration. The intrinsic value reflects the real value of the option contract based on the difference between the strike price and the underlying security value, and it does not erode with time, but it will fluctuate with the price of the underlying security. So as the stock goes up and down, the intrinsic value of the option contract will move up and down as well relative to that
[Time Decay is not Linear]
price fluctuation. If we take a look at, you know, the behavior of that time depreciation factor, you want to recognize that, you know, for a more passive investor if you go out a little bit on a longer time frame, the rate of time depreciation is relatively slow. So what happens is, you know, because there's a lot of time until expiration, the option time value component, it's rather slow on a day-to-day basis, but the closer we get to the expiration date, you'll see that it accelerates because again the market is able to predict... Let's say, for example, a great way to look at it is, you know, if I'm sitting here today and I'm looking at a $20 stock, right, and I buy a $25 call. Well, I can sit here and say, "Okay, there's a high probability that the stock over the course of the year is going to trade towards and above $25, right? And because there's one year to let that happen, right, the probability remains high for an extended period of time, right? But as we get closer to that expiration date and the less and less that happens, that probability diminishes, right? So you want to recognize that the more time you give yourself, the higher the probability it's going to happen. Now you're going to pay a higher premium, you know, you're essentially buying time, but as you get closer to expiration, that rate of time depreciation accelerates, right? So you need to be prepared to manage very quickly. Now we're going to talk about what, you know, time frames make sense when we are addressing specific strategies throughout the webinar series. So I just want to make sure that everybody understands that these are just general fundamental considerations, we will dig into the application of these considerations with each specific strategy we discuss. So not to worry, you know, I'm going to outline those considerations as we move forward. But first we got to understand just how these different principles, you know, impact the options positions in general.
Now options expiration, again, we want to reinforce that it's typically the third Friday of the expiration month selected. If you're utilizing a weekly option, which is something you can certainly consider if you're more of an active trader or investor, then that would be the Friday of the week that you've chosen, right? So options will expire on the Friday unless the Friday is a holiday, then it will be the Thursday before, and it's at the end of the trading day at 4:00pm, a value of the underlying stock is established, and then that is essentially how the option contracts are settled out. It's based on that settlement value at 4:00pm on the expiration Friday.
So couple of key considerations once again, just to kind of wrap everything up, an option buyer pays a premium for the right to buy or sell the underlying security. And that option buyer has a limited risk that is based on the premium that they've paid. So very important consideration that we'll talk about when we're looking, you know, at options as a stock replacement strategy. You know, when you buy a stock or when you short sell a stock, you have an unidentifiable risk exposure. When you use a call or a put option as a stock replacement strategy, you have a defined risk by way of the premium that you've paid, right? So it becomes a very, very interesting way to participate in the movement of the underlying stock. Now, again, the right is valid for a specific period of time. So you need to be confident that when you are selecting an option contract that you have allowed for a sufficient amount of time in order for your outlook to, you know, play out. I can tell you firsthand my initial experience with utilizing options was that I didn't really pay attention to the time component of it. And, you know, I had this great expectation that the stock was going to make a real quick move, really fast. I bought the shortest time that I could, and, of course, my option expired worthless and the following month, the stock did exactly what I thought it was going to do. So the lesson that I learned there is you need to make sure you give yourself enough time for your outlook to play out. One of the most common mistakes, as we'll talk about in an upcoming webinar, is not giving yourself enough time for your market outlook to come to fruition. So important to understand that options have an expiration date and we need to manage accordingly. A call option will expire worthless if the underlying share value is below the strike price. A put option will expire worthless if the underlying share value is above the strike price.
[To Learn More...]
So with all that in mind and before we get to the questions, just want to remind everybody that there's lots of great content that can be found on the Montreal Exchange site. We've got blogs at optionmatters.ca where industry professionals will post their writings and observations, great little spot to gain some insight on, you know, real time market outlook and considerations. Options trading newsletters, videos, and webinars, trading guides and strategies, calculators, there's a great little position simulator, and a really interesting tool that's been launched by the Montreal Exchange is OptionsPlay. Now OptionsPlay is just a great little resource where you can go in and you can take a look at a particular stock, and this little software will screen for different option strategies and give you different considerations that you might want to apply in your trading simulator, of course, before you go live. But certainly a real neat tool, you know, to take advantage of. That's available on the Montreal Exchanges site for free, so you can sign up any time.
