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Introduction to Derivatives


American Depositary Receipts

Your gateway to global stocks

Introduction to Derivatives - American depository receipts; picture of a animated plastic model bank sitting in front of the world depicted by a large toy globe

American Depositary Receipts, usually referred to as ADRs, are essentially a contract that represents the shares of a non-U.S. company and are issued by U.S. depositary banks who own these shares. These foreign shares held by the U.S. bank are referred to as "American Depositary Shares".

ADRs serve two purposes. Firstly they allow a non-U.S. company to expand their stockholders' to include Americans which in turn provides these foreign companies with additional capital. Secondly ADRs allow stock investors to invest in these foreign companies by using their normal stock broking account.

ADRs trade on the U.S. stock markets and as such their stock prices are quoted in U.S. dollars. The stock price takes into account any currency fluctuations between the U.S. dollar and the foreign countries currency.

Stock investors can actually take on the physical holding of these shares by exercising the ADR contract. This means that the U.S. depositary bank will transfer stockholder ownership from the bank into the investor's name and therefore the investor will be on the foreign company's books as a stockholder rather than the banks name.

Long-term investors (especially buy and hold investors), may transfer the ownership of the foreign stock into their name to avoid paying the annual fee typically charged by the U.S. depositary bank. The disadvantage of exercising an ADR is that should the investor decide to sell their foreign stock, they will need to find a stock broker who deals with the foreign company's stock exchange. Also any dividends received now will be in the foreign currency which the investor will have to convert.

The investor should keep in mind that in buying an ADR, the investor is buying a contract and not the stock. Ownership of the stock is only achieved if the investor exercises the ADR which then transfers ownership from the bank to the investor.

When an investor buys an ADR - they are

buying a contract, not the stock

ADRs may represent one foreign share for one ADR share, but quite often they are represented by a ratio. This is done to allow the ADR to be priced at a level that is more common of the U.S. stock market prices. For example, one share of an ADR may represent three shares of the foreign stock.

A depositary bank may charge a fee, called a custody fee, for the services it performs such as registration, compliance, dividend distribution and record keeping services. It is common practice for the ADR depositary bank to deduct this custody fee from the dividend payments. However not all foreign companies pay a dividend and therefore the custody fee is collected from the investor via their stock broker with the fee showing up on the investor's brokerage account statement.

Investing in an ADR involves a foreign company whose business dealings are in the foreign country and is therefore subject to the economic environment of that country. Just because the U.S. economy may be performing strongly does not mean that the foreign country's economy is in good shape. Investors need to consider the current and expected future economic conditions of that foreign country as this may have an impact on the ADRs performance.

ADRs allow investors to invest in foreign companies using their home currency and they are easily bought and sold on a stock exchange and are held in the investors normal stock broking account.

The decision whether to invest in an ADR is dependant on whether the investor is seeking to invest in a foreign owned company, which is the purpose of the ADR.

A current list of foreign companies with ADRs trading on the NYSE or NASDAQ markets is shown below in Table 2. (Data: April 2017). The table also shows the ADRs one year and five annual gains where available.

