Transcript: Options Trading: Mistakes To Avoid

Transcript: Options Trading: Mistakes To Avoid
Options Trading: Mistakes To Avoid
Patrick Ceresna
June 28, 2018
 

[Host:] 

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 our webinar. My name is Ammar, and I will be your host for this event.

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Now just a few things to note before we get started.

[DISCLAIMER]

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 link to the replay will be emailed to anyone that has registered.

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Also, if you wish to view this full screen, you may do so by clicking on the expander arrows located on the top right hand corner of your screen. And should you have any questions during the presentation, please take note. You will have the opportunity to submit your question after the presentation.

[SPEAKER Patrick Ceresna]

Our topic for today is "Options Trading: Mistakes to Avoid." In this webinar, we will identify common dangers of options trading and cover research and analysis related to options trading and more. We are very excited to have Patrick Ceresna join us once again as our speaker.

Patrick is a Chartered Market Technician and the founder of Big Picture Trading. Patrick is also an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada. With great pleasure, please join me in welcoming Patrick Ceresna.

[Speaker:]

Well, thank you very much. And hello, everyone. And thanks for joining us today.

[Option Trading Mistakes to Avoid June 28, 2018]

And this is one of my favorite presentations to make because a lot of people learn about options and hear either something scary or something really exciting about the types of money and returns that one can make in the markets. And what I like about this presentation is we get to talk about all of those things that beginners do wrong and where a lot of people hit stumbling blocks.

And if we can help all of you as investors avoid a lot of the little common mistakes, it will grow your confidence to be able to incorporate options trading as a part of your investment process.

[Limitation of liability]

Nonetheless, again, just this disclaimer, as always, that everything we're saying here is for educational purposes.

[Agenda]

So going into today's agenda, we want to first cover the idea of using options as an all-purpose strategy and some of the realities of you doing that. We're going to also talk about the pitfall of buying cheap options, or what we call 'Bargain' options. We're going to discuss volatility and the impact of volatility to investing. And then we're going to talk about the impact of things like the pricing in options going into an earnings announcement or how options behave when you overlay a dividend payment. And so we're just going to take into account all of the little things that they don't tell you when you just read a very basic options book.

[Using an All Purpose Strategy]

So the first thing that we want to kind of get into and talk about is using an all-purpose strategy for options trading and what are some of the realities and considerations that someone has to take into account.

[Strategy Selection]

The first thing that we're going to touch on is just the idea of strategy selection. So we always say options can be used in a variety of market conditions. Obviously, the beginner likes to think that the markets only ever go up and that things are always just smooth and steady.

But the markets are very cyclical in their nature. There's liquidity surges within the market that run very bullish in market environments where basically, no matter what stock you buy, you somehow make money. And then there's periods where liquidity is scarce and stocks struggle, no matter how good the news is. And understanding how an option strategy works and the different cycles within the market is always an important consideration.

If you're using just one blanket strategy and you think that it will work in every market condition, that rarely works out that way. So it's important for investors to have a clear understanding of what they want to accomplish, and how they plan on getting from point A to point B, and whether they're creating Alpha in applying options to their investment strategy— does it make you better, does it give you better results by incorporating options versus not using them at all?

You'll have to be able to kind of assess those types of circumstances when you're trading. So when an investor understands the dynamics of the option market, they can construct strategies to meet their objectives. A perfect example is there's growing talk amongst many analysts that at some juncture, an economic recession may come. During that period, not always but sometimes, comes a bear market during a recession, where stocks substantially reprice new sort of risks.

A strategy in this environment would be something like buying a tail risk hedge with a put option to remove the downside risk of a big event in your market. So it's like buying insurance on your portfolio. It reduces the volatility. But it's not a strategy you would use in all market conditions. There's the right time and a right place to consider each one of the different ways to approach the market. And that's just an example of how one would do that.

[Considerations]

So what are the considerations one has to have when doing options trading? Each circumstance has to assess a unique risk/reward proposition always—I mean, it's a catch word amongst hedge fund managers and other people— is the idea of seeking asymmetry. It's about finding an opportunity where the risk can be manageable and the opportunity extraordinary. And when you're using options in your trading, it allows you to take something that is not asymmetric, and through the application of options to it, you can turn the trade into something that has that low risk/high return profile. It doesn't guarantee you'll make money, but you certainly can construct the trade to have that kind of a build.

Nonetheless, the one consideration, of course, though, with options is the impact of time depreciation. It costs money to buy an option. And subsequently, if you're using options as an income strategy, you're earning that money through time depreciation. And the impact of time is important because you, with options, define a period from which you think the strategy will materialize.

You could theoretically buy a stock and hold it to infinity. And you can be right, just over a very long time period. But with options, it's defined by time and there is a cost of carry. Every day, there's a certain amount of cost associated with expressing the trade with an option. And that's just something that has to be accounted for when you're constructing your trade or opportunity.

We're going to obviously also talk about the impact of volatility. In fact, that's one of the core things we're going to talk about in just a moment. Volatility is a measure of risk. And subsequently, it changes the price of an option to adjust for all known risks. Subsequently, there's commissions, how much it costs to implement the strategies.

