BU673:

Investment
Management
PROFESSOR DAVID CIMON
LECTURE X: OPTIONS AND FUTURES

Lecture X BU673: INVESTMENT MANAGEMENT 1

 Last Class
• Last class we dealt with equity valuation.
• We looked at three subclasses of valuation:
• Industry and macro analysis.
• Models using dividends, P/E ratios and free-cash flow.
• Financial statement ratios.

Lecture X BU673: INVESTMENT MANAGEMENT 2

 Today: Options and Futures
• Today we’ll deal with the final unit, options and futures.
• We will only do a very brief introduction to these derivative instruments.
• We’ll discuss:
• The basics of options.
• Options values at expiry.
• Basic options strategies.
• The basics of futures.
• Basic futures strategies.

Lecture X BU673: INVESTMENT MANAGEMENT 3

 Options: Puts and Calls
• Options are a derivative which give the holder the option to buy or sell:
• A given security
• At a given price
• At a given point in time

• The most basic way to divide options is based on whether they allow the holder to buy or sell
the security:
• Call options allow the holder to buy the underlying security.
• Put options allow the holder to sell the underlying security.

• If the holder of the option eventually uses it to buy or sell the security, we say that the holder
has exercised the option.

Lecture X BU673: INVESTMENT MANAGEMENT 4

 Options: Basic Terminology
• Options contracts have two parties:
• The buyer (or holder), who purchases the right to buy or sell the underlying security.
• The seller (or writer), who must fulfil the option of the buyer exercises their option.

• Options have two prices associated with them:

• The premium (or market price) is the price that the option itself is traded for.
• The strike price (or exercise price) is the price that the option allows the holder to buy or sell the
underlying security for.

• The expiration date is the date on which the option expires:

• Depending on the type of option, the option can only be exercised on or before the expiration date.

Lecture X BU673: INVESTMENT MANAGEMENT 5

 In the money vs. out of the money
• We refer to options based on their exercise price, relative to the market price of the underlying
asset.
• If exercising the option would be profitable immediately, the option is in the money.
• For call options, this means the underlying asset’s price is above the exercise price.
• For put options, this means the underlying asset’s price is below the exercise price.

• If exercising the option would not be profitable immediately, the option is out of the money.
• For call options, this means the underlying asset’s price is below the exercise price.
• For put options, this means the underlying asset’s price is above the exercise price.

• If the exercise price is equal to the price of the underlying asset, the option is at the money.

Lecture X BU673: INVESTMENT MANAGEMENT 6

 In the money vs. out of the money
• Suppose GE is currently priced at $11.50 per share.

Call Premium Strike Price Put Premium

4.59 7.00 0.01
3.47 8.00 0.02
2.55 9.00 0.06
1.65 10.00 0.13
0.87 11.00 0.38
0.35 12.00 0.87
0.12 13.00 1.62
0.03 14.00 2.69
0.01 15.00 3.65

Lecture X BU673: INVESTMENT MANAGEMENT 7

 In the money vs. out of the money
• Suppose GE is currently priced at $11.50 per share.

Call Premium Strike Price Put Premium

4.59 7.00 0.01
3.47 8.00 0.02
In the money 2.55 9.00 0.06
calls
1.65 10.00 0.13
0.87 11.00 0.38
0.35 12.00 0.87
0.12 13.00 1.62 In the money
0.03 14.00 2.69 puts
0.01 15.00 3.65

Lecture X BU673: INVESTMENT MANAGEMENT 8

 In the money vs. out of the money
• Suppose GE is currently priced at $11.50 per share.

Call Premium Strike Price Put Premium

4.59 7.00 0.01
3.47 8.00 0.02
Out of the
2.55 9.00 0.06
money puts
1.65 10.00 0.13
0.87 11.00 0.38
0.35 12.00 0.87
Out of the 0.12 13.00 1.62
money calls 0.03 14.00 2.69
0.01 15.00 3.65

Lecture X BU673: INVESTMENT MANAGEMENT 9

 Options types:
American vs. European
• Options can also be viewed by when they allow the trader to exercise when.
• American options allow the holder to exercise them at any time up to and including the
expiration date.
• European options are only exercisable on the expiration date.
• Since American options allow early exercise, they have more value than a European option
with otherwise identical terms.
• Often, we don’t have a choice of what option type we’re using:
• Most stock options in North America are American options.
• Index options (not to be confused with an option on an ETF) may be European options.

