Understanding Puts and Calls via a Tutorial using the Bank of Nova Scotia

In this article, we'll use the Bank of Nova Scotia as an example to illustrate how you can make a steady income stream by trading derivatives. There are two important characteristics to keep in mind about BNS:

  1. a quarterly dividend is payed out

  2. options (puts and calls) are traded

We'll explain puts and calls shortly.

Firstly, the Bank of Nova Scotia (BNS on the Toronto Stock Exchange) currently pays a dividend of $0.55 per share. This means that every quarter year, we will receive (as of the time of writing) $0.55 for every share that we own:

Date Dividend Total Description
2011 07 29 $0.55 $0.55 Dividend
2011 10 31 $0.55 $1.10 Dividend
2012 01 31 $0.55 $1.65 Dividend
2012 04 30 $0.55 $2.20 Dividend
2012 07 31 $0.55 $2.65 Dividend

This is a nice way to either build up some cash, purchase more shares (BNS offers a dividend re-investment plan that automatically converts dividends into shares), or have a steady income stream (regular, quarterly payments). Our goal in this article is to achieve a steady income stream.

Conservative strategy

Using the most conservative strategy, we could increase the income stream by writing covered call options.

A call option is a contract between two parties. A call has a strike price, a premium, and an expiration. The strike price is the price at which the underlying security is to be bought or sold; the premium is the amount of money the call option is worth; and the expiration is just that — a point in time after which the call option has no value or meaning.

Here are the key things about calls:

  • A call gives the purchaser the right, but not the obligation, to purchase the underyling equity (stock) for the strike price.

  • A call obligates the seller of the calls to sell the shares at the strike price if the call is exercised.

The call would be exercised if the strike price was less than the value of the stock upon expiration.

Let's see how this works in practice:

Date Dividend Premium Total Description
2011 07 29 $0.55 $0.55 Dividend
2011 07 29 $0.97 $1.52 Wrote an October 2011 $56 covered call
2011 10 31 $0.55 $2.07 Dividend
2011 10 31 $1.04 $3.11 Wrote a January 2012 $54 covered call
2012 01 31 $0.55 $3.66 Dividend
2012 01 31 $0.53 $4.19 Wrote an April 2012 $56 covered call
2012 04 30 $0.55 $4.74 Dividend
2012 04 30 $0.85 $5.29 Wrote a July 2012 $56 covered call
2012 07 31 $0.55 $5.84 Dividend
2012 07 31 $0.78 $6.62 Wrote an October 2012 $54 covered call

The above table shows two income streams; one from the dividends that are associated with the BNS shares, and another from the premiums generated by selling (or "writing") covered calls.

A covered call is a call that's backed up by ownership of the shares.

Just looking at the total, we have now generated $6.62 versus $2.65! This is 2.5 times more than just plain dividends (you can think of this as effectively boosting our dividend from around 4% to 10%!)

Technical details

So how does this work? The assumption in the table above is that we own shares of BNS, and that we are writing covered calls. Let's look at one in detail:

Date Dividend Premium Total Description
2011 07 29 $0.97 $1.52 Wrote an October 2011 $56 covered call

In this case, on July 29th, 2011, we wrote a call that expires in October, 2011 with a strike price of $56.00, for a premium of $0.97.

Calls are written in lots (typically 100 shares at a time). The premium is multiplied by the lot size. Therefore, in the example above, we sold 1 lot (100 shares), and received $0.97 per share (or $97.00 total for 100 shares). The time a call expires is fixed — for TSE stocks traded on the MX, it's the third Friday in the given month (so October 21st, 2011 in the example above).

Recall that this obligates us, as the writer, to sell shares of BNS at the strike price ($56) if the calls are exercised. Therefore, there are three scenarios to consider:

  1. At expiration, BNS is trading for more than $56 — let's use a ridiculous number and say $80. Since we wrote calls, we are obligated to sell our shares for only $56 — even though they are worth far more.

  2. At expiration, BNS is trading for less than $56 — let's use a ridiculous number and say $30. We are completely off the hook, because nobody in their right mind would want to buy shares from us for $56 when they can buy them on the open market for $30. (We keep the premium that we received.)

  3. Some time before expiration, we change our mind and don't want to go through with the call option any more. In that case, we can rebuy our call options on the open market, and de-obligate ourselves. The call options may cost us more or less than what we received for them, depending on the price of the underlying stock, and the time to expiration.

What's the catch?

The best part is, there is no catch! The absolute worst thing that can happen is that our call gets "assigned" (case #1, above), meaning that the stock gets sold at the strike price for the call. Looking back at the table above, at the October 2011 call that we wrote in July:

Date Dividend Premium Total Description
2011 07 29 $0.97 $1.52 Wrote an October 2011 $56 covered call

If the call got assigned, we would be paid $56 per share, on top of the option premium that we already received, effectively selling the stock for $56.00 + $0.97 = $56.97!

