Introduction to Derivatives
American Depositary Receipts
Your gateway to global stocks
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.
|Symbol||Company||Country||Issuer||Annual Gain||5-year Annual Gain|
|AAAP||Advanced Accelerator Applications S.A.||France||BNY||14%||--|
|ACH||Aluminum Corporation of China Limited||China||BNY||51%||1%|
|ADAP||Adaptimmune Therapeutics plc||UK||Citi||-44%||--|
|AKTX||Akari Therapeutics Plc||UK||DB||-11%||--|
|AMCN||AirMedia Group Inc.||China||JPM||-50%||-2%|
|AMFW||AMEC Foster Wheeler plc||UK||DB||2%||--|
|AMOV||America Movil S.A.B. de C.V.||Mexico||Citi||-5%||-10%|
|AMRN||Amarin Corp. plc||UK||Citi||65%||-23%|
|AMX||America Movil S.A.B. de C.V.||Mexico||Citi||-4%||-10%|
|APOP||Cellect Biotechnology Ltd.||Israel||BNY||--||--|
|APOPW||Cellect Biotechnology Ltd.||Israel||BNY||--||--|
|ASML||ASML Holdings N.V.||Netherlands||JPM||40%||21%|
|ASND||Ascendis Pharma A/S||Denmark||BNY||58%||--|
|ASR||Grupo Aeroportuario del Sureste, S.A. de C.V. (ASUR)||Mexico||BNY||30%||19%|
|ASX||Advanced Semiconductor Engineering, Inc. - (ASE Corp.)||Taiwan||Citi||25%||5%|
|ATV||Acorn International, Inc.||China||Citi||69%||18%|
|AU||AngloGold Ashanti Limited||S. Africa||BNY||-21%||-20%|
|AUO||AU Optronics Corp.||Taiwan||Citi||40%||-2%|
|AVAL||Grupo Aval Acciones y Valores S.A.||Colombia||JPM||4%||--|
|AVDL||Avadel Pharmaceuticals Plc||Ireland||BNY||--||--|
|AVH||Avianca Holdings S.A.||Colombia||BNY||22%||--|
|BABA||Alibaba Group Holding Limited||China||Citi||47%||--|
|BBD||Banco Bradesco S.A.||Brazil||BNY||45%||-5%|
|BBDO||Banco Bradesco S.A.||Brazil||BNY||28%||-4%|
|BBL||BHP Billiton plc||UK||Citi||15%||-13%|
|BBVA||Banco Bilbao Vizcaya Argentaria, S.A.||Spain||BNY||15%||4%|
|BCH||Banco de Chile||Chile||JPM||17%||-4%|
|BCS||Barclays Bank plc||UK||JPM||15%||-4%|
|BFR||BBVA Banco Frances S.A.||Argentina||BNY||-14%||31%|
|BHP||BHP Billiton Limited||Australia||Citi||19%||-13%|
|BITA||BitAuto Holdings Company||China||Citi||24%||46%|
|BMA||Banco Macro S.A.||Argentina||BNY||31%||41%|
|BNTC||Benitec Biopharma Limited||Australia||BNY||62%||--|
|BNTCW||Benitec Biopharma Limited||Australia||BNY||-66%||--|
|BORN||China New Borun||China||BNY||-25%||-18%|
|BSAC||Banco Santander Chile||Chile||BNY||26%||-6%|
|BSBR||Banco Santander Brasil SA||Brazil||BNY||75%||0%|
|BSMX||Grupo Financiero Santander Mexico, S.A.B. de C.V. (""Santander Mexico"")||Mexico||JPM||5%||--|
|BT||BT Group plc||UK||JPM||-36%||3%|
|BUD||Anheuser - Busch InBev SA/NV||Belgium||BNY||-12%||9%|
|BVN||Compania de Minas Buenaventura S.A.||Peru||BNY||40%||-22%|
|BVXV||BiondVax Pharmaceuticals Ltd||Israel||BNY||63%||--|
|BVXVW||BiondVax Pharmaceuticals Ltd||Israel||BNY||--||--|
|CBD||Companhia Brasileria de Distribuicao||Brazil||JPM||47%||-15%|
|CCIH||ChinaCache International Holdings Ltd.||China||Citi||-86%||-27%|
|CCM||Concord Medical Services Holdings Limited||China||JPM||-7%||3%|
|CCU||Compania Cervecerias Unidas S.A. (Cia Cervecerias Unidas SA)||Chile||JPM||15%||-3%|