And for someone who has a larger account, reaching the economies of scale at a discount brokerage is relatively easy. But of course, if someone has $1,000 in a tax-free savings account, one has to ask themselves as to whether the commission is a drag on your overall performance of being transactional. There's all sorts of things that have to be accounted for, as well the idea of how complex you want to actually make your strategy.

Options don't necessarily have to be complex. But they certainly can be used to create quite complex strategies, if you seeked it. And I always say, generally, that I don't like to make options trading complex because in the end, the more variables you put into the trade, the harder it is to manage. Sometimes having the greatest confidence in a trade is keeping it simple because you know exactly what's going to happen under all the circumstances.

[The Reality]

Nonetheless, one of the realities that one has to face is that each strategy will perform differently, depending on market conditions. A perfect example of this is covered call writing. Covered call writing is a very popular strategy of income enhancement through the selling of covered calls against stocks that you own in your portfolio. Great strategy that can be done in your registered accounts. And you create a consistent income cash flow without actually needing to have the market appreciating to make the money.

That strategy works 90% of the time. 90% of the time, the stock market is calm, everything is fine. The markets are generally moving higher. And someone, more often than not, is able to harvest consistent income through the strategy. But then there's that old adage that they say in the stock markets, that the markets "rise like on an escalator, but drop on an elevator."

And what always ends up happening is that when you enter a period where the stock market is being challenged on liquidity and there's those scary drops in the market— well, covered call writing is not the best approach in that market environment. And so you have to have some flexibility, or at least have to recognize that this is a risk, when you are executing your strategy and how you manage it.

So I always say investors must assess the market conditions, and determine what objectives they have, and how they plan on getting from point A to point B with the strategy. They have to research the available option strategies to them. It's important to do this, for those of you that are considering this in your registered accounts, because while options are available in your RRSPs, there's only certain certain options strategies that are available.

You could do covered call writing. You could buy calls or puts. You could buy puts as a protection on stocks you own. But a more advanced strategy, such as spreads and another things like that, are not available to you. So you'll have to kind of assess— well, what am I able to do in the type of account that I'm prepared to do this in?

You have to also create a plan. Recognizing that options have a maturity date, a period from which the option ceases to exist, one has to have a plan for why you're getting in now, how you're going to manage it, and what you're going to do at the end of the time frame. And so you have to have a plan.

And most often, the people that are most successful have that plan in advance. Those people that just enter a trade because they think it's a good idea, and then often don't know what they're going to do when the stock moves, or when they're going to take their profits, or what they're going to do at the expiration— often, they end up being the ones that struggle.

You'll notice that the most successful investors and traders are very methodical in what they do and how they do it. They have a plan and then they execute the plan, and they're very consistent with it. In this industry, there is a growing number of financial advisors and money managers that, let's say, do options strategies within their portfolios or their books for their clients. And they have a very systematic way from which they execute this. They follow a very specific process, and they just do it consistently, year after year, in that same way.

And what makes them successful, often, is the consistency, the plan, the process that they've established. And I feel generally, while an average investor can do this for themselves at a discount brokerage, you do still have to take that extra step. If you're going to not pay fees to someone else and you're going to say, I'm going to save the fees and go for lower commissions, you still have to demonstrate some ability that you're effectively making good decisions for your own investments.

And so you also have to manage your expectations accordingly. If you go into options trading on the belief that you're going to make 100%, every single month, a return, then it just offers you the opportunity to be disappointed, and you give up. You have to have realistic expectations as to what you're going to be able to accomplish. And if you have realistic goals, it's much easier to be consistent.

[Buying "Bargain" Options]

So the next topic I wanted to touch on is this idea of buying "bargain" options. We call them bargain options, but really it's cheap options. And I can tell you from my personal experience, when in my early days of trading, me and many of my colleagues would fall victim to this, where we would see an option on a bank stock trading at $0.15 or $0.20, and we would immediately think, well, that's cheap. I could buy so many of those at $0.15 or $0.20 an option.

But one has to take into consideration why it was cheap. Well, why is it cheap? Why is someone willing to sell that for $0.10, $0.15, $0.20? There's a reason.

[Strike Price Selection]

And so let's talk about this and really understand the difference between options and how this all works.

And so what one has to recognize is that many investors wish to leverage their capital by purchasing many of these cheap options. They hear these stories of people making thousands of percent return by buying this one option for $0.20 and selling it for $2. And they flipped it for this big high percentage return. But why was the option cheap, and what was the real probability that that person was going to make money?

So the terminology we use in the options industry for an option that is cheap is usually because it's out-of-the-money. Out-of-the-money means that it needs to move a certain distance to have any chance of gaining intrinsic value. Those options are cheap because based on the probability distribution that goes into option pricing, they assign a very high probability to the fact that that option will expire worthless. And so you're getting the option cheap because the marketplace is in fact saying there's a very high probability this option is going to have no value. And all the money you did put into it could be worth very little if nothing at its expiration.

And so you'll have to understand what you're buying and why you're buying it. So let's take into account this cheap option versus expensive option.

[Strike Price Comparison]

And so here what I have is a comparison of options. So here we have stock XYZ, which is trading at $53.66. So an investor could just buy the shares at $53.66 and just own it. So 100 shares of the stock would cost $5,000 some odd dollars, and they could own it.