Obviously, if we paid more than $56.97 for the stock, then we would suffer a loss.

Can I still write calls even if I don't own the stock?

Technically, the answer is yes. This is a "naked call." But we don't recommend it, because your risk is unlimited! If BNS really did go to $80, and you wrote a $56 naked call, then you would be obligated to sell BNS for $56. Since you don't own the stock (the "naked" part of "naked call"), you would have to go out and buy it on the open market for $80, resulting in a $24/share loss.

Your broker protects you a little bit from yourself in this case. In order to write naked calls, you generally need to specifically request the ability to do this in your account, otherwise such trades will be rejected.

Optional risky strategy

If we don't yet own stock, or our shares get assigned, we can still make money! There is a higher element of risk involved (explained below) but we can use this technique to generate income even when we don't have the stock. This strategy uses something called "writing naked puts."

A put can be thought of as the opposite of a call. A put has a strike price, a premium, and an expiration, and these function just like they do with the call.

Here are the key things about puts, though:

  • A put gives the purchaser the right, but not the obligation, to sell shares at the strike price.

  • A put obligates the seller of the put to buy the shares at the strike price if the put is exercised.

The put would be exercised if the strike price was higher than the value of the stock upon expiration.

Practically speaking, naked puts mean that we are prepared to buy the stock for a certain price at a certain time in the future. Let's revisit the example of BNS above, except this time we start out not owning the stock.

In the "dividend only" case, we would get $0.00 — we don't own any stock, therefore we don't get any dividends. However, by writing naked puts, we can either get a constant revenue stream, or own the stock at a discount. Let's see how this works in practice:

Date Stock Price Premium Total Description
2011 07 29 $54.18 $1.25 $1.25 Wrote an October 2011 $52 naked put
2011 10 31 $52.53 $1.29 $2.54 Wrote a January 2012 $50 naked put
2012 01 31 $51.53 $1.17 $3.71 Wrote an April 2012 $50 naked put
2012 04 30 $54.80 $0.71 $4.42 Wrote a July 2012 $52 naked put
2012 07 31 $52.35 $1.00 $5.42 Wrote an October 2012 $50 naked put

The above table shows a new income stream, based on writing naked puts. Just looking at the totals, we once again have pure magic — $5.42 out of "thin air"! (Yes, it's legal). This is 82% of the $6.62 we would have made by writing covered calls.

Technical details

So how does this work? We're assuming that we want to (eventually) own BNS no matter what (here's where the element of risk comes in). By writing a naked put, we've agreed to buy the stock at the strike price. So, looking back at the table above, let's take a look at the October 2011 put that we wrote (in July):

Date Stock Price Premium Total Description
2011 07 29 $54.18 $1.25 $1.25 Wrote an October 2011 $52 naked put

This transaction commits us to buy the stock for $52 in October. Just like with the covered calls, there are three scenarios to consider:

  1. At expiration, BNS is trading for more than $52 (let's say $80). In this case, we're off the hook, because the buyer of the puts has the right, but not the obligation, to sell us the stock for the strike price ($52). Nobody in their right mind would willingly sell us an $80 stock for $52; they'd sell their shares on the open market and get $80 instead. (We keep the premium that we received.)

  2. At expiration, BNS is trading for less than $52 (let's say $30). In this case, we're obligated to buy BNS for the strike price, $52. This can be painful.

  3. Some time before expiration, we change our mind and don't want to go through with the put option any more. In that case, we can rebuy our put options on the open market, and de-obligate ourselves. The put options may cost us more or less than what we received for them, depending on the price of the underlying stock, and the time to expiration.

In the case of scenario #2, above, you should only use this riskier strategy in case you are comfortable owning the stock "no matter what" — effectively, if you are a long term investor in that stock. The upside is that the option premium that we received for the stock offsets our costs. In the table given above, even if we were forced to buy the stock for $52 in October, we would still have the $1.25 premium from July, effectively making the stock cost only $50.75.

In this regard, you can view writing naked puts as a way of getting your favourite stock at a discount, or at least collect a premium while you wait to get it. Since you are prepared to own the stock "no matter what," the assumption is that you would have bought it (and held it) anyway; at least this way you get a discount.

Combining the two strategies

Of course, it's only a matter of time until our covered call options are assigned. This would happen when the stock price is higher than the strike price. When that happens, we can switch to naked puts until we get assigned (and own stock again), and then switch back to covered call writing. We can do this as many times as we like.

If you write a covered call and the stock price drops dramatically, you can repurchase your covered call (for significantly less money than what you sold it for) and write another one, effectively collecting your premiums twice! Same with the naked put — if the price of the equity goes up, the premium of the naked put goes down, and you can repurchase your naked put (for less money that what you got for it) and write another one. (This is scenario #3 in both the call and put scenarios above). Over and over again!

In our examples above, we've shown the time horizon as three months. The available time horizons will depend on the underlying stock itself.