On that note, guys, I just want to thank everybody for joining in, and we will move towards answering some questions.
Thank you, Jason, that was very informative.
[Q & A]
We encourage questions from the audience, so if you have them ready, please type them into the Q&A panel located on the right hand side of your screen. While we wait for questions to come in, I would like to inform our audience that CIBC Investor's Edge offers basic option trading such as buying calls and puts in all our accounts including tax-free savings account and RRSP accounts. It is subject to approval and we also have more complex option strategies also available. If you'd like more information on that or how to apply, please speak with one of our investment representatives at our number which is 1-800-567-3343. So we'll go back to the Q&A. It looks like we have received a number of questions. Jason, the first question that I'd like to ask you from the audience is, how far out can the option expiry go?
So generally speaking with most option contracts, you can go out as far as a year. Depending upon the underlying security and how popular it is for lack of a better word, there are some options that will go out even as far as two years. Again, it's important to understand that it is really the CDCC that determines which options should be, or which expiration dates are posted. And again, it's all based on whether or not there is a likelihood of investors and traders utilizing those particular contracts. So it's going to be dependent upon the underlying security, but typically it's going to be at least a year.
Great. Thank you, Jason. Thanks for sending in that question. The next one we have is, what is the liquidity compared to an equity?
Yeah. So again great question. You know, the liquidity surrounding a series of option contracts is really going to be reflective of the liquidity and trading volume of the underlying equity. So what you'll find is that, you know, the more heavily traded stocks with the higher market capitalization have more heavily traded options markets. The liquidity is less in that you will find because... So if you recognize that each option contract represents 100 shares of the underlying security, you know, investors are buying and selling option contracts based on that multiplier which means that, you know, to represent 1,000 shares for example, they're only going to buy or sell 10 call or put options. So, you know, there's a smaller number of contracts being transacted because of the underlying multiplier. Once again, one of the important considerations if you're looking at integrating options into your portfolio is, just really trying build that portfolio with, you know, you're more heavily traded more liquid, higher market capitalized stocks, and then you're going to have a much more liquid and accessible options market to utilize.
Interesting. Thank you, Jason. It looks like we have time for one more question. And the question is how do you know if an option is fairly priced?
So again, what we have to recognize is that there is what's referred to as a market maker that is in place to essentially be the middleman, for lack of a better word, he or she is the buyer for every seller, and he or she is the seller to every buyer. So we are not trading directly with one another, we are trading through a market maker. That market maker only generates an income if trades are being transacted. So it's their job to ensure that they are calculating what's considered to be a theoretical or fair value for the option contract because if they're not, nobody is going to look to buy or sell those contracts, and they're not going to be generating any revenue off of their efforts. So understand that one of the things that we can do as well as a trader and investor, is we can go in and utilize what's referred to as a limit order. So if we feel that maybe a contract is overpriced or we feel that the underlying security is going to make a move within a certain time frame, we can go in with a limit order, set our defined price, a number that we're comfortable with, and we can see if somebody within the market takes it. At the end of the day, it's largely about supply and demand. It's a fair market when a trade is transacted, you know, it's one of those considerations whereby, you know, it's if there are people willing to buy or sell at a certain price, then you can consider that that option contract is fairly priced. And again, but I'll reiterate from the last question, very important to focus on trading your options on more highly traded liquid stocks. That way you're going to get much more action within the options market and prices are going to be much more in line with expectations as far as bid and ask and ability to execute at more favorable prices.
Great piece of information there. Thank you, Jason. It looks like that's all the time we have. Jason, I'm sure the audience would agree that I thoroughly enjoyed listening to your presentation. You've explained everything with clarity and made option trading seem easy. So thank you for a great presentation.
All right, thanks very much. Always a pleasure and looking forward to the next one.
Sounds good. And a reminder to the audience
that if you wish to listen to this webinar again, a link will be emailed to anyone that registered, or you may visit CIBC Investor's Edge website. I would like to thank the audience, we really appreciate your being here. Should you have any questions or comments, please visit Investor's Edge website or get in touch with us by phone, chat, or email. Thank you for joining us today, we will see you next time.