ADR List

SymbolCompanyCountry IssuerAnnual Gain5-year Annual Gain
AAAPAdvanced Accelerator Applications S.A.France BNY14%--
ABBABB LimitedSwitzerland Citi18%5%
ABEVAmbev S.A.Brazil BNY8%-31%
ACHAluminum Corporation of China LimitedChina BNY51%1%
ADAPAdaptimmune Therapeutics plcUK Citi-44%--
AEGAegon N.V.Netherlands Citi-11%2%
AKTXAkari Therapeutics PlcUK DB-11%--
AMCNAirMedia Group Inc.China JPM-50%-2%
AMFWAMEC Foster Wheeler plcUK DB2%--
AMOVAmerica Movil S.A.B. de C.V.Mexico Citi-5%-10%
AMRNAmarin Corp. plcUK Citi65%-23%
AMXAmerica Movil S.A.B. de C.V.Mexico Citi-4%-10%
APOPCellect Biotechnology Ltd.Israel BNY----
APOPWCellect Biotechnology Ltd.Israel BNY----
ASMLASML Holdings N.V.Netherlands JPM40%21%
ASNDAscendis Pharma A/SDenmark BNY58%--
ASRGrupo Aeroportuario del Sureste, S.A. de C.V. (ASUR)Mexico BNY30%19%
ASXAdvanced Semiconductor Engineering, Inc. - (ASE Corp.)Taiwan Citi25%5%
ATAIATA Inc.China Citi-34%-10%
ATHMAutohomeChina DB17%--
ATVAcorn International, Inc.China Citi69%18%
AUAngloGold Ashanti LimitedS. Africa BNY-21%-20%
AUOAU Optronics Corp.Taiwan Citi40%-2%
AVALGrupo Aval Acciones y Valores S.A.Colombia JPM4%--
AVDLAvadel Pharmaceuticals PlcIreland BNY----
AVHAvianca Holdings S.A.Colombia BNY22%--
AZNAstraZeneca plcUK Citi2%7%
AZULAzul S.A.Brazil Citi----
BABAAlibaba Group Holding LimitedChina Citi47%--
BAKBraskem S.A.Brazil BNY54%7%
BBDBanco Bradesco S.A.Brazil BNY45%-5%
BBDOBanco Bradesco S.A.Brazil BNY28%-4%
BBLBHP Billiton plcUK Citi15%-13%
BBVABanco Bilbao Vizcaya Argentaria, S.A.Spain BNY15%4%
BCHBanco de ChileChile JPM17%-4%
BCSBarclays Bank plcUK JPM15%-4%
BFRBBVA Banco Frances S.A.Argentina BNY-14%31%
BGNEBeiGene, Ltd.China Citi35%--
BHPBHP Billiton LimitedAustralia Citi19%-13%
BIDUBaidu, IncChina BNY-1%7%
BITABitAuto Holdings CompanyChina Citi24%46%
BLRXBioLineRXIsrael BNY-11%-21%
BMABanco Macro S.A.Argentina BNY31%41%
BNTCBenitec Biopharma LimitedAustralia BNY62%--
BNTCWBenitec Biopharma LimitedAustralia BNY-66%--
BORNChina New BorunChina BNY-25%-18%
BPBP plcUK JPM9%-4%
BRFSBRF S.A.Brazil BNY-7%-8%
BSACBanco Santander ChileChile BNY26%-6%
BSBRBanco Santander Brasil SABrazil BNY75%0%
BSMXGrupo Financiero Santander Mexico, S.A.B. de C.V. (""Santander Mexico"")Mexico JPM5%--
BTBT Group plcUK JPM-36%3%
BUDAnheuser - Busch InBev SA/NVBelgium BNY-12%9%
BVNCompania de Minas Buenaventura S.A.Peru BNY40%-22%
BVXVBiondVax Pharmaceuticals LtdIsrael BNY63%--
BVXVWBiondVax Pharmaceuticals LtdIsrael BNY----
BZUNBaozun Inc.China JPM161%--
CAJCanon IncJapan JPM5%-7%
CBDCompanhia Brasileria de DistribuicaoBrazil JPM47%-15%
CCIHChinaCache International Holdings Ltd.China Citi-86%-27%
CCMConcord Medical Services Holdings LimitedChina JPM-7%3%
CCUCompania Cervecerias Unidas S.A. (Cia Cervecerias Unidas SA)Chile JPM15%-3%
CEAChina Eastern Airlines Corp., Ltd.China BNY-2%12%
CEOCNOOC LimitedChina JPM-9%-11%
CGGCGGFrance BNY-76%-62%
CHAChina Telecom Corporation LimitedChina BNY-1%-1%
CHLChina Mobile LimitedChina BNY-8%0%
CHTChunghwa Telecom Co., Ltd.Taiwan JPM0%2%
CHUChina Unicom (Hong Kong) LimitedChina BNY11%-5%
CIBBanColombia S.A.Colombia BNY5%-10%
CIGCEMIG - Companhia Energetica De Minas GeraisBrazil Citi48%-27%
CLLSCellectis S.A.France Citi-18%--
CMCMCheetah Mobile IncChina BNY-32%--
CNCOCencosudChile BNY6%-15%
CNTFChina Techfaith WirelessChina BNY-43%-20%
COEChina Online Education GroupChina DB----
CPACCementos Pacasmayo S.A.A (""Pacasmayo Cement"")Peru JPM34%-3%
CPLCPFL Energia S.A.Brazil Citi52%-10%
CRESYCresud S.A.C.I.F.Argentina BNY99%17%
CRHCRH plcIreland BNY26%13%