Lecture X BU673: INVESTMENT MANAGEMENT 10

 Options types:
Non-equity options
• While the focus on options is often for individual equities, there are many non-equity options
available for trading.
• Often, non-equity options are European-style options, rather than American-style options.
• Index options offer the ability to trade on the value of an underlying index (such as the S&P
500) at a given price.
• Unlike stock options, which can actually be used to buy or sell the stock, index options don’t deliver
“the index”. Instead, the deliver the cash difference between the index value and the strike price.

• Foreign currency (FX) options offer the ability to buy or sell foreign currencies in terms of
domestic currencies (ex: USD for CAD).
• Futures options offer the ability to trade on the price of a future contract.

Lecture X BU673: INVESTMENT MANAGEMENT 11

 Options trading
• Similar to equities, options can trade either on exchange or over the counter.
• Options traded on exchanges are heavily standardized in expiration dates, strike prices and lot
sizes.
• In Canada, options are exchange traded at the Montreal Exchange.
• In the United States, options can be traded on several exchanges, including the Chicago Board
Options Exchange (CBOE) and the International Securities Exchange (ISE).

• In North America, some options can be traded over the counter. These options may be
uniquely designed for the transaction.

Lecture X BU673: INVESTMENT MANAGEMENT 12

 Options clearing
• After trading, options must be cleared. Unlike equities, the transaction is not “finished” after
the trade has cleared.
• If the buyer of the option exercises it, the writer must make payment. Thus, the writer of the
option faces a potential loss until the option expires.
• To protect against the clearinghouse against this risk, the options writer must post margin
(similar to a short or margined trade).
• In Canadian, options are cleared at the Canadian Derivatives Clearing Corporation (CDCC).
• In the USA, options are cleared at the Options Clearing Corporation (OCC).

Lecture X BU673: INVESTMENT MANAGEMENT 13

 Options payoffs
• One way to understand options is by their value at expiry.
• An option that expires “in the money” will be exercised by the holder.
• An option that expires “out of the money” will expire worthless.
• One important distinction is between the option’s payoff from the profit from buying (or
selling) the option.
• The total profit from the option’s trade also include the premium paid (if the option was bought) or
received (if the option was sold).
• Holding an option to expiry is only profitable if the payoff at expiry to greater than the premium paid
to purchase the option.

Lecture X BU673: INVESTMENT MANAGEMENT 14

 Options payoffs:
Call options
•  Suppose a call option has a strike price of X.
• If the price of the stock at expiry (ST) is above the strike price (ST>X), the option is exercised.
The payoff to the holder is ST – X.
• If the price of the stock at expiry is below the strike price (ST≤X), the option expires worthless.
The payoff to the holder is 0.
• The profit from the option at any given price ST is given by the payoff, minus the call
premium.

Lecture X BU673: INVESTMENT MANAGEMENT 15

 Options payoffs:
Call options, buyers
Payoff from a long call at expiry
Payoff

Stock price at
Strike price (X) expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 16

 Options payoffs:
Call options, buyers
Payoff from a long call at expiry Profit from a long call
Payoff Profit

Stock price at Stock price at

Strike price (X) expiry (PT) Call premium X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 17

 Options payoffs:
Call options, sellers
Payoff from a short call at expiry
Payoff

X
Stock price at
expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 18

 Options payoffs:
Call options, sellers
Payoff from a short call at expiry Profit from a short call
Payoff Profit

X Call premium
Stock price at Stock price at
expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 19

 Options payoffs:
Put options
•  Suppose a put option has a strike price of X.
• If the price of the stock at expiry (ST) is below the strike price (ST<X), the option is exercised.
The payoff to the holder is X-ST.
• If the price of the stock at expiry is above the strike price (ST≥X), the option expires worthless.
The payoff to the holder is 0.
• The profit from the option at any given price ST is given by the payoff, minus the put premium.

