©2015, College for Financial Planning, all rights reserved.

Session 15Derivatives – Options, Futures, and Warrants

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning

Session Details

Module 8

Chapter(s)

1,2

LOs 8-1 Explain terminology, characteristics, risks, concepts, and strategies for the use and valuation of various types of option investments.

8-2 Evaluate the effective use of options as speculative investments and as hedging instruments.

8-3

8-4

Explain terminology, characteristics, risks, concepts, and strategies for the use of commodity contracts.Evaluate investor situations to recommend appropriate hedge positions.

15-2

Option Terminology

15-3

Option Terminology

15-4

Option Terminology

15-5

Option Basics

• Buying options for speculation• Writing covered calls for income• Hedging by buying protective puts

15-6

The Intrinsic Value of an Option

The intrinsic value of an option to buy stock is

the difference between• the price of the stock,

and• the strike (exercise)

price

15-7

At the Money

CallPut Strike Price

$50$50 $50$50$50$50

15-8

In the Money

Call

Put$50$50

$60$60

$40$40

15-9

Out of the Money

Call

Put

$50$50$40$40

$60$60

15-10

Action Contractual Result

Buy a call The right, but not the obligation, to buy the stock at a specific price by a specific future date

Sell a call The obligation (if buyer exercises option) to sell the stock at a specific price by a specific future date

Buy a put The right, but not the obligation, to sell the stock at a specific price by a specific future date

Sell a put The obligation (if buyer exercises option) to buy the stock at a specific price by a specific future date

Option Strategies

15-11

Options Strategies & Risk (1)

Strategy Risk

Purchase a call or put

Speculative investments with a limited time frame, maximum loss is the cost of the option (premium)

Covered call writing

Conservative strategy: keep premium but give up upside potential – stock may be called away

Naked call writing

Extremely risky: as stock rises loss is increasing, theoretically an unlimited amount of loss since no limit on how high stock can go

Naked put writing

Moderately conservative strategy: write put options on stocks you wouldn’t mind owning, if you have to purchase stock risk limited as stock can only go down to zero

15-12

Option Strategies & Risk (2)

Strategy Risk

Covered put writing

Opposite of owning a stock and writing a covered call, here you would short a stock and write a covered put

Protective putIMPORTANT!

Strategy whereby you own stocks and want to protect the stock or portfolio from a downturn by purchasing a put

Straddle Combination of a put an call on the same stock, with the same expiration and exercise price (betting on a large price movement, just don’t know which way)

Spread Combining into one transaction one or more options with different strike prices and or expiration dates—looking to profit on change in the differential between contracts

15-13

Black/Scholes Option Valuation Model

Value of an option depends on

• current market price of the stock

• strike (exercise) price of option

• length of time until the option's expiration

• variability (standard deviation) of the stock’s return

• risk-free rate

15-14

Call Options

• Call options to buyo are created by investors

• Warrants are also an option to buy buto are created by

corporations

15-15

Warrants

Warrants Call Options

Sold by corporations Sold by individuals and institutions

Expiration typically several years out

Expiration typically less than 1 year

If exercised, proceeds go to company which issues stock

If exercised, option writer delivers stock to option purchaser

15-16

Commodity & Financial Futures

A formal agreement(contract) for the delivery (seller) or • receipt (buyer) of a

commodity

Participants in futures

markets are either • speculators or • hedgers

15-17

Futures Terminology

15-18

Futures Leverage Example: Gold• Gold contract is 100 troy

ounces, assume current price is $1,700 per ounce

• Value of contract is $170,000

• Initial margin requirement is $7,425 (4.37% of the contract value)

• Maintenance margin is $6,750, so decline in gold price of just over $6.75 (100 ounces x $6.75 = $675 loss) would generate a margin call($7,425 - $675 = $6,750)

• Must meet margin call immediately

15-19

Hedging

Hedging is the procedure for reducing risk

of loss by taking the opposite position in an asset• Short hedge: If long, then go short ― for example,

a wheat farmer (who is long wheat) would then short (sell) wheat futures as a hedge (against lower prices)

• Long hedge: If short, then go long ― for example, a baker who uses wheat is short wheat, so the baker would go long (buy) wheat futures as a hedge (against higher prices)

15-20

Hedging Examples

What type of hedge would you enter into if

• you were a gold mining company?• you were a jeweler?