CRTOCriteoFrance BNY25%--
CSCredit Suisse GroupSwitzerland BNY1%-9%
CTRPCTrip.com International Ltd.China BNY7%36%
CUKCarnival plcUK JPM17%13%
CXCementos Mexicanos, S.A. de C.V. (CEMEX)Mexico Citi25%6%
CYADCelyad S.A.Belgium Citi-39%--
CYOUChangyou.comChina BNY59%5%
DBVTDBV Technologies S.A.France Citi-1%--
DCMNTT DOCOMO, Inc.Japan BNY-3%7%
DEODiageo plcUK Citi7%3%
DLChina Distance EducationChina DB-21%27%
DQDaqo New EnergyChina JPM-23%14%
DRDDRDGOLD LimitedS. Africa BNY-12%-10%
EEni S.p.A.Italy BNY0%-6%
ECEcopetrol S.AColombia JPM-1%-32%
EDAPEDAP Technomed S.A.France BNY-25%5%
EDNEmpresa Distribuidora y Comercializadora Norte S.A. - EdenorArgentina BNY134%74%
EDUNew Oriental Education & Technology Group, Inc.China DB67%21%
EHICeHi Car Services LtdChina JPM-4%--
ELPCompanhia Paranaense de Energia (COPEL)Brazil BNY17%-18%
ENIAEnel Americas S.A.Chile Citi20%--
ENICEnel Chile S.A.Chile Citi-12%--
EOCAEndesa Americas S.A.Chile Citi----
EOCCENEL GENERACION CHILE S.A. (Endesa Chile)Chile Citi-14%--
ERICEricsson (Telefonaktiebolaget LM Ericsson)Sweden DB-23%-8%
ERJEmbraer-Empresa Brasileira de Aeronautica S.A.Brazil JPM-19%-11%
FANHCNINSURE Inc.China JPM----
FBRFibria Celulose S.A.Brazil Citi0%3%
FENGPhoenix New Media LimitedChina JPM-15%-12%
FLYFly Leasing Ltd.Ireland DB9%1%
FMSFresenius Medical Care AGGermany BNY0%5%
FMXFomento Economico Mexicana S.A.B. de C.V.Mexico BNY-3%2%
FORTYFormula Systems (1985) Ltd.Israel BNY27%20%
FTEOFronteo Inc.Japan BNY----
FWPForward Pharma A/SDenmark BNY-12%--
GDSGDS Holdings Ltd.China JPM----
GENEGenetic Technologies LimitedAustralia BNY-53%-39%
GFAGafisa S.A.Brazil Citi-39%-26%
GFIGold Fields Ltd.S. Africa BNY-13%-23%
GGALGrupo Financiero Galicia S.A.Argentina BNY37%48%
GGBGerdau, S.A.Brazil JPM54%-20%
GLPGGalapagos NVBelgium Citi88%--
GOLGol Linhas Aereas Inteligentes S.A.Brazil BNY365%-10%
GOLDRandgold Resources Ltd.UK Citi-5%-1%
GRAMGrana y Montero S.A.A.Peru JPM-48%--
GRFSGrifols SASpain DB29%18%
GROAgria CorporationChina BNY----
GRVYGravity Co. Ltd.Korea BNY530%3%
GSHGuangshen Railway Company LimitedChina JPM30%9%
GSKGlaxoSmithKline plcUK BNY-4%-2%
GSUMGridsum Holding, Inc.China Citi----
GWPHGW Pharmaceuticals plcUK Citi39%--
HCMHutchison China MediTech LimitedHong Kong DB48%--
HDBHDFC Bank LimitedIndia JPM28%19%
HIMXHimax TechnologiesTaiwan BNY-30%29%
HLGHailiang Education Group Inc.China DB-5%--
HMCHonda Motor Co., LtdJapan JPM1%-4%
HMYHarmony Gold Mining Co. LtdS. Africa DB-31%-26%
HNPHuaneng Power International, Inc.China BNY-11%4%
HQCLHanwha Q CELLS Co., Ltd.China BNY-48%-10%
HSBCHSBC Holdings plcUK BNY24%-2%
HTHTChina Lodging Group Ltd.China Citi90%39%
IBAIndustrias Bachoco S.A.B. de C.V.Mexico BNY8%21%
IBNICICI Bank LimitedIndia DB12%6%
IHGIntercontinental Hotels Group plcUK JPM27%16%
IIJIInternet Initiative Japan Inc.Japan BNY-10%-1%
IMOSChipMOS TECHNOLOGIES INC.Taiwan Citi-2%5%
INFYInfosys Technologies Ltd.India DB-24%4%
INGING Groep N.V.Netherlands JPM30%18%
IRCPIrsa Propiedades Comerciales S.A.Argentina BNY22%30%
IRSIRSA, Inversiones y Representaciones S.A.Argentina BNY72%27%
ITCBItau CorpBancaChile DB10%--
ITUBItau Unibanco Holding S.ABrazil BNY39%-3%
IXORIX CorporationJapan Citi3%11%
JASOJA Solar Holdings Co., Ltd.China BNY-25%0%
JDJD.com, Inc.China DB28%--
JHXJames Hardie Industries plcAustralia DB16%17%
JKSJinkoSolar HoldingChina JPM-23%25%
JMEIJumei International Holding LimitedChina BNY-42%--
JMUJMU LimitedChina Citi----
JOBS51job, Inc.China JPM31%6%
JPJupai Holdings Ltd.China JPM-7%--
JRJCChina Finance Online Co. LimitedChina JPM-52%6%