Lecture X BU673: INVESTMENT MANAGEMENT 20

 Options payoffs:
Put options, buyers
Payoff from a long put at expiry
Payoff

Stock price at
X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 21

 Options payoffs:
Put options, buyers
Payoff from a long put at expiry Profit from a long put
Payoff Profit

Stock price at Stock price at

X expiry (PT) X Put premium expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 22

 Options payoffs:
Put options, sellers
Payoff from a short put at expiry
Payoff

X
Stock price at
expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 23

 Options payoffs:
Put options, sellers
Payoff from a short put at expiry Profit from a short put
Payoff Profit

X Put premium
Stock price at Stock price at
expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 24

 Options strategies
• An options strategy consists of buying or selling multiple options as well as potentially taking
a long or short position in the underlying asset.
• Traders can use an options strategy to create a specific payoff structure, which is different than
that from buying or selling the options on their own.
• Goals from options strategies include:
• Hedging a cash position.
• Eliminating upside or downside risk.
• Profiting from (or eliminating the risk of) volatility.

Lecture X BU673: INVESTMENT MANAGEMENT 25

 Options strategies:
Protective put
• A protective put is used to limit the down-side risk from a long cash position.
• The protective put consists of buying the underlying stock, as well as a put option.
• The protective put costs the option premium, but limits the downside risk of the stock at the
put’s exercise price.

Lecture X BU673: INVESTMENT MANAGEMENT 26

 Options strategies:
Protective put
Payoff from long stock Payoff from a long put at expiry
Payoff Payoff

Stock price at
purchase

Stock price at Stock price at

X expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 27

 Options strategies:
Protective put
Payoff from a protective put at expiry Profit from a protective put
Payoff Profit

Put premium X
Stock price at Stock price at
X expiry (PT) expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 28

 Options strategies:
Covered call
• A covered call is used to create a steady, positive payoff if the stock does not substantially
decrease in value.
• The covered call consists of selling a call option, and then buying the underlying asset.
• The writer profits from the call option premium, and hedges the options risk by buying the
security.

Lecture X BU673: INVESTMENT MANAGEMENT 29

 Options strategies:
Covered call
Payoff from long stock Payoff from a short call at expiry
Payoff Payoff

Stock price at
purchase

Stock price at Stock price at

X expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 30

 Options strategies:
Covered call
Payoff from a covered call at expiry Profit from a covered call
Payoff Profit

Call premium
Stock price at
purchase

Stock price at Stock price at

X expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 31

 Options strategies:
Straddles
• A straddle is used to profit from a stock’s volatility.
• A straddle consists of buying a put and a call at the same strike price.
• The buyer pays the premium on both options, but profits if the price either increases or
decreases by a large amount.

Lecture X BU673: INVESTMENT MANAGEMENT 32

 Options strategies:
Straddle
Payoff from long call at expiry Payoff from a long put at expiry
Payoff Payoff

Stock price at Stock price at

X expiry (PT) X expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 33

 Options strategies:
Straddle
Payoff from a straddle at expiry Profit from a straddle
Payoff Profit

Call premium + Put premium

X
Stock price at Stock price at
X expiry (PT) expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 34

 Options strategies:
Money Spreads
• Money spreads can be used to limit both upside and downside risk.
• A bull spread earns a profit when the stock increases in value. The trader buys one call option
at a low strike price and sells another at a higher strike price.
• A bear spread earns a profit when the stock decreases in value. The trader buys one put
option at a high strike price and sells another at a lower strike price.

Lecture X BU673: INVESTMENT MANAGEMENT 35

 Options strategies:
Bull Spread
Payoff from long call at expiry Payoff from a short call at expiry
Payoff Payoff

Stock price at Stock price at

XL expiry (PT) XL XH expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 36

 Options strategies:
Bull Spread
Payoff from bull spread at expiry Profit from bull spread
Payoff Profit

High call premium – Low call

premium

Stock price at Stock price at

XL XH expiry (PT) XL XH expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 37

 Options strategies:
Bear Spread
Payoff from short put at expiry Payoff from a long put at expiry
Payoff Payoff

Stock price at Stock price at

XL expiry (PT) XL XH expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 38

 Options strategies:
Bear Spread
Payoff from bear spread at expiry Profit from bear spread
Payoff Profit

Low put premium – High put premium

Stock price at Stock price at

XL XH expiry (PT) XL XH expiry (PT)

Lecture X BU673: INVESTMENT MANAGEMENT 39

 Do you want to know more?
• This lecture only scratches the surface on options.
• Options pricing is a complex topic, outside the scope of what we’ll do in this course.
• Two models of options pricing, covered in the book:
• Binomial model of options pricing.
• The Black-Scholes model.

• Another interesting topic in options-pricing is options greeks.

• Options greeks describe how the value of an option changes in response to certain factors.
• Factors include: time, price of the underlying security, volatility, interest rates, etc.

Lecture X BU673: INVESTMENT MANAGEMENT 40

Futures

Lecture X BU673: INVESTMENT MANAGEMENT 41

 Futures:
Basics
• Futures are a contract for the delivery of some asset at a given point in the future.
• Futures are similar to options, insofar as they place a price on the delivery of an asset at a
specific date in the future.
• The key difference is that there is no “option” to buy or sell the asset in the futures contract.
The buyer must purchase the asset from the seller at the given price.

Lecture X BU673: INVESTMENT MANAGEMENT 42

 Futures:
Terminology
• The buyer of a futures contract takes the long position. This trader will owe cash and receive
the asset underlying the future.
• The seller of a futures contract takes the short position. The trade will owe the asset underlying
the future and receive the cash payment.
• Futures contracts transact at the future price, which is the amount that the buyer will pay the
seller at expiry.
• The number of active contracts in a given future that have not yet expired are referred to as the
open interest.

Lecture X BU673: INVESTMENT MANAGEMENT 43

 Futures:
Contract specifics
• Futures contracts often differ substantially depending on what contract is being traded.
• Important elements of the underlying contract include:
• Whether the contract allows for physical or cash delivery.
• The delivery process.
• Whether the futures is centrally cleared.
• What margin is required for the contract.
• What specific assets are acceptable for fulfilling the contract.
• What quantity of assets are covered in each contract.

• As an example, the Montreal Exchange has produced a guide on trading Government of

Canada Bond futures: https://www.m-x.ca/f_publications_en/bond_futures_manual_en.pdf

Lecture X BU673: INVESTMENT MANAGEMENT 44

 Futures:
Profits
• Futures have a linear payoff that depends of the differences between the spot price of the
underlying asset at the time the future matures, and the futures prices.
• The spot price represents the actual, current price of the asset at the time the future settles.

• For a long futures contract, the profit is given by:

• Spot Price at Maturity – Futures Price (PT – F0)

• For a short futures contract, the profit is given by:

• Futures Price – Spot Price at Maturity (F0 – PT)

Lecture X BU673: INVESTMENT MANAGEMENT 45

 Futures:
Profits
Profit from a long future Profit from a short future
Profit Profit

Spot price at Spot price at

expiry (PT) expiry (PT)
F0 F0

Lecture X BU673: INVESTMENT MANAGEMENT 46

 Types of futures contracts
• Future contracts exist for many underlying assets.
• Popular futures contracts include:
• Foreign currency
• Agricultural commodities
• Metals
• Energy (oil, gas and electricity)
• Bond rates
• Short-term interest rates
• Equity indicdes

Lecture X BU673: INVESTMENT MANAGEMENT 47

 Types of futures contracts:
Canada
• In Canada, futures contracts trade on the Montreal Exchange (The MX).
• Popular contracts on the MX include:
• The three-month Canadian Bankers’ Acceptance futures (BAX).
• 2 year Government of Canada Bond futures (CGZ).
• S&P/TSX 60 Index Standard futures (SXF).

• Other contracts include:

• Other Government of Canada Bond futures (5 year, 10 year and 30 year).
• Other index futures (energy, financials, utilities, IT, etc.).

Lecture X BU673: INVESTMENT MANAGEMENT 48

 Futures trading
• Futures generally trade on exchange.
• As with other assets that trade on exchange, futures are highly standardized.
• Standardization and exchange-trading are the key elements that distinguishes a futures contract
from the otherwise similar forwards contract.
• Similar to options, the futures contract does not end after a trade occurs.
• Since delivery must be made when the contract expires, there is still risk. Thus, there is margin
involved with clearing futures.

Lecture X BU673: INVESTMENT MANAGEMENT 49

 Futures trading:
Clearinghouses and CCPs
• Modern futures are often cleared through a clearinghouse or central counterparty (CCP).
• The central clearer reduces the counterparty risk:
• If traders are concerned that their specific counterparty may default on the futures contract, then it is
much more difficult to trade on exchanges and achieve standardized contracts.

• In futures, the central counterparty takes commodity delivery from traders that are short the
futures contract, and cash from those that are long the contract.
• Further, the central counterparty allows traders to avoid physical delivery by netting out their
own positions:
• Suppose a trader is long contracts for1000 bushels of corn, and would receive actual corn.
• The trader could then sell contracts for 1000 bushels of corn with the same expiry, to ensure they
neither receive nor deliver any corn.

Lecture X BU673: INVESTMENT MANAGEMENT 50

 Futures trading:
Margining
• To reduce the risk from default on futures contracts, traders on each side of the futures contract
must post margin.
• The initial margin is the margin that must be posted when the trader enters into the contract.
• As time goes on, the spot price of the underlying asset changes. At expiry, the price of the
futures contract should converge to the spot price.
• As the spot price changes the futures contract is marked-to-market, to represent how its value is
changing.
• The trader may have to post maintenance margin if the spot price moves in a direction which harms
the value of their position.

• The actual process of handling a default with centrally-cleared futures can be quite complex.
Especially if the default is by a trader with a large number of contracts at the clearer.

Lecture X BU673: INVESTMENT MANAGEMENT 51

 Delivery:
Cash vs. actual
• One important distinction in futures contracts is whether the contract calls for cash delivery or
actual delivery.
• In a contract with actual delivery, holding the contract to expiration will result in purchasing
the actual underlying asset:
• This may be bonds, an agricultural commodity, a foreign currency, etc.

• In a contract with cash delivery, holding the contract to expiration will result in purchasing the
cash-value of the underlying asset:
• For example, index futures are often cash delivery.

Lecture X BU673: INVESTMENT MANAGEMENT 52

 Regulation
• In Canada, futures trading is regulated by the provincial securities regulators.
• These include agencies such as the Ontario Securities Commission (OSC), the Autorité des Marches
Financiers (AMF), and the BC Securities Commission (BCSC).

• Since the MX is located in Montreal, it is most often regulated by the Autorité des Marches
Financiers (AMF), Quebec’s securities regulator.
• In the United States, futures markets are regulated by the Commodity Futures Trading
Commission (CFTC).

Lecture X BU673: INVESTMENT MANAGEMENT 53

 Futures strategies
• Futures are useful for a wide variety of strategies which would be difficult (or very
impractical) to achieve without them.
• For example, suppose I wanted to trade on the price of oil:
• I could literally buy oil. However, I would have to transport and store the oil. Moreover, finding a
seller and an eventual buyer could be quite difficult.
• I could buy a collection of oil stocks, but these would be an imperfect tracker of the oil price.
• Alternatively, I could buy an oil future and sell an identical contract before expiry.

• Two broad uses of futures contracts are hedging and speculation.

Lecture X BU673: INVESTMENT MANAGEMENT 54

 Futures strategies:
Hedging
• A common use of futures contracts is to hedge some underlying business risk.
• Some common risks that businesses wish to hedge include interest rate risks, commodity price
risks and foreign exchange risks.
• The direction of contract that a hedger will purchase depends on whether they are concerned
about a demand-side risk or a supply-side risk.
• A business that is concerned about the price of their sales (demand) will go short in a contract
that represents the price of the goods they sell.
• A business that is concerned about the price of their inputs (supply) will go long in a contract
that represents the price of the inputs they buy.

Lecture X BU673: INVESTMENT MANAGEMENT 55

Futures strategies:
Hedging by an oil producer

Source: Investments, 9th Canadian Edition

Lecture X BU673: INVESTMENT MANAGEMENT 56

 Futures strategies:
Hedging and Basis Risk
• A key element of hedging exposures using futures is the assumption that the price of the future
and the spot price of the underlying asset will be identical on the expiration date.
• However, before expiry, spot prices and future prices may be very different. We refer to this
difference (Futures price – Spot price) as the basis.
• When the contract expires, the basis should be equal to zero, or else arbitrage would exist.
• However, if the hedger wishes to exit their position before expiry, there may still be a
difference between the spot price and the price they exit their position at.
• The risk created by this problem is referred to as the basis risk.

Lecture X BU673: INVESTMENT MANAGEMENT 57

 It’s over!
• That’s all the material for BU673.
• Next class, we’ll do presentations and valuation reports.
• The class after will be the final exam.
• If you have any questions before then, please come see me in office hours.

Lecture X BU673: INVESTMENT MANAGEMENT 58