But now this investor believes that, whether you're using technical analysis or whether you're using some other fundamental reason why you believe the stock is imminently going to move, this investor has a conviction that over the next two months the stock is going to rise. Now alternatively to buying the shares, one investor could consider buying an option.

What I have here are three options on the three different rows. We have an option at the $50 strike, the $54 strike, and a $58 strike. So let me explain a little bit here, just in greater detail, if some of you have not taken the Option Basics or Option Fundamentals webinar. But the strike price is the price in the contract from which you have a guarantee to be able to buy the stock.

And so when we're talking about a $50 option, even though the stock's trading at $53.66, when we buy the option, a $50 strike option, we have a contract which we can, at any point, exercise and physically buy the shares at $50. Because we're $3.66 in the money, that premium of $4.40 has to account for the fact that you're getting the stock at such a deep discount. The intrinsic value is being built into it.

So if we had the right to buy the stock at $50 and we paid a $4.40 premium for the option, our break even on the stock is actually $54.40. We would need the stock to rise above that level by expiration to on-balance be profitable on this position. But what is the advantage? Well, by paying $4.40, we're only outlaying $440 capital, rather than $5,000 and change to buy the shares.

So to buy one call option, we can define our maximum risk to $400. If there was a market crash and everything collapsed, you are going to be no worse off than having lost $4.40, while somebody who owns the shares has downside risk far beyond $4 if there was a big drop in the stock. But notice here—and someone says, well, $4.40— well look, I could buy the $54 strike option for $1.65. And instead of paying $440 for this option, I could pay $165 and buy twice as many of these options at $54. But now look at the difference.

Here, we're entering a contract where we now have the right to buy the stock at $54 per share instead of $50. So now, that option is considered out-of-the-money. And that premium $1.65, if the stock remains unchanged, is at risk of actually losing all of its value.

Now let me just rewind here for a moment. If two months from now the stock did absolutely nothing, and two months from now it's still trading at $53.66, if that first option at $50— if I had the right to buy it at $50, and the stock was still trading at $53.66, what would be the intrinsic value left on the option?

$3.66. In other words, the risk of me actually losing that entire $4.40 is actually very low. The only way that I could risk losing the entire $4.40 is if the stock was tanking and heading south of $50. And then I would be at risk of losing the entire premium. But both the $54 and the $58 strike options, if the stock remained unchanged, risk expiring at a full loss and being worth $0 at its expiration, if the stock remained unchanged.

Notice here that the break even on the $54 strike becomes $55.65. And the $58 strike, which now you can see would cost only $0.30— in other words, I could literally go out and buy 15 of these contracts, synthetically controlling even 1,500 shares, for the same dollar outlay as I would buying just one option at $50. So the speculator in everyone's like, I'd rather buy 10 or 20 of these $0.30 options than I would just buying one of these at the $50 strike. But what is the downfall of this?

Well, notice that the break even on the $58 strike option is $58.30 at expiration. You need that much more of an extraordinary move in the stock for those options to have any value. Of course, you look like a rock star superhero if the stock goes to $60. But in the end, on a balance of probabilities, there's a much greater chance that you're going to lose the entire premium outlaid at $58 than you would by owning the $50. And that's just the probability adjustment of it.

The other variable that you see is the column called Delta. And Delta is one of the option Greeks that we can get into in one of the more advanced sessions that we could do in future webinars. But the Delta is telling you the rate at which the option participates for every $1 change in the value of the stock. And what that means is that you would literally get an $0.80 on the dollar participation of that $4.40 option for a $1 rise in the stock. So if the stock went from $53.66 to $54.66, a $1 rise, that option would rise by $0.80.

Notice that the $58 option is only participating $0.13 on the dollar. You're only actually going to get a move from $0.30 to $0.43, which is actually a high percentage return, but it's only participating at a smaller rate. And so the process of choosing which option I want to own for getting the move that I want— you have to take into account all these types of variables as to what is the right option for the expectation I have for the stock.

[Strike Price Break Even Points]

So looking at this chart, here we have the stock chart of the stock trading at $53.66. Look at what the different break evens are for the three different options. Understand, notice that if held till maturity, that $50 strike option, know it was $4, it's much easier to be right. It's much easier to be making money on that option.

I consider that $58 strike at $0.30 to be sort of the equivalent of buying lottery tickets. It's an outlier chance—maybe you have less than a 5-10% chance of making money. But if you do, you make big money. That's where the gambling element, where investors want to speculate with options, can work in there. But I don't like to teach options as speculation. But yet that's what attracts a lot of people because they love that element of hitting one out of the park, right?

[Considerations]

What are the considerations here? Out-of-the-money options are composed only of time value. And so those options will have a greater return when there's a very quick and volatile move in your favor. But on balance of probabilities, you have the greatest probability of them expiring worthless and the chance of a complete loss.

And so you always have to ask yourself, what do I want? Do I just need something that behaves like the stock? And you're choosing something that's in-the-money. It has intrinsic value. While if you're looking for something that is highly leveraged, you're going to go out of the money. But also, you have to recognize the much greater chance of loss.

[Expiration Month Selection]

So let's talk about expiration month and selection. Short-term options are obviously cheaper. And they're less expensive to longer term dated options. But that's also due to the fact that there's a greater probability of you being right with more time.