KANGiKang Healthcare Group IncChina JPM-32%--
KBKB Financial Group IncKorea JPM46%5%
KEPKorea Electric Power Corporation (KEPCO)Korea Citi-24%16%
KOFCoca-Cola FEMSA, S.A.B. de C.V.Mexico BNY-14%-7%
KONEKingtone Wirelessinfo Solultion Holding LtdChina BNY64%56%
KTKT CorporationKorea Citi21%5%
KTOVKitov Pharmaceuticals Holdings Ltd.Israel BNY-63%--
KTOVWKitov Pharmaceuticals Holdings Ltd.Israel BNY-69%--
KYOKyocera CorporationJapan Citi13%3%
LEJULeju Holdings LtdChina JPM-36%--
LFCChina Life Insurance Company LimitedChina DB26%2%
LFLLatam Airlines Group S.A.Chile JPM92%-14%
LITBLightInTheBoxChina BNY-8%--
LNLine CorporationJapan JPM----
LNDBrasilAgro Companhia Brasileira de Propriedades AgricolasBrazil BNY15%--
LPLLG Display Co., Ltd.Korea Citi25%4%
LUXLuxottica Group S.p.A.Italy DB9%11%
LXFRLuxfer Holdings PLCUK BNY-13%--
LYGLloyds Banking Group plcUK BNY-13%12%
MBTMobile Telesystems PJSCRussia JPM20%-10%
MDGSMedigus LtdIsrael BNY-85%--
MESOMesoblast Ltd.Australia JPM30%--
MFGMizuho Financial GroupJapan BNY14%3%
MIXTMiX Telematics LimitedS. Africa BNY56%--
MLCOMelco Resorts & Entertainment LtdHong Kong DB----
MOMOMomo Inc.China DB131%--
MTArcelorMittalLuxembourg Citi48%-14%
MTFBMotif Bio PlcUK BNY----
MTLMechel PAORussia DB158%-21%
MTLSMaterialiseBelgium BNY43%--
MTPMidatech Pharma plcUK DB-42%--
MTUMitsubishi UFJ Financial Group, Inc.Japan BNY24%6%
MZORMazor RoboticsIsrael BNY177%--
NBRVNabriva Therapeutics AGAustria BNY20%--
NCTYThe9 LimitedChina BNY-55%-30%
NGGNational Grid plcUK BNY-8%4%
NICENice Systems Ltd.Israel JPM5%13%
NMRNomura Holdings Inc.Japan BNY29%8%
NNDMNano Dimension Ltd.Israel BNY-14%--
NOAHNoah Holdings LimitedChina Citi4%30%
NOKNokia CorporationFinland Citi-8%8%
NQNQ Mobile Inc.China DB-27%-20%
NTESNetease.com, IncChina BNY109%36%
NTLNortel Inversora S.A.Argentina JPM16%11%
NTZNatuzzi S.p.A.Italy BNY101%3%
NVGNNovogen LimitedAustralia BNY-58%-16%
NVONovo Nordisk A/SDenmark JPM-34%4%
NVSNovartis AGSwitzerland JPM0%7%
OASMOasmia Pharmaceutical ABSweden BNY-54%--
OIIMO2Micro International LimitedChina BNY72%-14%
OMABGrupo Aeroportuario del Centro Norte, S.A.B. de C.V. (OMA)Mexico JPM-3%23%
ORANOrange SAFrance JPM-4%3%
OSNOssen Innovation Co. Ltd.China JPM-37%-8%
PACGrupo Aeroportuario del Pacifico, S.A.B. de C.V.Mexico BNY12%21%
PAMPampa Energia S.A.Argentina JPM177%54%
PBMDPrima BioMed LimitedAustralia BNY-32%-36%
PBRPetroleo Brasileiro S.A. - PetrobrasBrazil BNY34%-17%
PHGKoninklijke Philips Electronics N.V.Netherlands Citi28%11%
PHIPLDT Inc.Philippines JPM-11%-10%
PKXPOSCOKorea Citi20%-7%
PRANPrana Biotechnology LimitedAustralia BNY-26%-21%
PSOPearson PlcUK BNY-31%-15%
PTNRPartner Communications Company Ltd.Israel Citi0%-7%
PTRPetrochina Co. Ltd.China BNY-2%-14%
PUKPrudential plcUK JPM6%12%
PZEPetrobras Argentina S.A.Argentina JPM80%1%
QIWIQIWIRussia BNY19%--
RBSRoyal Bank of ScotlandUK BNY-10%-3%
RDHLRedHill BiopharmaIsrael BNY-22%--
RDYDr. Reddy's Laboratories LimitedIndia JPM-12%4%
RELXRELX PLCUK Citi12%--
RENNRenren Inc.China Citi-53%-25%
RENXRELX NVNetherlands Citi13%--
RIORio Tinto plcUK JPM25%-7%
RYAAYRyanair Holdings plcIreland BNY13%22%
SANBanco Santander, S.A.Spain BNY35%1%
SAPSAP SEGermany DB28%9%
SBGLSibanye Gold LtdS. Africa BNY-42%--
SBSSABESP: Companhia Saneamento Basico de Sao PaoloBrazil BNY31%-6%
SFUNFang Holdings Ltd.China JPM-40%-2%
SHGShinhan Financial Group Co., Ltd.Korea Citi16%4%
SHISinopec Shanghai Petrochemical Company LimitedChina BNY18%20%
SHPGShire plcUK Citi-4%12%
SIDCompanhia Siderurgica Nacional - CSNBrazil JPM-30%-23%
