What are equity options?
Equity options are agreements between two parties for a specified time period (up to the expiry date) that give holders the right, not the obligation, to buy or sell a specified number of shares, usually a lot of 100, at a pre-determined price (exercise or strike price). You can buy or sell options just like shares.
What is a call option?
A call option contract gives the holder the right to buy and obliges the writer to sell a specified number of shares at a specified strike price, any time before its expiry date.
What is a put option?
A put option contract gives the holder the right to sell and obliges the writer to buy a specified number of shares at a specified strike price, any time before its expiry date.
What is a strike price?
The strike price is the price at which the option holder can buy (call option) or sell (put option) the underlying stock.
What is the option premium?
The option premium is the price the buyer pays the seller for the rights conveyed by the option contract. It is the price of the option.
What is the difference between at-the-money, in-the-money and out-of-the-money options?
An option is "at-the-money" when the underlying stock price is identical or relatively close to the option strike price.
A call option is "in-the-money" when the underlying stock price is higher than the strike price. A call option is "out-of-the-money" when the underlying stock price is lower than the strike price.
A put option is "in-the-money" when the underlying stock price is lower than the strike price. A put option is "out-of-the-money" when the price of the underlying is higher than the strike price.
What is the contract size of a equity option?
The contract size of an option contract (the number of underlying securities covered by the option) is 100 shares, unless adjusted for a special event such as a stock split, reverse stock split or consolidation.
What is open interest?
Open interest represents the total number of options contracts on a particular share that have not yet been closed or exercised. This is an important concept, but it has no direct impact on the price of an option.
An opening transaction increases the open interest whereas a liquidating transaction reduces it. The greater the open interest, the more liquidity in the market, therefore the easier it is to take or dispose of a position.
What does "being assigned" mean?
An assignment takes place when a holder exercises an option. Option writers each receive an exercise notice that obligates them to sell (in the case of a call option) or buy (in the case of a put option) the shares at the stipulated strike price.
What does "exercising" mean?
Exercising an option is the process by which holders exercise their right to buy (in the case of a call option) or sell (in the case of a put option) according to the terms specified in the contract.
What is the difference between American and European options?
American options allow the holder to exercise the option at any time during the life of the option. With European options, on the other hand, the holder can only exercise the option on its expiry date. Options on the S&P/TSX 60 Index (SXO) are European style.
All equity options traded on MX are American style, which gives investors more flexibility. However, this extra privilege comes at a price that is built into the option premium, which is why the value of American options is usually higher than the value of European options.
What is the expiry date?
The expiry date is the date on which the option and the right to exercise it cease to exist. Options expire at noon on the Saturday following the third Friday of the expiry month (last trading day).
What is the CDCC?
The Canadian Derivative Clearing Corporation (CDCC) is the sole issuer of all equity options listed on MX. CDCC is also responsible for clearing of all options transactions on MX.
How are options transactions guaranteed?
The role of a clearinghouse is to guarantee the financial obligations on every contract it clears. Therefore, CDCC guarantees all contractual obligations of the parties to a trade. This is achieved by the clearinghouse acting as the buyer for every seller, and the seller for every buyer.
What happens to options in case of a stock split?
When there is a stock split, MX will generally do two things: it will increase the number of contracts outstanding and it will cut the strike prices of these options.
For example: If stock ABC announces a two-for-one split and you own one call (representing 100 shares) with a strike price of $50, MX will credit your account with two calls (representing 200 shares) and it will reduce the strike price of those calls from $50 to $25. There is no beneficial change to the holder of the calls.
In the case of a reverse stock split, or consolidation, MX will credit your account with the adjusted number of options and it will adjust the strike prices in the same way as for a split.
MX issues, close to record date, a circular disclosing all details of the stock (and option) split, i.e. the ex-distribution date, the payable date, etc.
What happens to options in case of a takeover or a merger?
When there is a takeover, a merger or any other event that affects the shares owned by shareholders, MX will change the deliverable to reflect what shareholders would receive.
