Transcript: CIBC Investor’s Edge — What are options?

[Title Name: CIBC Investor’s Edge employee.]

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[A CIBC Investor’s Edge employee stands and speaks to the camera.]

CIBC Investor’s Edge employee: Hello and welcome to Investor's Edge. In this video, we are going to explore the fundamentals of options and how they can potentially be used to capitalize on price fluctuations in the marketplace and add returns to your portfolio. So what are they? 

[A split screen. “Current value of house - $750,000”. Beside the text is an icon of a house. Beside this an icon of a person appears. Next only the two icons. Beside these: “For 12 months, she will have the rights to buy your house for $800,000”. Below is an icon of a document.]

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 split screen. “Market value of house” with an arrow up sign beside, as the amount rises from “$750,000” to “$900,000”. Beside this is an icon of a house. Another icon of a dollar with a check mark appears. Next only the icons remain. Then text appears: “You must sell for $800,000”. An icon of a coin with an arrow up attached to it. Text beside reads: “You miss out on $100,000”. The coin icon disappears and the following appears in its place: “$900,000 (market value in future)”. Below appears: “- $800,000 (sale price you agreed to)”. An icon of a signed document. Text beside it reads: “Friend must pay for the rights”. Icon of a dollar with a checkmark, with text: “Payment for the right is called a premium”. The dollar icon expands to include an arrow sign to a person icon. Beside it text reads: “Premiums are collected up front”.]

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. Are you going to hand those rates 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 of those rights is called a premium. You are the option seller and you will collect that 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. So now we take that concept and apply it to stocks. 

[The following text appears, with an icon below each phrase: “An option is a contract.” Below this is an icon of a document and pen. Text: “to buy or sell a stock” with an icon of a coin with arrows coming out of it. Text: “in the future” with a calendar icon. Text: “at a designated price (strike price)” with a dollar icon. The last two items then become: “at a designated price (strike price)” with a dollar icon and “for a specified period of time” with a clock icon. The clock hands move and the wording above it changes to: “or until the expiry date”.]

An option is a contract to buy or sell a stock in the future at a designated price, otherwise known as a strike price, for a specified period of time, or up until the expiry date.

[Next screen is titled “Call option”. Similar icons as on the previous screens below each phrase: "Give the buyer the right”, then “to purchase a stock”, “at a strike price” and “until the contract expires”. Next, under “Call option” the wording changes to “If the owner of the call, exercises right.” Beside that, “the seller is obligated” appears with an icon of a person. Finally, “to deliver shares for cash” with an icon of a bar graph and an arrow trending upwards.]

To start, there are two types of options. There are call options and there are put options. A call option gives the buyer the right to purchase a stock at a strike price up until the contract expires. If the owner of the call exercises her right, the investor who sold that option is obligated to deliver shares in exchange for cash.

[Next screen is titled “Put option”. Similar icons as on the previous screens below each phrase: “Gives the buyer the right”, then “to sell a stock”, “at a strike price” and “until expiry”. Everything disappears except “Put option”. Below the title: “If the buyer exercises right” and the icon below is a document and pen with a checkmark. Beside that, “the seller is obligated” with an icon of a person. Finally, “to buy the shares at the strike price” with an icon of a bar graph and an arrow trending upwards.]

A put option, on the other hand, gives the buyer the right to sell a stock at the strike price up until expiry. If a put option buyer exercises her right, then the option seller is obligated to buy the shares from her at that same strike price. Notice a trend here? Buyers of options have rights, whereas sellers have obligations.

[Icon of a document. Beside it, text reads “1 contract = 100 shares”. Below an icon of a bar graph and an arrow trending upwards. Next to it, text reads “If one option = $2.00”. Finally, a new signed document icon and text reading “$2.00 x 100 = $200”.]

When we buy a stock, we are buying individual shares of a company. When we buy options, we are buying contracts. Most contracts represent 100 shares of the underlying company. Therefore, since the option price is quoted on a per share basis, we must multiply it by 100 to get the overall dollar figure. Now most equity and ETF options are referred to as American style, meaning the buyer of those options can exercise her rights at any point throughout the term of the contract prior to or at the expiration date.