SIFYSify Technologies LimitedIndia Citi-31%-22%
SIMOSilicon Motion Technology Corp.Taiwan BNY14%17%
SKMSK Telecom Co., Ltd.Korea Citi27%13%
SKYSSky Solar Holdings, Ltd.China Citi-43%--
SMFGSumitomo Mitsui Financial GroupJapan Citi11%3%
SMISemiconductor Manufacturing International Corporation (SMIC)China JPM39%19%
SMMTSummit Therapeutics plcUK BNY49%--
SNDESundance Energy Australia Ltd.Australia BNY----
SNESony CorporationJapan Citi31%15%
SNNSmith & Nephew plcUK DB-3%11%
SNPChina Petroleum & Chemical Corporation (SINOPEC)China Citi20%1%
SNYSanofiFrance JPM5%4%
SOLReneSola Ltd.China BNY-66%-23%
SPISPI Energy Co. Ltd.China BNY-89%--
SPILSiliconware Precision Industries Co., Ltd.Taiwan JPM7%7%
SQMSociedad Quimica y Minera de Chile S.A.Chile BNY74%-9%
SQNSSequans Communications SAFrance BNY40%9%
SSLSasol LtdS. Africa BNY-2%-8%
STMSTMicroelectronics N.V.Netherlands JPM183%22%
STOStatoil ASANorway DB1%-9%
STVChina Digital TV Holding Co.China DB0%-15%
SUPVGrupo Supervielle S.A.Argentina BNY----
SYTSyngenta AGSwitzerland BNY12%6%
TEDUTarena International, Inc.China Citi67%--
TEFTelefonica S.A.Spain Citi5%-5%
TEOTelecom Argentina S.A.Argentina JPM23%9%
TEVATeva Pharmaceutical Industries Ltd.Israel JPM-45%-8%
TGSTransportadora de Gas del Sur, S.A. (TGS)Argentina BNY134%45%
TITelecom Italia S.p.A.Italy JPM-6%-4%
TIGTiGenix NVBelgium DB----
TKCTurkcell Iletisim Hizmetleri A.S.Turkey Citi-16%-7%
TLKPT Telekomunikasi Indonesia TbkIndonesia BNY17%13%
TLNDTalend SAFrance JPM----
TMToyota Motor CorporationJapan BNY1%6%
TOTTotal S.A.France JPM6%2%
TOURTuniu CorpChina JPM-29%--
TRIBTrinity Biotech plcIreland BNY-48%-13%
TRPXTherapix BiosciencesIsrael BNY----
TRVGTrivago NVNetherlands DB----
TSTenaris S.A.Luxembourg DB24%-3%
TSMTaiwan Semiconductor Manufacturing Company Ltd.Taiwan Citi32%16%
TSUTIM Participacoes S.A.Brazil JPM54%-11%
TTMTata Motors Ltd.India Citi13%3%
TVGrupo Televisa, S.A.B.Mexico BNY-3%5%
TXTernium S.A.Argentina BNY38%1%
UGPUltrapar Participacoes S.A.Brazil BNY11%0%
ULUnilever plcUK DB11%8%
UMCUnited Microelectronics Corp. (UMC)Taiwan JPM-4%-6%
UNUnilever NVNetherlands DB16%8%
VALEVale S.A.Brazil Citi76%-17%
VCOVina Concha y Toro S.A.Chile BNY-3%-4%
VDTHVideocon d2h LtdIndia DB38%--
VEDLVedanta LimitedIndia Citi142%13%
VEONVeonNetherlands BNY----
VIPSVipshop Holdings Ltd.China DB7%93%
VISNVisionChina MediaChina BNY----
VIVTelefonica Brasil SABrazil Citi29%-12%
VJETvoxeljet AGGermany Citi-47%--
VLRSControladora Vuela Compania de Aviacion S.A.B. de C.V.Mexico BNY-39%--
VNET21 Vianet Group, Inc.China Citi-73%-14%
VODVodafone Group plcUK DB-21%-1%
VRNAVerona Pharma plcUK Citi----
WBWeibo CorporationChina JPM124%--
WBAI500.comChina DB-28%--
WBKWestpac Banking CorporationAustralia BNY9%2%
WFWoori BankKorea Citi45%5%
WITWipro LimitedIndia JPM-21%0%
WNSWNS HoldingsIndia DB-4%22%
WPPGYWPP plcUK Citi-5%10%
WUBA58.com Inc.China Citi-29%--
XINXinyuan Real Estate Co., Ltd.China JPM-6%7%
XNETXunlei LimitedChina BNY-48%--
XNYChina Xiniya Fashion LtdChina DB20%-25%
XRFChina Rapid Finance LimitedChina Citi----
XRSTAL Education GroupChina JPM----
XTLBXTL Biopharmaceuticals Ltd.Israel BNY-48%-2%
YGEYingli Green Energy Holding Co. Ltd.China JPM-47%-41%
YINYintech Investment Holdings Ltd.China BNY20%--
YPFYPF Sociedad AnonimaArgentina BNY32%13%
YRDYirendai Ltd.China DB98%--
YYYY Inc.China DB-26%--
YZCYanzhou Coal Mining Company LimitedChina BNY----
ZNHChina Southern Airlines Co., Ltd.China BNY8%9%
ZPINZhaopin LimitedChina JPM13%--
ZTOZTO Express (Cayman) Inc.China JPM----
ZXChina Zenix Auto InternationalChina BNY53%-16%