|CEA||China Eastern Airlines Corp., Ltd.||China||BNY||-2%||12%|
|CHA||China Telecom Corporation Limited||China||BNY||-1%||-1%|
|CHL||China Mobile Limited||China||BNY||-8%||0%|
|CHT||Chunghwa Telecom Co., Ltd.||Taiwan||JPM||0%||2%|
|CHU||China Unicom (Hong Kong) Limited||China||BNY||11%||-5%|
|CIG||CEMIG - Companhia Energetica De Minas Gerais||Brazil||Citi||48%||-27%|
|CMCM||Cheetah Mobile Inc||China||BNY||-32%||--|
|CNTF||China Techfaith Wireless||China||BNY||-43%||-20%|
|COE||China Online Education Group||China||DB||--||--|
|CPAC||Cementos Pacasmayo S.A.A (""Pacasmayo Cement"")||Peru||JPM||34%||-3%|
|CPL||CPFL Energia S.A.||Brazil||Citi||52%||-10%|
|CS||Credit Suisse Group||Switzerland||BNY||1%||-9%|
|CTRP||CTrip.com International Ltd.||China||BNY||7%||36%|
|CX||Cementos Mexicanos, S.A. de C.V. (CEMEX)||Mexico||Citi||25%||6%|
|DBVT||DBV Technologies S.A.||France||Citi||-1%||--|
|DCM||NTT DOCOMO, Inc.||Japan||BNY||-3%||7%|
|DL||China Distance Education||China||DB||-21%||27%|
|DQ||Daqo New Energy||China||JPM||-23%||14%|
|DRD||DRDGOLD Limited||S. Africa||BNY||-12%||-10%|
|EDAP||EDAP Technomed S.A.||France||BNY||-25%||5%|
|EDN||Empresa Distribuidora y Comercializadora Norte S.A. - Edenor||Argentina||BNY||134%||74%|
|EDU||New Oriental Education & Technology Group, Inc.||China||DB||67%||21%|
|EHIC||eHi Car Services Ltd||China||JPM||-4%||--|
|ELP||Companhia Paranaense de Energia (COPEL)||Brazil||BNY||17%||-18%|
|ENIA||Enel Americas S.A.||Chile||Citi||20%||--|
|ENIC||Enel Chile S.A.||Chile||Citi||-12%||--|
|EOCA||Endesa Americas S.A.||Chile||Citi||--||--|
|EOCC||ENEL GENERACION CHILE S.A. (Endesa Chile)||Chile||Citi||-14%||--|
|ERIC||Ericsson (Telefonaktiebolaget LM Ericsson)||Sweden||DB||-23%||-8%|
|ERJ||Embraer-Empresa Brasileira de Aeronautica S.A.||Brazil||JPM||-19%||-11%|
|FBR||Fibria Celulose S.A.||Brazil||Citi||0%||3%|
|FENG||Phoenix New Media Limited||China||JPM||-15%||-12%|
|FLY||Fly Leasing Ltd.||Ireland||DB||9%||1%|
|FMS||Fresenius Medical Care AG||Germany||BNY||0%||5%|
|FMX||Fomento Economico Mexicana S.A.B. de C.V.||Mexico||BNY||-3%||2%|
|FORTY||Formula Systems (1985) Ltd.||Israel||BNY||27%||20%|
|FWP||Forward Pharma A/S||Denmark||BNY||-12%||--|
|GDS||GDS Holdings Ltd.||China||JPM||--||--|
|GENE||Genetic Technologies Limited||Australia||BNY||-53%||-39%|
|GFI||Gold Fields Ltd.||S. Africa||BNY||-13%||-23%|
|GGAL||Grupo Financiero Galicia S.A.||Argentina||BNY||37%||48%|
|GOL||Gol Linhas Aereas Inteligentes S.A.||Brazil||BNY||365%||-10%|
|GOLD||Randgold Resources Ltd.||UK||Citi||-5%||-1%|
|GRAM||Grana y Montero S.A.A.||Peru||JPM||-48%||--|
|GRVY||Gravity Co. Ltd.||Korea||BNY||530%||3%|
|GSH||Guangshen Railway Company Limited||China||JPM||30%||9%|
|GSUM||Gridsum Holding, Inc.||China||Citi||--||--|
|GWPH||GW Pharmaceuticals plc||UK||Citi||39%||--|
|HCM||Hutchison China MediTech Limited||Hong Kong||DB||48%||--|
|HDB||HDFC Bank Limited||India||JPM||28%||19%|
|HLG||Hailiang Education Group Inc.||China||DB||-5%||--|
|HMC||Honda Motor Co., Ltd||Japan||JPM||1%||-4%|
|HMY||Harmony Gold Mining Co. Ltd||S. Africa||DB||-31%||-26%|
|HNP||Huaneng Power International, Inc.||China||BNY||-11%||4%|
|HQCL||Hanwha Q CELLS Co., Ltd.||China||BNY||-48%||-10%|
|HSBC||HSBC Holdings plc||UK||BNY||24%||-2%|
|HTHT||China Lodging Group Ltd.||China||Citi||90%||39%|
|IBA||Industrias Bachoco S.A.B. de C.V.||Mexico||BNY||8%||21%|
|IBN||ICICI Bank Limited||India||DB||12%||6%|
|IHG||Intercontinental Hotels Group plc||UK||JPM||27%||16%|
|IIJI||Internet Initiative Japan Inc.||Japan||BNY||-10%||-1%|
|IMOS||ChipMOS TECHNOLOGIES INC.||Taiwan||Citi||-2%||5%|
|INFY||Infosys Technologies Ltd.||India||DB||-24%||4%|
|ING||ING Groep N.V.||Netherlands||JPM||30%||18%|
|IRCP||Irsa Propiedades Comerciales S.A.||Argentina||BNY||22%||30%|
|IRS||IRSA, Inversiones y Representaciones S.A.||Argentina||BNY||72%||27%|
|ITUB||Itau Unibanco Holding S.A||Brazil||BNY||39%||-3%|
|JASO||JA Solar Holdings Co., Ltd.||China||BNY||-25%||0%|
|JHX||James Hardie Industries plc||Australia||DB||16%||17%|
|JMEI||Jumei International Holding Limited||China||BNY||-42%||--|
|JP||Jupai Holdings Ltd.||China||JPM||-7%||--|
|JRJC||China Finance Online Co. Limited||China||JPM||-52%||6%|
|KANG||iKang Healthcare Group Inc||China||JPM||-32%||--|
|KB||KB Financial Group Inc||Korea||JPM||46%||5%|
|KEP||Korea Electric Power Corporation (KEPCO)||Korea||Citi||-24%||16%|
|KOF||Coca-Cola FEMSA, S.A.B. de C.V.||Mexico||BNY||-14%||-7%|
|KONE||Kingtone Wirelessinfo Solultion Holding Ltd||China||BNY||64%||56%|
|KTOV||Kitov Pharmaceuticals Holdings Ltd.||Israel||BNY||-63%||--|
|KTOVW||Kitov Pharmaceuticals Holdings Ltd.||Israel||BNY||-69%||--|
|LEJU||Leju Holdings Ltd||China||JPM||-36%||--|
|LFC||China Life Insurance Company Limited||China||DB||26%||2%|
|LFL||Latam Airlines Group S.A.||Chile||JPM||92%||-14%|
|LND||BrasilAgro Companhia Brasileira de Propriedades Agricolas||Brazil||BNY||15%||--|
|LPL||LG Display Co., Ltd.||Korea||Citi||25%||4%|
|LUX||Luxottica Group S.p.A.||Italy||DB||9%||11%|
|LXFR||Luxfer Holdings PLC||UK||BNY||-13%||--|
|LYG||Lloyds Banking Group plc||UK||BNY||-13%||12%|
|MBT||Mobile Telesystems PJSC||Russia||JPM||20%||-10%|
|MFG||Mizuho Financial Group||Japan||BNY||14%||3%|
|MIXT||MiX Telematics Limited||S. Africa||BNY||56%||--|
|MLCO||Melco Resorts & Entertainment Ltd||Hong Kong||DB||--||--|
|MTFB||Motif Bio Plc||UK||BNY||--||--|
|MTP||Midatech Pharma plc||UK||DB||-42%||--|
|MTU||Mitsubishi UFJ Financial Group, Inc.||Japan||BNY||24%||6%|
|NBRV||Nabriva Therapeutics AG||Austria||BNY||20%||--|
|NGG||National Grid plc||UK||BNY||-8%||4%|
|NICE||Nice Systems Ltd.||Israel||JPM||5%||13%|
|NMR||Nomura Holdings Inc.||Japan||BNY||29%||8%|
|NNDM||Nano Dimension Ltd.||Israel||BNY||-14%||--|
|NOAH||Noah Holdings Limited||China||Citi||4%||30%|
|NQ||NQ Mobile Inc.||China||DB||-27%||-20%|
|NTL||Nortel Inversora S.A.||Argentina||JPM||16%||11%|
|NVO||Novo Nordisk A/S||Denmark||JPM||-34%||4%|
|OASM||Oasmia Pharmaceutical AB||Sweden||BNY||-54%||--|
|OIIM||O2Micro International Limited||China||BNY||72%||-14%|
|OMAB||Grupo Aeroportuario del Centro Norte, S.A.B. de C.V. (OMA)||Mexico||JPM||-3%||23%|
|OSN||Ossen Innovation Co. Ltd.||China||JPM||-37%||-8%|
|PAC||Grupo Aeroportuario del Pacifico, S.A.B. de C.V.||Mexico||BNY||12%||21%|
|PAM||Pampa Energia S.A.||Argentina||JPM||177%||54%|
|PBMD||Prima BioMed Limited||Australia||BNY||-32%||-36%|
|PBR||Petroleo Brasileiro S.A. - Petrobras||Brazil||BNY||34%||-17%|
|PHG||Koninklijke Philips Electronics N.V.||Netherlands||Citi||28%||11%|
|PRAN||Prana Biotechnology Limited||Australia||BNY||-26%||-21%|
|PTNR||Partner Communications Company Ltd.||Israel||Citi||0%||-7%|
|PTR||Petrochina Co. Ltd.||China||BNY||-2%||-14%|
|PZE||Petrobras Argentina S.A.||Argentina||JPM||80%||1%|
|RBS||Royal Bank of Scotland||UK||BNY||-10%||-3%|
|RDY||Dr. Reddy's Laboratories Limited||India||JPM||-12%||4%|
|RIO||Rio Tinto plc||UK||JPM||25%||-7%|
|RYAAY||Ryanair Holdings plc||Ireland||BNY||13%||22%|
|SAN||Banco Santander, S.A.||Spain||BNY||35%||1%|
|SBGL||Sibanye Gold Ltd||S. Africa||BNY||-42%||--|
|SBS||SABESP: Companhia Saneamento Basico de Sao Paolo||Brazil||BNY||31%||-6%|
|SFUN||Fang Holdings Ltd.||China||JPM||-40%||-2%|
|SHG||Shinhan Financial Group Co., Ltd.||Korea||Citi||16%||4%|
|SHI||Sinopec Shanghai Petrochemical Company Limited||China||BNY||18%||20%|
|SID||Companhia Siderurgica Nacional - CSN||Brazil||JPM||-30%||-23%|
|SIFY||Sify Technologies Limited||India||Citi||-31%||-22%|
|SIMO||Silicon Motion Technology Corp.||Taiwan||BNY||14%||17%|
|SKM||SK Telecom Co., Ltd.||Korea||Citi||27%||13%|
|SKYS||Sky Solar Holdings, Ltd.||China||Citi||-43%||--|
|SMFG||Sumitomo Mitsui Financial Group||Japan||Citi||11%||3%|
|SMI||Semiconductor Manufacturing International Corporation (SMIC)||China||JPM||39%||19%|
|SMMT||Summit Therapeutics plc||UK||BNY||49%||--|
|SNDE||Sundance Energy Australia Ltd.||Australia||BNY||--||--|
|SNN||Smith & Nephew plc||UK||DB||-3%||11%|
|SNP||China Petroleum & Chemical Corporation (SINOPEC)||China||Citi||20%||1%|
|SPI||SPI Energy Co. Ltd.||China||BNY||-89%||--|
|SPIL||Siliconware Precision Industries Co., Ltd.||Taiwan||JPM||7%||7%|
|SQM||Sociedad Quimica y Minera de Chile S.A.||Chile||BNY||74%||-9%|
|SQNS||Sequans Communications SA||France||BNY||40%||9%|
|SSL||Sasol Ltd||S. Africa||BNY||-2%||-8%|
|STV||China Digital TV Holding Co.||China||DB||0%||-15%|
|SUPV||Grupo Supervielle S.A.||Argentina||BNY||--||--|
|TEDU||Tarena International, Inc.||China||Citi||67%||--|
|TEO||Telecom Argentina S.A.||Argentina||JPM||23%||9%|
|TEVA||Teva Pharmaceutical Industries Ltd.||Israel||JPM||-45%||-8%|
|TGS||Transportadora de Gas del Sur, S.A. (TGS)||Argentina||BNY||134%||45%|
|TI||Telecom Italia S.p.A.||Italy||JPM||-6%||-4%|
|TKC||Turkcell Iletisim Hizmetleri A.S.||Turkey||Citi||-16%||-7%|
|TLK||PT Telekomunikasi Indonesia Tbk||Indonesia||BNY||17%||13%|
|TM||Toyota Motor Corporation||Japan||BNY||1%||6%|
|TRIB||Trinity Biotech plc||Ireland||BNY||-48%||-13%|
|TSM||Taiwan Semiconductor Manufacturing Company Ltd.||Taiwan||Citi||32%||16%|