[To the right of the speaker the following is added: “What influences the price of an option?” Below the following appear: an icon of a dollar with “Underlying stock price” beside the point. An icon of a coin with arrows coming out in both directions and “Option strike price” beside it. Next a clock icon with “Time until expiration”. The top item then changes to an icon of a bar graph and an arrow trending upwards and beside it, “Interest rates”. Below the coin icon changes to a dollar with a check mark and beside it, “Dividend payments”. Below, the clock icon changes to a gauge and beside it, “Implied volatility”.]

Option prices continue to fluctuate up until expiry, so which factors impact these prices? Without getting too granular, the main factors that will influence price of an option are the underlying stock price, the option strike price, the time until expiration, interest rates, dividend payments, and volatility. If we examine the relationship between time to expiry and the costs of the option premium, we will notice a couple things.

The greater amount of time to expiration, the more uncertainty there is on where the stock price will end up, which translates into higher premiums. Longer-dated options therefore have greater time value embedded into them and are more expensive than those with earlier expirations. 

[Title: “An option has two components”. Below is an icon of a unfolded document, and beside it reads “Intrinsic value”. Below is an icon of a clock and beside it reads “Time value”. Below the first item the following is added: “Call = stock price - strike price”. This then changes to: “Put = strike price - stock price”. This line then changes to “Intrinsic values can only be positive. If calculation is negative, then = 0”.]

The option itself is made up of two components, intrinsic value and time value. The intrinsic value for a call option is calculated by subtracting the strike price from the current stock price. For puts, you would subtract the stock price from the strike price.

[Same screen titled “An option has two components” is shown. Below is an icon of a closed document, and beside it reads “Intrinsic value”. Below, the clock icon is highlighted and beside the icon reads “Time value = option premium - intrinsic value. Erodes to zero as contract expires”.]

Intrinsic values can only be positive, so if you do your math and it comes out negative, then the intrinsic value is just zero. Time value is calculated by subtracting the intrinsic value from the option premium, and it erodes to zero as the contract expires. 

[A graph titled “Stock XYZ trading at $25. Call option premium $5”. Dollar values start at $20 and go up by $2 to $28. A fluctuating graph line is shown starting at $23 and eventually ending at $25. A dotted line shows the “strike price” is $22. The difference between the end point and the strike price is shown: “Intrinsic value: $25 stock price - $22 strike price = $3”. Below “Time Value: $5 option premium - $3 intrinsic value = $2” is added. At the top, the “Call option premium $5.00” is highlighted.]

Here is an example of the components of a call option premium. XYZ stock is trading at $25 and the $22 strike call option can be purchased for $5. Doing some quick math, we know the intrinsic value is $3, so the time value must be $2 to add up to the $5 option premium. 

[A graph titled “Stock XYZ trading at $20. “Put option premium $4.50”. Dollar values start at $16 and go up by $2 to $24. A fluctuating graph line is shown starting at $18 and eventually ending at $20. A dotted line shows the “strike price” is $22. The difference between the end point and the “strike price” is shown: “Intrinsic value: $22 strike price - $20 stock price = $2”. Below “Time Value: $4.50 option premium - $2 intrinsic value = $2.50” is added. At the top, the “Put option premium $4.50” is highlighted.]

For our put option example, we get the intrinsic value of $2 by subtracting the stock price of $20 from the strike of $22.This means the remaining time value on the contract is $2.50, which adds up to our option premium of $4.50. 

[A graph titled “Stock XYZ trading at $11.” Dollar values start at $10 and go up by $1 to $14. A fluctuating graph line is shown starting at $10 and eventually ending at $11. “Call option strike price” is shown, with the following values: $10, $11, $12, $13, $14. A dotted line shows the strike price is $10. $10 is highlighted and indicates: “in the money”.]

Now we're going to take a look at a call option chain. XYZ stock is currently trading at $11, with the option prices listed. Any contract that has intrinsic value can also be referred to as in the money.

[The same graph is shown, but the dotted “strike price” line has moved up to $11 and the highlight now shows: “$11 - at the money”. The highlighted area then moves to show the “strike price” above $11 and the highlight shows “$12, $13, $14 - out of the money”.]

Here, only the $10 call option is in the money. If the stock price is the same as the strike price then we refer to it as at the money. And finally, if the strike price is above where the stock is currently trading, it is referred to as out of the money. The only options that will have any value at expiration are the ones that are in the money because again, time value will be zero.

Stay tuned for more videos, as we dive into how you can view and trade options on our platform, along with other options strategies. Thank you for watching.

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[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 of 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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