ADR issuers

  • BNY - BNY Mellon
  • Citi   - Citigroup
  • DB    - Deutsche Bank
  • JPM - JP Morgan

An Overview of Options

Options can provide investors with benefits, but care needs to be taken

Introduction to Derivatives - An Overview of Options; picture of a road sign with yellow background with black writing on it saying stock options just head for investors and traders

An option is simply a contract to buy or sell a financial instrument such as a stock, commodity or currency. In effect, there are two types of option contracts.

Call Option: This is a contract to buy a financial instrument.

Put Option: This is a contract to sell a financial instrument.

For simplicity, stocks will be used as the financial instrument to illustrate what options are and how they work. The same principles apply to options over other financial instruments.

When an investor buys a call option they are actually buying a contract. This contract enables the investor to buy the stock at a future date at a fixed price that is stated in the option contract irrespective of what the stock's price is in the future. If the future stock price is not attractive, the investor is under no obligation to buy the stock. This is why they are called an option contract - the investor has the option to buy the stock. The investor does not receive a refund if the investor does not buy the stock.

All options contracts state the following information.

Option Contract information:

  • Call or Put: All options contracts state whether it is a call option or whether it is a put option.
  • Underlying: This is the company that the contract is over. For a call option, this is the stock that can be bought. For a put option, this is the stock that an investor can sell.
  • Strike: This is the price that the stock can be bought for with a call option or the price that the stock can be sold for with a put option.
  • Expiry date: All options contracts have a time limit that the contract is valid until. Once the expiry date has passed, the option contract is no longer valid.
  • Multiplier: This states how many shares the options contract includes. The majority of option contracts are for 100 shares. This means if an investor buys one call option, the investor can buy 100 shares.

Some examples of option contracts are shown below.

Option Examples: .

Contract Name: AAPL170519C00142000

  1. The Stock symbol is AAPL (which is obtained from the first letters of the contract name).
  2. The Option expiry is 170519 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is May 19, 2017.
  3. This contract is a Call Option (Determined by the letter following the expiry which for this contract is the letter "C").
  4. The strike price is $142.000 (Determined from the remaining digits which gives the strike to three decimal places).

Contract Name: V170721P00092500

  1. The Stock symbol is V (which is obtained from the first letter of the contract name).
  2. The Option expiry is 170721 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is July 21, 2017.
  3. This contract is a Put Option (Determined by the letter following the expiry which for this which for this contract is the letter "P").
  4. The strike price is $92.500 (Determined from the remaining digits which gives the strike to three decimal places).

The investor buys an option contract in exactly the same manner as buying stocks and most stock brokers are also options brokers. The options are not bought from NYSE or NASDAQ, but from a variety of options exchanges.

Introduction to Derivatives - An Overview of Options; picture of an animated contract depicting that stock options are an agreement between two parties

The price an investor pays for an option contract is known as the option premium and the investor can buy as many contracts as they wish. Options contracts can also be sold through an options exchange to another investor or market maker at any time before the options expiry date.

Should the investor decide to buy the stock, the investor must pay the Strike price multiplied by the number of shares (usually 100). This process is known as "exercise" and terminates the contract. Thus, once the investor buys the stock, a call option contract no longer exists and the investor can no longer sell their call option contract.

The value of an option contract varies from day to day and is dependant on the price of the stock that the option is over. Option prices are actually derived from a complex mathematical formula. Basically, a call option is worth more if the stock's price increases and a put option is worth more if the stock's price decreases.

When the stock price of a call option is above the strike price, the option's strike price is attractive to investors as they can exercise the call option and effectively buy the stock for less than the current stock price. When the stock price for a Call Option is above the strike price, Call Options are referred to as being "in-the-money".

When the stock price of a call option is below the strike price, the option's strike price is not attractive to investors since they can buy the stock from the stock market for less than the option's strike price. When the stock price for a Call Option is below the strike price, Call Options are referred to as being "out-the-money".

Option Examples: .

In-the-money Call Option MCD170519C00120000

  • McDonald's Corp. In-the-money Call Option with $120 Strike and option price of $16.60 with the stock price at $132.64 (April 19, 2017).

Out-the-money Call Option MCD170519C00145000

  • McDonald's Corp. Out-the-money Call Option with $145 Strike and option price of $0.04 with the stock price at $132.64 (April 19, 2017).

As the above example shows, the price of an option drops sustainably as it goes out-the-money. In fact it can be near impossible to sell out-the-money options as they approach their expiry dates. Despite this there are plenty of investors and traders willing to speculate that an out-the-money option will go into the money before its expiry.

Options still remain to be a popular contract and they do have a wide variety of uses other than merely speculating on the stock price increasing.

Investors might buy call options when they are concerned about the future price of the stock, such as an upcoming earnings announcement. Buying a call option, the investor can wait and see what happens to the stock's price. If in the future the stock's price has increased, the investor can simply exercise the option and buy the stock at the strike price. If the stock's price falls, then the investor has simply lost the amount paid for buying the option.

Similarly, investors might buy a put option as a hedging tactic if they are concerned about the future price of a stock they own. If the stock's price declines, the investor can exercise their put option and sell their stock for the strike price.

Introduction to Derivatives - derivative contracts; picture of an animated contract with a pen signing the signature for an agreement between investors

Derivative

Contracts

These give the investor leverage or they can be used for hedging

A derivative contract is a financial product whose price is based upon or derived from the price of another financial product.