If I told you that Apple's stock is going to go north of $200, if I told you it was going to do it in the next month or if I told you it was going to do it in the next two years, which one do I have a better chance of being right on? Well, over the next two years. And so therefore, the option with a two-year duration has to be more expensive because it actually has a greater probability of actually being right.

While if you're bold enough to predict that Apple's going north of $200 in the next one month, it's going to be a much cheaper option and you have a much greater chance of being wrong. And so the options are right-pricing your probability-adjusted risk of being right over the time frame from which you're picking the option.

[Time Decay Is Not Linear]

So what are some of the other considerations? Well, recognize that time decay is not linear. Usually, when you think of something like an insurance premium, insurance, really—to insure, let's say, your car on a day-by-day basis— it's a very linear thing. It costs x amount of dollars per day to insure your car.

But options are not priced the same way. It's not a linear 45 degree time decay. Because there's always the risk of a very big move in a short period of time. And so a certain amount of time has to be accounted for, even in the final months of an option's life. And so the time decay rapidly decays in the final stages of an option. And hence why there's a very fun amount of—fun— a certain amount of traders that enjoy trading very short term options, which are known as weeklies. They expire, literally, one or two weeks out.

But what is the downfall of that is that it's really a binary outcome. Either you're right or it's worthless. It's a very rapid experience of a short term move in the markets. While somebody who chooses a longer dated option— let's say something with 9 months or 12 months of time on and you're buying a long term option— the rate of change of the decay of that option, the cost of carry, is a much slower and gradual pace.

And so if you want something that is behaving far more like an equity and far less as this binary outcome of an option, you're going to want to add duration to your option, which then it gives you— there's an entire school of traders that will buy six month options, even though they have no intention of holding it for the whole six months. They just don't want to experience this rapid time decay.

What they do is they might hold it for a couple months, but they're holding the option as an alternative to stock ownership. And they're using the longer dated options so that they don't experience that rapid decay, that occur with short term options. So you can see you're paying a higher premium for the cost of the option, but the rate of change is much slower. While somebody who buys a very short term option pays a much cheaper premium, but experiences very rapid decay of time in that option.

[Ignoring Implied Volatility]

And that's some of the considerations. So I want to move on here to volatility and what are some of the considerations that we have to take into account in terms of what volatility is. Now volatility is something that— implied volatility is something that was introduced to a lot of traders back in late January and early February, when the stock market had its little crash event, largely driven due to volatility traders blowing up. And most people don't even know that this exists, that this entire market is out there.

But volatility is actually an incredibly important variable in options pricing. It is what is the adjusting variable that determines the difference between an option on something like, let's just say, Blackberry versus an option on BCE. If Blackberry and BCE just happen to be trading at the same stock price, what differentiates the fact that Blackberry is capable of swinging 20%, 30% in its stock price in a week, while BCE—a 10% move in BCE in a half a year is a big deal.

How does an option price account for the different personalities of different types of quality of stock? And this is where implied volatility differentiates. This is what makes an option more expensive on a Blackberry and much cheaper on a stock like BCE.

[Implied Vs. Historical Volatility]

So how do we account for this?

Well, first of all, volatility— there's a big difference between historical volatility and implied volatility. Historical volatility is easy. Just look at a chart. If you see that the stock has swung $20 in the last three weeks, that's historical volatility. That's what the stock has been capable of doing in the past. But the markets don't price historical. Historical volatility is like the beginning benchmark. That's the starting point of analysis.

But implied volatility is actually the market's future expectation of volatility. And what is interesting is that a lot of people mistakenly believe that implied volatility is determined by a market maker sitting behind a black curtain with some algorithm saying that this is the right implied. In fact, we as traders are responsible for the discovery of implied volatility as much as market makers.

Because a market maker's role is not to take the other side of the trade. It is to provide liquidity. And almost like a bookie in Vegas, a market maker does not want the inventory on his book. They want to have a buyer and a seller, match them, and in the end, they made a profit from facilitating the liquidity of providing a buyer and seller at right times.

But what if everybody in the market thought this option was cheap, and everyone wanted to buy the call, and no one was willing to sell it? Well, then that means the option market is mispriced. What happens is that, therefore, the option price will keep having to rise higher to disincentivize people from buying it and at the same time make it attractive for people to sell it, until the market discovers where's the right price, where there's an equilibrium between the amount of buyers and sellers. And that's the market discovery, a price discovery, that occurs in the market.

An adjusting variable in that is the adjustment of implied volatility. So implied volatility is sort of discovered by the whole marketplace in terms of where does the whole market discover what is the right price for this option, where there's an equal amount of interest to buy and sell, based on all known information. And that implied volatility is what is determined in the marketplace.

[Why Volatility Is Important]

So implied volatility is an adjustment for risk. Implied volatility is impacted by a company's earnings, its pending announcements or mergers, and macro events, such as a broader market event, such as, you know, a Donald Trump tweet. But in the end, what you have with volatility is an adjustment for all known information. So if a stock has not been very volatile for the last three months but has its earnings announcement next week, the market has to now price in the fact that earnings is next week, not that it was not volatile for the last three months.