For example: Stock XYZ gets taken over by company MNO. They announce that shareholders of XYZ will receive 50 shares of MNO for every 100 shares of XYZ they own. If you own 1 XYZ call and if you were to exercise it, you would receive what the holder of 100 shares of XYZ is entitled to receive, i.e. 50 shares of MNO. The seller of the calls will have to deliver 50 shares of MNO. It is to be noted that the seller of the call probably owns 100 shares of XYZ, he will therefore receive 50 shares of MNO in exchange for his shares; he will own the shares that need to be delivered. The holder of an XYZ put will have to deliver 50 shares of MNO per contract held and the seller of an XYZ put will take delivery of 50 shares of MNO.
What happens when a stock is halted?
If trading in a stock is halted because of regulatory concerns, the stock and options exchanges will coordinate the halt in trading so that trading in the options will also be halted. However, if trading is halted on an exchange because of a technical problem and the stock trades on another liquid market that can be accessed by investors, options will continue to trade.
It is to be noted that if a stock is halted for whatever reason, options that are held can be exercised despite the trading halt.
Who are market makers?
Market makers are simply professional traders who send in orders to buy and sell specific series of options. They are approved by MX and must provide sufficient liquidity in such series.
If I buy an option and forget to exercise it at expiry, will I lose my investment?
CDCC will automatically exercise any equity option held by a client that is $0.01 or more in-the-money. Automatic exercise is only triggered at expiration time according to the following rules:
- An option that is $0.01 or more in-the-money will automatically be exercised. The option buyer/holder can advise his broker to notify CDCC not to auto-exercise an option. So, if you are the holder of such option, you have the alternative to override the automatic exercise process.
- If an option is less than $0.01 at-the-money or in-the-money, it will not automatically be exercised by CDCC. The holder/buyer of such option must notify his broker to exercise it.
- Conversely, if you are the seller/writer of a $0.01 or more in-the-money option, you will be assigned (in this case, there is no override alternative).
- If the option sold is less than $0.01 in-the-money, the writer may or may not be assigned. Upon receipt of an exercise notice, CDCC will assign to a randomly selected firm (or clearing member) that has declared a short position. The firm then re-assigns the exercise notice to a customer (usually on a first-in, first-out basis).
Can I sell covered calls in a registered account such as my RRSP?
The Canada Revenue Agency recognizes the following eligible derivatives:
- Purchase of call options on stocks
- Writing covered call options on stocks
- Purchase of put options on stocks
- Writing put options on stocks
In addition to RRSPs, the above-mentioned strategies also extend to Registered Retirement Income Funds (RRIFs), Registered Education Savings Plans (RESPs), Deferred Profit Sharing Plans (DPSPs) and Tax-Free Savings Accounts (TFSAs).
Why aren't there options on every stock?
First, let's mention that it is the clearing house, the Canadian Derivatives Clearing Corporation, that sets the eligibility criteria of equity options. These criteria are the following:
- The stock is listed on a Canadian Exchange.
- The market capitalization of the stock is within the top quartile (25%) of securities listed on all Canadian Exchanges as of the last trading day of the previous quarter. The specific dollar amount of threshold is published by the Corporation.
- The monthly North American volume of the stock is within the top quartile (25%) of securities listed on all Canadian Exchanges as of the last trading day of the previous quarter. The specific threshold is published by the Corporation.
In addition, MX also monitors the stock's volatility, volume and price. MX must also assess interest from market makers.
If I buy an option, do I have to exercise it?
No. In fact, most options buyers do not exercise their options. Rather, they simply sell their options in the market, much like they would do with stocks. When you sell an option you hold, you are closing your position.
If I sell an option, can I be assigned before its expiration date?
Most options sellers will not be assigned ahead of the options' expiration date. Nevertheless, an early assignment is certainly possible. You are most likely to be assigned early if the options are deeply in-the-money or, if you have sold calls, if the stock is about to pay out a big dividend. If an option is deeply in-the-money, there is most likely no time value left and the options holder may prefer exercising it. If the stock is about to pay out a big dividend, the call holder may prefer holding the stock rather than holding the calls because call holders do not receive the dividend that is paid out, shareholders do. The rule of thumb is that if the amount of time value available for a call is lower than the dividend that is about to be paid out, then you are running the risk of being assigned.
It is to be noted that if you have sold a covered call, an early assignment is a good thing. It means that you will be taking in your maximum possible profit.
Can I sell an option I don't own?