The most common derivatives that stock investors will come across are Options contracts and Futures contracts. These contracts can be over stocks, indices, commodities and currencies. The financial product that the options or futures contracts are over is known as the underlying.

An Options contract is an agreement where the option holder may buy or sell a financial product in the future at a price specified in the agreement. Options contracts are split into buy and sell contracts. A buy contract is referred to as a Call Option and a sell contract is referred to as a Put Option.

The option holder is not obliged to buy or sell in the future, but does have the option to do so. The option holder pays for this privilege. The price of the options contract is based on the price of the underlying but does not follow it directly. Option prices are actually derived from a complex mathematical formula. Basically, if the underlying price increases, the price of call options increase and the price of put options decrease.

A Futures contract is an agreement made between two parties, the buyer and the seller. The price of a futures contract follows the price of the underlying. If the price of the underlying goes up, the futures buyer receives the increased price difference as a cash payment and this is paid by the futures seller. Conversely, if the underlying price goes down, the futures buyer must pay the futures seller the amount that the contracts price decreased by. Thus, a futures contract is essentially an agreement between a buyer and a seller that one will pay the other the price difference.

Single Stock Futures are becoming more popular nowadays. These are future contracts over stocks rather than the traditional futures contracts which are over commodities (such as oil) or over Indices or over Currencies. Single Stock Futures also have contacts over some of the popular index tracking ETFs (Exchange Traded Funds).

Table 1. below shows a sample of some of the popular Single Stock Futures for stocks and index ETFs

Table 1. Popular Single Stock Futures

Derivative Contracts Table 1. Popular Single Stock Futures for investors to use when trading or hedging

There are some basic differences with using Options compared to Single Stock Futures. These are best explained using the following examples.

Example: A stock investor wants to buy a stock in the future but wants to pay the current price of $20 (or at least close to it), the investor can either buy a Call Option for say $2 or enter into a Single Stock Futures contract. Let's suppose that in the future the stock's price has increased to $25.

  • The Call Option allows the investor to buy the stock for $20 even though the price is actually now $25, but the investor did have to pay $2 for this privilege. So the stock actually cost the investor $22.
  • The Single Stock Futures contract requires the seller to pay the investor the price increase of $5, but the investor has to pay the seller $25 for the stock to take delivery of the stock. The net result is that the stock still cost the investor around $20 (which is the $25 paid for the stock less the $5 received from the seller).

But what happens if the stock's price instead of increasing actually decreased to $15.

Example: The stock price decreased to $15

  • The Call Option is just that, an option to buy. If the investor still wants to buy the stock, then the investor can simply buy the stock from the stock market for $15. The total cost for the stock then becomes $17 (the $15 stock price plus the $2 paid for the option).
  • The Single Stock Futures contract requires the investor to pay the seller $5, but the investor now only needs to pay the seller $15 to buy the stock. The net result is that the stock still cost the investor around $20 (which is the $15 paid for the stock plus the additional $5 paid to the seller).

Thus, an options contract costs the investor money to buy the contract, but this does give the investor the option of whether to buy from the option contract or to buy direct from the stock market.

With the Single Stock Futures contact, the investor effectively locks in the current price today (or close to it) and can take settlement of the stock at a future date. Also there are no additional costs with futures contract. However in reality, Single Stock Futures contracts tend to be priced slightly higher than the current stock price. This takes into account the interest rate over the time period until the contracts expiry date.

Both Options and Single Stock Futures contracts have a termination date after which the contract ceases to exist and both Options and Single Stock Futures contracts can be sold at any time prior to their termination date. Also most Options and Single Stock Futures contracts are for 100 shares of the underlying stock. This means the investor has to deal with lots of 100 shares. The investor cannot buy an Options or Single Stock Futures contract for say 133 shares.

Care needs to be taken with derivatives

since they have an expiry date

The price to buy an Options contract can be a small portion of the underlying price. A Single Stock Futures contract involves an upfront payment known as a deposit margin, which is generally also small (in the order of 20% of the underlying price).

Options and Single Stock Futures contracts typically provide a significant amount of leverage. This means that these contracts can be entered into with only a small upfront payment and because of this a lot of short-term speculators and traders actively use derivatives. The derivatives are commonly used to profit directly from the derivative by short-term buying and selling, rather than using the derivative as a means of acquiring the underlying.

Derivatives are also extensively used for hedging purposes. Buying Put Options and selling Single Stock Futures contracts are popular hedging strategies which offset the price decline of the underlying.

For example, a stock investor who is concerned about the short-term price decline of a stock they own can buy a Put Option. If the stock's price drops, the value of the Put Option actually increases which helps offset the stock's loss. The investor also has the option of selling the stock on the Options contract for the price specified in the contract.

An Introduction to Hedging

Introduction to Derivatives - The basics of hedging; picture of an umbrella covering and protecting a pile of investors money from the risk by hedging the funds

Insurance for your stocks

Hedging is a tactic used in the financial markets to reduce or eliminate the potential loss of an adverse movement in a financial instrument. It is effectively a means of insuring against a significant loss. All hedging strategies involve a cost for this protection which may be in the form of a direct cost or in the form of limiting the potential profit.