[Price Adjustment]

And so that's all a price adjustment in the option pricing. And so option pricing, implied volatility is an expansion or contraction that influences the options price, even if the stock does nothing. And so what happens is if you own an option and volatility expands, you actually will make money in owning the option, even though the stock price hasn't actually moved.

And when you get to more advanced options trading, that is known in the option Greeks world as the impact of Vega, or the changes of volatility to your option pricing. And so nonetheless, one has to consider that investors manage expectations. And you'll have to be able to know what the volatility of the market is. You have to know that if volatility is considerably higher right now, you are going to be paying more to buy a call or to buy a put. And therefore, maybe you should not be so ambitious to do so, if you risk that you're overpaying for an option in a market environment where everybody is scared, or some other variable that is causing an option misprice.

Now, you can be right about the direction of a stock, But if you're wrong about its volatility, the trade may not be profitable. So I wanted to illustrate this with an example. Now of course, this is an extreme example because I don't want to—normally, you would never see this big of a variance in volatility. But I think it really comes across as a way of explaining it.

[Volatility Adjustment Example]

So imagine that we have a stock that is trading at $62, right before its earnings. And everybody expects this stock to blow out its earnings. And it's going to make an extraordinary move when the earnings announcement comes out. And so looking on the left hand side over there, with 30 days of time, a call option was, let's say, trading at $2.05 at the $70 strike. But it’s being priced at an extraordinary implied volatility of 70%. The market is pricing, already to that option, an extraordinarily big move by making the volatility of the option very expensive.

And so the option Greeks that— again, if you're new to options, you're not going to be familiar with the concept of Delta and Vega, but this is us measuring the impact of changes in price and the changes in volatility. And so what you can see is— let's say the earnings announcement came out 33 days later, and the stock actually shoots up. It goes from $62 up to $66. And in fact, an investor would have been right, by all accounts, that the stock rose.

But at the same time, implied volatility after the earnings announcement imploded, and it went from having been 70% to now normalizing near 40% for the stock, a very large mean reversion normalization of volatility. And so what you see here is the option based on its Delta rose by $1.21. For being right about the stock direction, the Delta was making you right. But the massive contraction of volatility caused a $1.80 throwback in the Vega, or the volatility, component of the option. And yet, you were right about the stock direction. It went from $62 to $66. And yet the call option you bought for $2 is only trading at $1.46.

Now this is an extraordinary example. Most of the time, you won't experience this. But I wanted to really create an amplified example to really show you that when you buy options during a period where volatility is very high, you now have a new variable you've introduced to your options trade that is not about you being right about the stock direction. But now you have to take it into account how much premium you paid in terms of volatility.

[Disregarding Earnings and Dividend Payments]

So the last part of what I wanted to talk about then is the idea of disregarding earnings and dividend payments. I wanted to just simply account for this idea of what does it mean when you own an option through an earnings announcement or over a period where a dividend from a company is being paid, and what impact does that have?

[Earnings]

So let's start with earnings. Just like I gave that example during volatility, one has to account for the fact that option premiums typically increase ahead of an earnings due to its implied volatility. Now this actually makes a lot of sense if you think about it. When is it that most retail investors generally want to speculate on a stock in the belief that a stock will make a big move right before its earnings? And naturally, whether you're speculating is going to go higher or lower, or you want protection, there is an increased demand for the purchase of options prior to an earnings. Whether it's from a speculation side or from a protection side, there's a growing demand.

And so implied volatility has to expand to compensate option sellers for the increased demand that is in the marketplace. So it is a very common occurrence for options to increase in their prices through implied volatility prior to an earnings, and then more importantly, normalize after the earnings. And so it's very important to take that into account. So premium is reflecting an increased risk of a surprise. And it's an expectation that the stock is likely to be more volatile, and the direction being far more uncertain, going into that earnings announcement.

[Typical Mistake]

So a typical mistake— investors believe that a stock is going to make a significant move, let's say, lower on earnings. They wish to buy a put option to participate, but they don't realize that the implied volatility has expanded, making the put option far more expensive, relative to historical levels and what the option premium is. And so there are ways around this. As you educate yourself on options, sometimes traders approach this by opening debit spreads, which are volatility neutral, or other types of strategies that reduce the impact volatility has to your overall options strategy.

Point is, it's a pretty rookie mistake to just be trading options directly on earnings. Because what you want to account for is usually one standard deviation move, an expectation within a 68% probability of what the stock is capable of doing, has been almost fully priced into that option. And so you really have to be predicting that a stock is going to make an outlier move, a tail move, something to the second or third standard deviation, whether higher or lower, in order for the option to pay off in a big way. And so really, often, investors—unless you believe that there's an extraordinary move coming into earnings, most of the time, speculating on that earnings with an option usually doesn't pay off. There's a reduced risk to that.

[Company Pre-Earnings]

The market is usually very good at pricing that in— all the variants in there. So here's an example of an options chain. Notice here that the 30 day historical volatility was near 15%. But notice that this option here is being priced with a much higher implied volatility going into an earnings than what has historically been its volatility. And so you're actually paying a vol premium in order to speculate on this option prior to its earnings. And the same you can see for the put option— the implied volatility, as well, is much higher than what it would historically be in that period.