Yes. Options can be sold without your owning them and, no, this is not short selling. When you buy an option, you pay out money to someone and obtain the right to buy (or sell, in the case of put options) the underlying stock at a given price. If you are right, then you will buy (or sell) the shares at the option's strike price. Who sells you these shares? The seller of the option.The buyer of an option pays out money to the seller of the option and receives the "option" of buying or selling the underlying shares. The seller therefore takes money in, but also takes on the obligations that go along with the contract.
Given that options sellers take on an obligation, why would anyone sell them?
To invest. One of the general rules for using options is that options buyers are usually trying to profit from a view of the market and options sellers are investors (an exception would be when an investor buys puts to protect himself from a drop in the stock price).
If you own shares, it is very important that you "cover" them by selling calls. This strategy is called "covered call writing". There are a number of reasons an investor would do this:
- Studies have shown that selling covered calls reduces the risk of a portfolio by 30% to 50%.
- Theoretically, selling covered calls will maintain the same returns as would be achieved with an uncovered portfolio but with much less risk. Many studies have further found that selling covered calls actually increases your returns while reducing your risk.
- Covered calls allow you to sell your stocks as they rise–they instill a proper discipline and remove much of the emotions that lead people into losses. Too often, investors become greedy, never wanting to sell their shares because they may still go up. Paper profits are not real profits until you sell your shares.
- Covered calls allow you to make money in any market without having to guess on a stock's direction.
- Covered calls allow you to reevaluate your share holdings on a periodic basis.
- The option premium received when selling options is considered to be a capital gain in the year the option is sold. Capital gains are taxed at a much lower rate than bond coupon payments or dividends. Covered calls are therefore an excellent, tax-efficient way to take in revenue for investors who usually hold bonds or preferred shares for revenue.
Selling covered calls requires me to sell my shares if they go up. Is there any way of avoiding this?
There are ways of avoiding having to sell your shares in a rising market. You can buy back your calls (given that you had previously sold the calls, if you buy them back, you are closing your position) and perhaps sell other calls with a higher strike price and a longer term until expiration, or both. This is called "rolling" your calls.
Should you roll your calls? With the exception of high commissions, there is no reason to want to roll your calls. As mentioned previously, if you are unwilling to sell your shares because you think they might still go up, you are becoming greedy. You must ask yourself: "When will I sell my shares? Too often, investors hold onto their paper profits for too long and see their stocks drop.
Selling covered calls is a passive investment strategy. It carries relatively little risk. Covered call writing can and should be done systematically on all of your share holdings. The one thing you need to remind yourself is that this strategy works well on the stocks you want to buy and hold for a long period of time. If you are very involved in the management of your portfolio, if you buy and sell your shares trying to time the market, then writing covered calls could frustrate you. Covered calls are simple, but they work.
When I sell calls to cover my stocks, I take in money. It sounds too good to be true. I don't believe in free money. Where's the catch?
Writing covered calls brings in money, but it is not "free" money. If your shares rise above the calls' strike price, you are foregoing all profits beyond that price because that's where you will be selling your shares. You are foregoing the big "home run" types of profits in favor of taking in smaller amounts of money more often. The money taken in from selling the calls is essentially an "advance" on the future, potential profits of the stock. Theoretically, both amounts should be equal over the long term and, once again, studies have shown that the profits from selling calls actually outpace buy-and-hold over most historical periods.
Which calls should I sell?
There are two variables in the choice of calls to sell: the call's strike price and expiration month. There are two rules of thumb for making these decisions. For the expiry month, you should seek to sell the shortest-term options you can as often as possible. Unfortunately, commissions may keep you from being able to sell one-month options if you have a small position because you would be taking in smaller amounts of money more frequently over many trades (read: many commissions). You must gauge how much of the premium you are taking in is going to your broker and find the right frequency for you.
As for which strike price to choose, one usually sells the first strike price above the current price of the stock. It is possible that there are wide intervals between strike prices and the nearest strike price is so far above that you would not be taking in much money by selling that call. In such a case, you should sell the first strike price below the stock's price. This is counterintuitive, but selling in-the-money options is a very reasonable strategy–it is actually much more conservative than selling out-of-the-money options. You must also always remember that it is the money taken in from the sale of the call that you wish to maximize, not the height of your ceiling. This will allow you to earn the highest returns over the long term.
Are there any other option strategies available to investors?