With regards to the stock market, investors may decide to hedge during times of increased market volatility or for an uncertain future outlook. Hedging is more commonly utilized on a short-term basis, even though some longer-term hedging might be incorporated into the portfolios of some stock investing strategies.

There are numerous approaches and reasons investors may consider hedging and some of the common ones are as follows.

Investors such as growth investors who are concerned about an upcoming earnings announcement might buy a put option to hedge a stock they own. If the announcement causes a significant decline in the stock's price (especially if the stock's price gaps down when the market opens after the announcement is made), the put option will have increased substantially in price helping to offset the capital loss from the stock. If the investor chooses to keep the stock, the put option can be sold for a nice profit.

Example: An investor owns a $30 growth stock that has an earnings announcement due and is concerned that the result may be less than expected. The investor buys a put option for $2. After the earnings are announced there are several possible outcomes.

  1. The earnings disappointed the market and the stock price plunged $10 within a week. The investor is faced with a capital loss of $10, but the put option may now be worth $10. The investor can sell the put option to lock in a net $8 profit ($10 put option less $2 paid for the option). Thus the net loss was reduced to only $2.
  2. The market did not react to the earnings announcement with the stock price still at $30. The investor can simply sell the put option for say $1.50, as it is no longer required. Thus, the net cost for this hedge was only $0.50 ($2 paid for the option less $1.50 received for selling it).
  3. The earnings actually surprised the market who reacted by gaping the price up to $40. The investor now has an additional capital gain of $10. After the cost of the put option (which is now worthless), the net gain is $8 ($10 gain less $2 paid for the option).

This example illustrates how options can be used to hedge an undesirable risk, but there is a cost associated with this protection. Using options for short-term protection is a common practice and cost effective. However, using options for long-term hedging is an expensive exercise and for the most part is not financially viable as it erodes away any profits made. This is illustrated in the following example.

Hedging with Options:

Example: Microsoft $65 Strike Put Options, Stock price $65.04 (Data April 19, 2017)

  • April 28, 2017 Expiry (1 week) Option asking price $0.85
  • July 21, 2017 Expiry (3 months) Option asking price $2.78
  • June 15, 2018 Expiry (1 year) Option asking price $5.85

The cost to hedge for 1 week is around 1% of the stock price, but increases to 4% for a 3 month hedge and further increases to 9% for a full year hedge. As the hedging time increases the cost severely reduces the investor's net capital gain. As a general rule, hedging with options is generally more suited to short time frames due to the cost of the options.

A lot of stocks nowadays have futures contracts over them and these contracts are also used extensively for hedging purposes. These contracts are known as Single Stock Futures and they behave differently to options when used for hedging. When an investor sells a futures contract over a stock they own, they are effectively locking in the current stock price that the stock can be sold for in the future. This is best illustrated using the above example for the put option.

Futures Contracts:

  1. With the earnings disappointment, the stock's price dropped $10. But with the short futures contract the investor receives a $10 per share payment from the futures contract buyer. Thus the net effect is zero.
  2. Where the market did not react to the earnings announcement, both the stock and the short futures contract are still at the same price, thus zero gain or loss.
  3. For the case where the earnings surprised and the stock's price is up $10, the investor must pay the buyer of the futures contract $10 per share. The net result is zero. While the investor has a $10 capital gain, it has cost them $10 a share.

Using a futures contract, the only cost the investor has is simply the brokerage cost for the selling and buying back the futures contract, and the Bid-Ask spread which is the cost associated with selling the futures contract at the Bid price and buying it back at the Ask price.

Introduction to Derivatives - The basics of hedging; picture of a road sign with green background and blue shy with clouds behind with white writing saying futures for hedging

The effect of using futures contracts for hedging is that it basically neutralizes any gains or losses as the price movement in the stock is offset by the gain or loss in the short futures contract.

Unlike options contracts, futures contracts can be used long-term and the only direct costs are brokerage. Futures contracts do however have indirect costs, the first being that it eliminates any profit potential and the second is that a deposit margin is required to enter a futures contract which is typically 20% for single stock futures contracts. While this margin is refunded when the investor exits the future contract, it is money that's tied up and cannot be used for other purposes.

Futures contracts are suitable for hedging during times of uncertainty. Investors will generally use futures contracts as hedges when they are more concerned about the potential losses than they are about the potential gains. Options contracts are only suitable for short-term hedging due to their costs, but they do allow for a decent capital gain with only a moderate risk of loss.

The stock investor can also buy a put option or sell a futures contract over a stock index such as the S&P 500. Hedging an index is appropriate if the investor has a balanced diversified stock portfolio that basically behaves the same as the index. Investors may choose to short an index futures contract during times of economic uncertainty to hedge their stock portfolio.

There are many uses and strategies used in hedging and it ultimately depends on the investor's personal circumstances and risk profile. In some cases hedging is a practical means to manage risks and in other cases it may be more profitable to use other risk management tactics.

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