[The Risk]

So what are some of the other risks associated with this? So some of the risks are things like if implied volatility contracts, after, the option premium will drop in its value. So exactly like the example I gave during the volatile period is that you'll see that the option will normalize afterwards. In fact, what's interesting— and I know a number of retail investors, like many of you online, that take advantage of it, because there a number of money managers that do it as well. When they're income selling premium, often, they take advantage of the higher premiums they'll earn on great stocks that they're willing to own right before earnings and accept that additional premium as income because they're willing to own that stock through its earnings.

And often, those money managers and investors that are very comfortable in stocks they own, they'll actually take advantage of this. They say, well, if someone who's the buyer is not in a good situation, that means it's a great situation for the seller, and often will take the other side of the trade. And you as a retail investor— it's very important for all of you to remember— you can be the seller of an option just as easily as you can be a buyer. And so if you feel the buyer is at a disadvantage, well that means you're going to make money by being a seller. And when you educate yourself on options, you can take advantage of these strategies, not only from an income perspective, but also from a directional perspective. There's all sorts of ways to approach options trading.

[Uncertainty]

Nonetheless, you have to take all this into consideration. So what are some of the uncertainties? Well, earnings represent uncertainty in the stock price. There's always the potential for a surprise on new information. And this could obviously always result in an extraordinary move. And this is why option prices generally go up right before an earnings, because they have to account for the fact that the stock is capable of doing something much bigger than it normally would.

[Dividends]

Now finally, I want to just touch briefly and give lip service to dividends. I just wanted to really emphasize the importance of understanding what happens on your ex-dividend date. One of the most common mistakes a beginner makes is the belief that there's a mispricing in options when it comes to dividends. So I've heard many people tried to build an argument for me that what they'll do is they'll buy a stock right before its dividend. They'll sell a covered call and use the premium to buy a protective put. And they basically remove almost all the risk of a loss associated with the stock and harvest a free dividend out of the exercise.

And what I can assure you of is the stock market and the options market is very good at removing, or in arbing out, all chance of you harvesting free money from the market. While there's plenty of opportunities to profit from the markets, rarely will the market offer you a free way, a risk-free way, of making profit. Just the very nature of the markets, you must take a risk to earn a return. And us being as investors, we're always trying to be incredibly smart about the risks we take. But we still have to take a risk to make money.

And thinking that there's a way— going to the market, and you've somehow outsmarted everyone else and can go in there and, as a retail investor, harvest out a free income stream without any risk— I think you have to reevaluate that. Because what happens with options in general is that a stock will normally drop by the size of its dividend the day it goes ex-dividend. So if a bank stock is about to pay a $1 dividend, what you will literally see, the day it goes ex-dividend, the next day it opens $1 lower.

And what happens is the options market knows this in advance. And so what you will literally see is that that dividend is being arbed out, where the call is cheaper and the put is more expensive, to actually bridge the gap to make there be no opportunity to actually make a free return. And so the point being is that there are lots of amazing ways to make money with options, but trying to game the dividend is not one of them.

Another common misconception amongst dividends is that I prefer covered call writing over, let's say, put selling because I own the stock and earn the dividend. While a put seller does not earn the dividend because they don't own the stock. But again, when you now know that it's actually accounted for, then actually the seller of puts is earning a larger premium in the put that they're selling, and the covered call writer is getting a smaller call premium. And in the end, the two are actually almost equal.

It's not that one is better and another is worse. In fact, if the option market is doing its job right, the two strategies should actually yield you about the same. And so it's about the market overall and having that opportunity to be right-priced. And what you always want to approach the markets is just know that generally, the options market rarely offers a mispricing. Sometimes, obviously, those people that are trading on insider information are not only risking going to jail, but those people may have an inside edge on something like that. But all known information is usually fully accounted for in dividends that way.

[Early Exercise]

One thing that has to be accounted for as a covered call writer, when you sell covered calls, which is you own the shares and you are the seller of the call, which undertake the obligation of potentially having to sell the shares away for a guaranteed income stream that you've earned in doing so. But one has to recognize that there is a risk that you may get called away early. To me, I've never had a problem with this. Especially if you're doing this, let's say, in an RRSP, there's no tax disposition of losing the stock. You can always replace it with another one or buy back the same shares.

But some people get really worked up about the idea of losing their stock when they're covered call writing, and they don't like it or don't want it to happen. Recognize that generally, there's always a risk that somebody may call the stock away from you prior to its ex-dividend date. And the simple way of knowing this is a simple little exercise. Those of you that know how to calculate— because I didn't build it in the presentation— but those that know how to calculate what the time value is in an option, the simple rule is this. If the time value left on an in-the-money covered call is less than the size of the dividend, you actually have a risk of being exercised early.

And it's a very simple rule. So if there's $1 dividend being paid and there's only $0.20 of time value left in the option, there's a very high probability you are about to be exercised early on the ex-dividend date. And so often, the way to avoid that is to close the covered call and sell a farther out covered call out that has enough time value to avoid being exercised early. And so that's often a solution one can do in dealing with that. But just recognize that with dividends, there's always that risk from a covered call writing perspective on that.

[Conclusion]

So what do I want to basically leave you with as a conclusion?

[Plan Your Actions]

I just want to emphasize most people learn about options the wrong way. They learn how to speculate with options. They first learn about this idea of buying a call, and I can make me 1,000% return. And they approach options through speculation. And like speculation, you get very much a gambler's style result, which is you either look like a rock star and you make a pile of money, or two, you lose a lot of money, and gives this very volatile experience.