Investors can also sell secured puts or covered straddles. Secured puts are identical to covered calls in terms of risk/reward characteristics; the reasoning is just inverted. If you want to buy a stock, you can sell a put instead and set the cash that would have been used for the stock's purchase aside in Treasury bills.
Covered straddles are even more conservative. They involve selling both covered calls on shares you own and secured puts for shares you would want to buy.
Last, investors can buy puts as insurance policies to protect shares against a drop in the stock price.
I like the idea of buying puts for all my shares. That way, I can profit if the stocks rise and I am protected if they fall. Why shouldn't I do this systematically?
The reason is that you are spending money to protect money. Buying puts costs money and, over the long term, can turn a portfolio's profits into losses. Buying puts as insurance works well, but you should do this only when you: a) have gains you want to insure, and b) still think that the stock can rise. If you do not have any gains to insure, the insurance will have you start off with negative returns (the cost of the insurance). If you do not think the stock can still rise, you might as well sell it rather than spend good money to insure your profits.
Why are the available quantities on the bid and ask different from series to series?
MX has adopted an open, transparent electronic options market. In such a market, no individual's orders have priority over any other individual's and no orders can be excluded from being posted in the book. If a client sends an order to buy one contract with a specified price that is below the best available selling price, the order will be posted–and the bid will be good for one contract. Note that the depth of the market can be seen; you can quickly find out at what price you can buy or sell your desired quantity of options (if you cannot see the depth of the market, your broker has a quote screen on which it can be seen).
I know that I should sell short-term options. Does it mean that I should buy long-term options?
When buying options, you should seek to buy only the amount of time you need for the stock to make its move. If you think that a stock will be rising within three months, it is not necessarily a good idea to buy long-term options because they will not follow the stock price's moves as closely.
I've read in some places that I should only buy in-the-money options and in others, that I should buy out-of-the-money options. Which ones are better?
Neither in-the-money nor out-of-the-money options are "better", it just depends on your preferences. Out-of-the-money options are much less expensive than in-the-moneys, but you have a much lower chance of making money on any individual trade. When you do win with out-of-the-money options however, the percentage gains will be much higher. On the other hand, buying in-the-money options often allows you to salvage something from the purchase. In-the-money options have a better chance of being worth something at expiration. Of course, they are much more expensive so you have less leverage (the percentage gains will be lower than with out-of-the-money options).
As you can see, it depends on your temperament. If you are used to trading stocks and are a good manager of your capital–i.e. you know when to cut your losses when you're wrong–then in-the-money options are probably better suited to your style. If you simply want to buy lottery tickets (i.e. you are patient and you don't mind losing often in the hopes of getting that one big gain), out-of-the-money options are for you. Neither offers systematically better returns over the long term.
I bought a call and the stock price rose, yet the call price didn't move or even dropped. What's going on?
This is hardly an impossible situation and it has happened quite often in the past (note that it can happen with puts also). The option price is a function of many different variables: the price of the underlying stock, the time until the option expires, the changes in interest rates, the changes in the underlying stock's dividend payout policy and the implied volatility of the option. Of these, three usually account for most of the moves in the price of an option over its life: the underlying stock price, the time to expiry and the volatility.
If you had bought an at-the-money three-month call for $5.00 expecting stock XYZ's price to rise and this rise only happens one week before the call expires, you will find that much of your purchase price has already been eroded by the passage of time. Furthermore, you may have overpaid for the option. If you had purchased the call at a time when options are relatively high-priced, you may be right and the stock price may rise, but the market's assessment of the price of the option may be dropping simultaneously (the implied volatility of the option may drop). In such a case, the call's price may not rise much, or may even drop. This is why, if you purchase options often, you must be aware of the implied volatilities at which options are trading in order to not purchase an overpriced option.
It is always important to remember that the options market is separate and distinct from the stock market. Options prices are set by buyers and sellers (not by computers programmed with big mathematical models). Stocks can be over- or undervalued, so can options.
I've read on the Internet that there are ways of making guaranteed, big money in the options market with little cash down. Is this possible?
Yes, for the writers of the websites you have been visiting. Unless you are a professional options trader and have an agreement with a brokerage firm (thereby giving you big reductions in commissions in exchange for heavy trading), there is little to no chance of you making guaranteed money in the options markets by finding anomalies. The options market is often seen as being exotic to newcomers. In fact, once you get to know how things work, you will find that options are quite intuitive and common sense becomes your guide.
It is important to remember that if someone has a "system" by which they make guaranteed returns, the "system" would no longer work if many other people started using it.
Which order types are available on the options market?
MX supports the following order types:
- Limit order: Order for which a limit price is specified.
- Market order: Order for execution at the best price available in the market for the total quantity available from any contract bid (offer). Any residual volume, left after part of a market order has been executed, is automatically converted to a limit order at the price at which it was just executed.
- Market-on-open order: Order for execution at the market opening at the CTO (Calculated Theoretical Opening) price. If a market-on-open order is only partially filled, any residual quantity is automatically converted to a limit order at the price at which the original order was executed. Market-on-open orders have priority over limit orders.
- Day order: Order that must be filled on the day it was sent or it will be cancelled at the close of trading. Unless specified otherwise, an order is always a day order.
- Good 'til date (GTD): Order that will remain valid in the book until a specified date, after which it will be cancelled.
- Good 'til cancelled (GTC): Order that will remain valid in the book until it is cancelled.
- Fill and kill order: Order that will be executed at the specified price. If it is not filled completely, the remaining quantity will be cancelled.
Can you refer me to material explaining tax treatment of different option strategies?
The Montréal Exchange has commissioned KPMG for an analysis of the tax treatment of equity options. Though we recommend that you consult your own experts, this brochure is an excellent starting point for any discussions.
Can you tell me what happens if an underlying security goes bankrupt and is delisted from the TSX?
When an underlying goes bankrupt, the option ceases to trade and the class is delisted. However, CDCC maintains a book on the option class untill all potential put and call holders exercise their position in exchange for cash.
Why are options bid and ask prices always quoted in multiples of $0.05? I noticed this since I started trading calls recently. What would happen if I placed an order to sell my call at, say, $0.58?
MX operational procedures state that:
- If the option premium is equal to or less than $0.10, the tick is $0.01.
- If the option premium is greater than $0.10, the tick is $0.05.
This means that if you place an order to sell you calls at $0.58, your order should be rejected by your broker. If the broker does not notice the wrong price and sends it to MX, the order will be rejected by SOLA (the automated order system) and it will bounce back to your broker with an error message: "invalid price".
Do you have a guide on how to interpret the options quote listing?
We do not have a guide, but here is some explanation:
- Series/Strike price represents the option series on a specific option class.
- Bid size is the number of contracts available to be sold at the bid price.
- Bid price is the price you can sell your option at. In other words, it is the price at which a market participant is ready to buy the option from you.
- Ask size is the number of contracts available to be purchased at the ask price.
- Ask price is the price you can buy your option or the price at which a market participant is ready to sell the option to you.
- Last price is the last price an option was traded at during a trading session (bought or sold). If there is no volume on an options series, the last price is the previous day's reference price and stays at that level until new trades are executed. At the end of the trading day, we determine the reference price based on the following: 1) always the offer, 2) if there is no offer, we use the last traded price, and 3) if there is no last trade, we use the previous day's reference price.
- Net change represents the difference between the last price and the previous day's closing price.
- High is the higest price an option traded during a trading session.
- Low is the lowest price an option traded during a trading session.
- Volume represents the number of contracts traded during a trading session.
- Open interest represents the number of contracts opened on the series that have not been closed or exercised yet.
- Implied volatility (%) is the volatility of the underlying anticipated by market participants; implied volatility is an indication on whether an option is overvalued or undervalued.
What is historical volatility as it is used on your options quote sheet?
Historical volatility is a statistical measurement of past price movements (in our case, the last 30 trading days). There are two types of volatility: implied and historical. Implied volatility is the future volatility of the underlying stock anticipated by market participants today and is reflected in the option price. It is an indication on whether option premiums are overvalued or undervalued. Implied volatility is an estimation of future volatility. We can try to guess what will be the future volatility by looking at the historical volatility of the stock. But sometimes, historical volatility is not a good indication of the future because current events hitting the market may have changed the volatility of the underlying (rumors of takeovers or revisions in earnings).
Option traders usually compare historical volatility with implied volatility (expected by the market) to build their own expectations of the future volatility. If implied volatility is higher than historical, it means that the market is overestimating the future volatility of the stock and it is also an indication that the option is overvalued (or expensive). Traders would be selling the option. The higher the implied volatility, the higher the option premium.