Transcript: CIBC Investor’s Edge — Understanding Call Options: How They Work

[Understanding Call Options: How They Work]

[CIBC logo. CIBC Investor’s Edge — Understanding Call Options: How They Work. A mobile phone is shown with a line graph on the screen. The screen scrolls up to show another line graph and a bar graph.]

[A CIBC Investor’s Edge employee stands in front of a wall with the CIBC logo on it and speaks.]

[A graphic is shown with an icon of a house on the right and it is labelled: “Current value of house $750,000”. To the right a new icon is shown of a person, both then slide to the left and a new icon is shown on the right, of a document which is labelled: “For 12 months, she’ll pay $800,000”. The house icon then rolls over all of the icons leaving it as the only icon on the screen.]

>> CIBC Investor’s Edge employee: So, what are they? Let's start off with an example from the real estate world. Suppose your house is worth $750,000 on the market today. A friend of yours who's rather optimistic about the housing market comes to you and says that she would like to strike a deal with you. For 12 months, she will have the rights to buy your house for $800,000 at any point throughout that 12-month period.

She wants to make this deal with you because she thinks that the price of your house will skyrocket above $800,000 in the coming months. If you say yes to her proposal, what's in it for you? If the value of your house does not go above $800,000, your friend will not exercise her right to buy it from you at that price if she could get it for a lower amount on the market. 

[A graphic is shown with an icon of a house on the right and it is labelled: “Market value of house” with an arrow pointing up beside the wording: “$750,000” This price then goes up to $900,000. A new icon of money and a checkmark appears beside the house icon. Both icons slide to the left and the following wording is shown on the right: “You must sell for $800,000”. All icons slide off and a new money icon with an arrow point upwards appears. To the right the following wording appears: “You miss out on $100,000”. The icons on the left disappear and are replaced with the following wording: “$900,000 (market value in future) - $800,000 (sale price you agreed to)”.]

Now let's say your house does skyrocket to $900,000. Then your friend will gladly exercise her option and you are obligated to sell your house to her for the agreed upon $800,000. In this example, you will be missing out on $100,000 of price appreciation. 

[A graphic of a document and pen icon is shown. To the right the following wording appears: “Friend must pay for the rights”. This slides off and a new icon of money with a checkmark is shown. To the right the following wording appears: “Payment for the right is called a premium”. An arrow appears going from the money icon to a new person icon and the following wording appears: “Premiums are collected up front”.]

Are you going to hand those rights over to your friend for free and potentially miss out on those gains? The answer is no. Your friend must pay for those rights. If we use option terminology, the payment for those rights is called a premium. You are the option seller, and you will collect this premium upfront. This agreement is called a contract and it expires in 12 months. I have just introduced you to an example of a call option.

[CIBC Investor’s Edge is a division of CIBC Investor Services Inc. This document is provided for general informational purposes only and does not constitute investment advice. The information contained in this document has been obtained from sources believed to be reliable and believed to be accurate at the time publishing, but we do not represent that it is accurate or complete and it should not be relied upon as such. All opinions and estimates expressed in this document are as of the date of publication unless otherwise indicated, and are subject to change. The CIBC logo is a registered trademark of CIBC. The material and its contents may not be reproduced without the express written consent of CIBC.]

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