And then what happens is because then, people hear that options are risky, they completely discount them and say, I don't want to use them. But when you educate yourself on options and you learn how to use them to protect yourself, how to hedge, how to generate consistent income, and to do all of these things without taking more risk in your portfolio, in fact, often reducing your risk— most people don't even know these strategies are available to them because they're so busy hearing stories about all these speculators gambling with options.

While each of you are going to know what you want from the markets and approach the markets in a different way, one thing I ask is just take the time to learn of all the different amazing uses of options and not just the speculative side of it, especially if we ever end up entering another bear market, or some other period where protecting your portfolio becomes an important consideration, or enhancing the income stream you're making during a period when stocks are not appreciating. There's all sorts of really important strategies to making money that don't involve you always having to have the stock go up to make money. And options offer that. It's so important.

So what are some of the last things I want to leave you? Plan your actions. Build a strategy where you choose the appropriate option and the strategy that is going to—what you want to achieve for your portfolio. Make less emotional decisions. I always say the most common mistake retail investors do is they make impulsive decisions based on fear and greed. And often, what you'll see is the most consistent investors are the ones that have a methodology where, in spite of all the emotions they feel, they remain very consistent to a method from which they execute in the markets and do it methodically.

One of the really good things about options, in my mind, is actually the control you feel. When you buy a stock and you buy a protection on it, knowing for certain that you cannot lose money beyond an x amount allows you to feel in control. You know, a lot of times, what causes panic is not knowing how bad something can get. And that causes the impulse of people to act, to feel like they need to get out. And so there's all sorts of things that you can use to do that. As well, you can manage risks and lock in profits.

When the stock has made an extraordinary move, and you're sitting on all these profits, often, wanting to sell it is the last thing you want to do. But often, you can use an option to secure a guaranteed sale price at a profit. Now you can continue to see whether the stock can appreciate, but you can, at the same time, know you're not going to lose the profits that you've made. There's all sorts of really amazing applications to options. And the only way you can do it is taking the time to learn and educate yourself on how to do this.

[To Learn More... ]

So I just wanted to highlight— I'm here, obviously, representing the Montreal Exchange. And I do always like to point out some of the really amazing resources that the Montreal Exchange offers, in addition to the resources that CIBC provides. There's all sorts of free e-learning tools, including a blog which I'm a regular contributor on. There's all sorts of videos and webinars, trading guides and strategy guides, that help you with different types of option strategies. There's option calculators.

There's also—what's really great is an options trading simulator. A lot of people get very nervous about placing their first options trade because they're putting real money at stake. One of the best things you can do is go onto the Montreal Exchange website, open a paper trading account, where you can buy the same Canadian stocks that you own, and go and apply an options strategy. And you can see if it's working, what happens, how it all plays out. So many amazing resources available to you, including they give you access to OptionsPlay and all sorts of other great resources on there. So please take advantage of it. You go to the Montreal Exchange website. You can either google Montreal Exchange or go to the m-x.ca website for that.

So with that, we're going to get to the Question and Answer part of the session. So I'll be happy to take the time to answer any questions any of you may have.

[Q & A]

I'm pretty sure that I'll be able to answer almost anything. So feel free to throw it at me and let's see what happens.

[Host:]

Thank you, Patrick. I just want to say that was a very insightful presentation. And just a reminder to the listeners that we would like to take your questions. So if you have them ready, you can actually type them in to the Q&A panel. It's located on the right hand side of your screen. And while we wait for questions to come in, I just want to point out that CIBC Investor's Edge offers basic option trading, such as buying calls and puts in all of our accounts, including tax-free savings account and RRSP accounts. It is subject to approval.

And there are more complex options strategies also available. If you want to know more information about that, please speak with one of our investment representatives. Our toll-free number is 1-800-567-3343. So as the questions are coming in, I will pass it back to you, Patrick, so we can go through some of them now.

[Speaker:]

Absolutely. So the first question from Michael is not based on options, but rather short sellers. I'll just very briefly— when someone short sells stock, they certainly can influence a market. They're providing more stock onto the market. But equally, I wouldn't say that it has a permanent effect because when they are forced to cover, they have to buy back in the shares, which actually provides a buying pressure to the upside. Often you will see, for instance, even in the last few months, most shorted stocks in the stock market have been actually the best performers because as short sellers are getting caught in those positions, they in fact are driving the prices higher. So I wouldn't say it has a permanent effect.

But anyway, let's stick with options questions. So Helen's asking, how do you determine a one standard deviation price move from implied volatility? That, actually, you can just educate yourself on. Implied volatility calculators are available to you. So you can actually just go and just google implied volatility calculators, including ones that are built for Excel spreadsheets. And you can actually put in the implied volatilities on a stock and determine what is the implied range that the market is actually pricing it.

So Alexander, you're asking what is the appropriate investment behavior with options in a bear market? I don't necessarily think that that's a simple question to answer. Obviously, if volatility is still low, the purchase of put options to hedge your existing positions is always a good way to protect yourself on the downside. But often during bear markets, when volatility spikes, those options become extraordinarily expensive and you have to adjust the strategy that you're doing.