15-21

Question 1

Which of the following would purchasing a stock index option potentially allow an investor to do?I. participate in market movementsII. hedge a portfolioIII. limit the amount at risk to the amount

investedIV.receive premium income

a. I and II onlyb. I, II, and III onlyc. I, II, and IV onlyd. II, III, and IV onlye. I, II, III, and IV

15-22

Question 2

Your client, Tony “Tiger” Jones had purchased 10 puts on XYZ Enterprises with a strike price of $45. XYZ is currently trading at $43 per share. You would advise Tony thata. the options are “in-the-money” by $1,000.b. the options are “in-the-money” by $2,000.c. the options are “out-of-the-money” by

$1,000.d. the options are “out-of-the-money” by

$2,000.

15-23

Question 3

Which of the following statements is true?a. If the strike price is less than the market

price, then a put option is “in-the-money.”b. If the market price and the strike price are

the same, then the option is said to be “in-the-money.”

c. If the market price is greater than the strike price, then a call option is “out-of-the-money.”

d. If the strike price is greater than the market price, then a call option is “out-of-the-money.”

15-24

Question 4

Rank the following strategies from most conservative to the riskiest.a. covered call writing, call purchase,

naked call writingb. covered call writing, naked call writing,

call purchasec. call purchase, naked call writing,

covered call writingd. naked call writing, call purchase,

covered call writing

15-25

Question 5

All of the following, according to Black-Scholes, would cause the value of a call option to increase, except ana. increase in the current market price of

the underlying stock.b. increase in the risk-free rate.c. increase in the standard deviation of

the stock.d. increase in the length of time until

expiration.e. increase in the strike price of the

option.15-26

Question 6

Which of the following statements is incorrect when comparing options and warrants?a. Warrants are often issued along with

bonds.b. Options are sold by an individual

option writer, whereas warrants are issued by corporations.

c. Warrants, unlike options, do not have market risk.

d. Warrants typically have longer expirations than options.

15-27

Question 7

Frances Farmer has been raising corn for use in ethanol fuel. She believes prices are near their peak, and she wants to “lock in” the current price. She would enter into aa. long hedge, as a hedge against lower

prices.b. short hedge, as a hedge against lower

prices.c. long hedge, as a hedge against higher

prices.d. short hedge, as a hedge against higher

prices.15-28

Question 8

Which of the following statements comparing commodity futures and options is correct?a. Purchasing an option and going long on a

futures contract carries approximately the same amount of risk.

b. Option traders pay a premium, whereas futures traders are required to make a good faith deposit.

c. Individuals and institutions trade options, but only institutions trade in commodity futures.

d. Futures can be used for hedging, but options cannot.

15-29

Question 9

Which of the following is a feature associated with investing in futures contracts?a. Profits increase in a short position in

futures when the spot price increases.b. Open interest always declines as

commodity futures contracts approach expiration.

c. Futures prices will follow the spot price more closely as the contract expiration date approaches.

d. Most futures contracts are settled by either delivering or receiving the underlying commodity.

15-30

Question 10

Sam creates large sculptures for office buildings, and uses a large amount of copper in his sculptures. He has several large orders he will need to complete over the next year, and he is concerned about the direction of copper prices. To protect himself he woulda. buy a futures contract, called a long hedge, to

protect against the price of copper increasing.b. buy a futures contract, called a short hedge, to

protect against the price of copper increasing.c. sell a futures contract, called a long hedge, to

protect against the price of copper increasing.d. sell a futures contract, called a short hedge, to

protect against the price of copper increasing.15-31

©2015, College for Financial Planning, all rights reserved.

Session 15End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning