Page 248 - A Canuck's Guide to Financial Literacy 2020

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The stock price goes up. You make a profit if the share climbs to $40. Your profit is
reduced by $1 a share because your put option is now worthless.

How Options Work

There are several factors which help determine the price of options.

The current price of the underlying security – Being mindful of the price of the underlying
investment plays an important part in determining the option price. There is a direct
relationship between the current price of the security to the option premium. When the
current value of the underlying security rises, call option premiums also increase. Put option
premiums would decrease.

Strike Price – There are different strike prices of an option. Each strike price shows a
different response to the changes in the market. Option prices are more volatile for strike
prices which are near to the current price of the underlying security and vice versa.

Expiry Period – Options have a limited lifespan and expire after a certain time. The value of
an option will increase with more time available before expiry date. The reason for this is
because the more time available before the expiry date, the higher the chance of generating
a profit.

Dividends – Believe it or not, the price of call and put options get affected by the value of
dividends declared by the underlying company. To understand how, it’s important to be
aware of the dividend landscape and potential risks. Before launching into a broader
discussion, here is a brief review of some important terms related to dividends:

▪ Declaration Date: the date details of the dividend (amount and timing) are announced
to the public
▪ Record Date: the date an investor needs to own the stock in order to receive the
dividend
▪ Ex-Dividend Date: the date investors buying the stock will no longer receive the
dividend

Both call and put options are affected by the ex-dividend date. Put options become more
expensive since the price will drop by the amount of the dividend. Call options become
cheaper due to the anticipated drop in the price of the stock, although for options this could
start to be priced in weeks leading up to the ex-dividend.

American vs. European Options

▪ American Style Options – The term “American style” options has nothing to do with
geographical boundaries but merely defines certain terms of the contract. Option
contracts have an expiry date at which the option owner has the right to buy or sell the
underlying security. With American style options, the owner of the contract has
the right to exercise the options at any time prior to the expiry date. American style
options offer more flexibility and a real advantage in comparison to European style
options.