And so it's not a blanket right or wrong. Just like I explained earlier, it all depends on what the volatility condition is at the time. But you definitely want to think that during bear markets, which are declining markets, the most important thing is to hedge your downside risk because the one— there was an old saying of "The one who loses the least during a bear market is the real winner."

So Helen, can you determine the post earnings volatility? Well, you can look at what the volatility was in normal periods prior to an earnings. So if you saw implied volatility on a stock was 15% and now at earnings it's 20%, you can make a basic assumption that it will mean revert back towards 15. That may not always be the case. But that's a general rule of thumb that you can sort of see is what the volatility is on that.

So the OptionsPlay on the Montreal Exchange website, Mark, is that time limited? I don't know how long the Exchange will continue working with them, but so long as they are, it's not limited in its time. Obviously, if the contract ends with them, they always reserve the right to cease that. But right now, you can use that continuously at this moment.

Walt, absolutely. One can use options for ETFs, not for mutual funds. But while you can buy options on exchange traded funds— in fact, I think that was the last presentation I did here. We were specializing on ETFs. But yes, there's a very liquid options market for ETFs. And the one thing is if you wanted to protect yourself with options on mutual funds— let's say if you had a Canadian Equity Fund— well, at that moment you can use the Canadian Index ETF options. It's not going to be a perfect hedge. But you know, generally, that your mutual fund is going to have a very strong beta correlation to that of the ETF, and so you could just create a synthetic that way. But you can't buy put options on mutual funds themselves.

How good is a strategy to write put options to be ready to buy— I love that strategy. The question is, how good is the strategy to sell a put to be ready to buy the stock? I actually, quite commonly, personally do that. It's a very effective way of generating an income while selling at a premium where you can dollar cost average your price at a lower level. And so yes, it's perfectly good.

The key thing to selling a put is that you have to understand that you have an obligation to buy the stock at that specific price. So long as you're willing to honor the counterparty obligation, you're generating an income and entering the stock at a price level you know you're looking to get. And that's certainly a valuable way of doing that.

Does foreign exchange add the volatility enhanced option premium? No, because Canadian options are done in Canadian dollar, US options are in US dollars. And so volatility does not adjust, at least not as directly, into the option pricing.

The next question. When an options contract is near expiration, the intrinsic value of the contract is decayed? No, not the intrinsic value. The time value is decayed. The intrinsic value is the equity component of the option's value. That does not decay. So whatever amount is in-the-money— in the earlier example, when we were at $3.66 in-the-money on that $50 strike option, there was no point where the $3.66 is decayed. The only way that you can lose that $3.66 is from a price drop, because it's the equity component of the value of the option on that.

So next question. Can I sell a covered call before the expiration, and how often does that happen? Yeah, well you can—I'm not sure what you mean by before an expiration. I'm assuming every option has an expiration. Are you referring maybe to its earnings or something? I'm not sure. David, if you can just re-explain the question. I'm not certain if I understand what you're asking.

Robert, is it a good sign if you are the volume for a gift option? No, no, Robert. Listen, I always say, in the options market, what you want to realize is that the liquidity is actually much greater than the volume and open interest. What you want to think is the volume and open interest is just telling you how many options have come to existence. But really what you want to take into account is a market maker, a market maker's willingness to create a market, is very much dependent on how big of a book they have and what they're willing to do. And so just because you might be the only volume for the day doesn't mean that the liquidity isn't there. You don't want to just immediately connect one with the other.

Let's go to the next one. Do you want to keep going?

[Host:]

Yep.

[Speaker:]

So the next question here. So the question here is large institutions can drive stock prices up or down by calls or puts to generate profit. I would say no. Generally, yes. A general demand of price rising can continue to have a stock appreciate and someone could profit from it. But I wouldn't generally say that a market can, over any short term period, be manipulated. I guess you can, in theory, say that because it is an open market. But I would generally say the options market is pretty good at closing loopholes for that. I think that's a generalization that— I don't think that's a fair generalization in general.

So Alexander, you're asking, what is your view on inverse ETFs at the moment? Generally, I think options are better than inverse ETFs. Because the problem with inverse ETFs— not only do they have tracking errors, but they also have an undefined risk. In other words, you don't know how far something can go against you when it's going. What I least like about options is that when you put them on, while there's a risk of loss, you know in advance what your worst case scenario is. And I think that's a very important thing to be able to do, is to know what your worst case risk is on that.

[Host:]

All right. Thanks, Patrick. Just one last clarification. I know some clients have asked questions about information on the options. So if you log into your Investor's Edge account, you can click on the Stock Center. Once you find the security, there's actually an Options tab, where you can get all the information regarding the options.

So I just want to say that it looks like that's all the time we have. So Patrick, it was a very informative presentation. And I think I speak on behalf of our audience that we're very comfortable with trading with options now. So thank you again, Patrick.

[Speaker:]

Oh, thank you very much. Thanks, everyone.

[Host:]

A reminder to the audience that if you wish to listen to this webinar again, a link will be emailed to anyone that registered. I would like to thank the audience. We really appreciate you being here. Should you have any comments or suggestions, please visit Investor's Edge website or get in touch with us by phone, chat, or email.

[Thank you]

Thank you for joining us today. We will see you next time.

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