|TSU||TIM Participacoes S.A.||Brazil||JPM||54%||-11%|
|TTM||Tata Motors Ltd.||India||Citi||13%||3%|
|TV||Grupo Televisa, S.A.B.||Mexico||BNY||-3%||5%|
|UGP||Ultrapar Participacoes S.A.||Brazil||BNY||11%||0%|
|UMC||United Microelectronics Corp. (UMC)||Taiwan||JPM||-4%||-6%|
|VCO||Vina Concha y Toro S.A.||Chile||BNY||-3%||-4%|
|VDTH||Videocon d2h Ltd||India||DB||38%||--|
|VIPS||Vipshop Holdings Ltd.||China||DB||7%||93%|
|VIV||Telefonica Brasil SA||Brazil||Citi||29%||-12%|
|VLRS||Controladora Vuela Compania de Aviacion S.A.B. de C.V.||Mexico||BNY||-39%||--|
|VNET||21 Vianet Group, Inc.||China||Citi||-73%||-14%|
|VOD||Vodafone Group plc||UK||DB||-21%||-1%|
|VRNA||Verona Pharma plc||UK||Citi||--||--|
|WBK||Westpac Banking Corporation||Australia||BNY||9%||2%|
|XIN||Xinyuan Real Estate Co., Ltd.||China||JPM||-6%||7%|
|XNY||China Xiniya Fashion Ltd||China||DB||20%||-25%|
|XRF||China Rapid Finance Limited||China||Citi||--||--|
|XRS||TAL Education Group||China||JPM||--||--|
|XTLB||XTL Biopharmaceuticals Ltd.||Israel||BNY||-48%||-2%|
|YGE||Yingli Green Energy Holding Co. Ltd.||China||JPM||-47%||-41%|
|YIN||Yintech Investment Holdings Ltd.||China||BNY||20%||--|
|YPF||YPF Sociedad Anonima||Argentina||BNY||32%||13%|
|YZC||Yanzhou Coal Mining Company Limited||China||BNY||--||--|
|ZNH||China Southern Airlines Co., Ltd.||China||BNY||8%||9%|
|ZTO||ZTO Express (Cayman) Inc.||China||JPM||--||--|
|ZX||China Zenix Auto International||China||BNY||53%||-16%|
- 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
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
- The Stock symbol is AAPL (which is obtained from the first letters of the contract name).
- The Option expiry is 170519 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is May 19, 2017.
- This contract is a Call Option (Determined by the letter following the expiry which for this contract is the letter "C").
- The strike price is $142.000 (Determined from the remaining digits which gives the strike to three decimal places).
Contract Name: V170721P00092500
- The Stock symbol is V (which is obtained from the first letter of the contract name).
- The Option expiry is 170721 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is July 21, 2017.
- This contract is a Put Option (Determined by the letter following the expiry which for this which for this contract is the letter "P").
- 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.
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.
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
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
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.
- 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.
- 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).
- 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.
- 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.
- 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.
- 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.
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.