*Note: Although the following text was intended to be a generally comprehensive text on the subject, many points and nuances were not discussed due to the diversity of related topics. Many of these rules are also subject to change by the time you are reading this text. Therefore, never settle on these discussions and always consult your financial advisor before any decisions.
Capital means wealth, either tangible like buildings and land, or indirect like money and shares. Capital is the extra income savings of individuals, organizations, and governments, which are always limited and in demand. Investment means to forgo something to obtain added value in the future. The most important reasons for investment include maintaining actual capital value or attempting to increase it. Keeping or saving money/capital in cash is the opposite of investment. The problem with holding money in cash is that not only does it not increase capital, it will also almost certainly reduce purchasing power and actual capital value due to inflation.
Not all economic investment goals are the same. If a person with surplus income at the end of every month or a retired employee who has just received a severance package deposit their money in the bank, it would lose its value. A high-income individual or a factory owner could also be constantly concerned about their future in the event of corporate or factory bankruptcy.
Contrary to popular belief, you do not need tens of thousands of dollars to start investing. There is no predetermined amount for investment, and any person can start investing right away with any amount of money. Your most important asset in investment is not your money, but your time.
Canada’s finance and investment markets are its major economic pillars. These markets’ main role is to move capital from “savors” to “consumers” to create economic growth, create jobs, and increase gross domestic product.
To begin investing, two points are important to know, namely your financial means and your risk tolerance. In general, various investment opportunities have different capital growth potential and risk. Lower risk often means lower capital growth potential, and the more risk you are willing to tolerate, the more potential you have for capital appreciation. However, keep in mind that “risk” is a double-edged sword. Although riskier investments (e.g., derivatives) have greater capital appreciation potential than low-risk investments (e.g., guaranteed investment certificates), there is also as much risk of loss and reduced capital value, especially over the short-term.
There are various investment vehicles in Canada with different growth potentials and risks.
Savings accounts are perhaps the simplest and most widely-adopted investment in Canada. Due to their nature and low profitability, this text will not view these savings accounts as an investment, but as savings vehicles. Other than savings accounts, the various investment vehicles can be categorized as follows:
Securities: Fixed-income Securities: Fixed-income securities are investment instruments in which the borrower commits to pay you monthly, annual, or semiannual interest in return for the money that they borrow, and return your principal payment at the due date. These securities include government and treasury bonds. Hence, if you purchase Microsoft’s bonds – instead of stocks – you have not taken partial ownership of the company, but loaned money to Microsoft and receiving interest in return (as well as your principal money at the contract’s due date). There are various types of fixed-income securities with certain differences, including bonds, debentures, mortgages, treasury bills, and commercial paper.
Securities: Equity Securities: By purchasing equities, you purchase a share of a company or organization and share its profits or losses relative to your investment. The difference between purchasing equities and fixed-income securities is that purchasing equities makes you a co-owner of the company, whereas purchasing bonds means loaning it money.
Derivatives: Derivatives are complex financial securities whose value depends on another financial instrument (underlying asset) such as equities or bonds.
Managed Products: Managed products include mutual funds, which are managed by professionals and invest in a wide range of financial instruments according to their predetermined objectives. For example, a mutual fund could contain 20 different stocks from Canadian companies (40%), 10 from American companies (15%), 10 from European and international stocks (15%), some bonds from the Canadian government (10%), some American bonds (10%), and cash and treasury bonds for the remainder. The contents of these funds are not constant and their managers change them according to economic circumstances. However, you and I as investors do not deal with the fund’s changes or trades. The share which we purchase partially represents the fund’s total value. If the fund’s total value grows, so will your share; and if it decreases, your share will do the same. The advantage of these funds is that you don’t need investment knowledge or to follow the capital market every day, since a professional team will manage the fund. As expected, however, these funds receive compensation in return for their investment operations, which often ranges from fraction of a percent to several percentages of the investment.
Structured Products: The term “structured” often refers to products that are produced using financial engineering and have a mixture of the aforementioned investment instruments’ characteristics (equities, fixed-income securities, and mutual funds). These products include principal-protected notes or index-linked GICs.
For your information, these investment types are briefly explored as follows:
Bonds: Bonds are securities in which the investors lend money to a legal or institutional person (corporate or government), and the investee (recipient) commits to reimburse the cash or credit in the specific time-frame or pay fixed interest. The specific time-frame for the principal investment’s reimbursement is known as the date of maturity, and the periodic payments (predetermined periods) are security coupons. In the old days, paper bonds would pay interest by the pieces of paper attached to the side or bottom. After each coupon’s due date, the person would separate and take it to the issuing organization or company to receive their payment. Finally, the actual bond would be taken to receive the principal payment. The following image shows an old bond.
Securities are often issued by companies and governmental institutions like municipalities, federal, provincial, or foreign governments, and are financing instruments for governmental and municipal projects and operations. As mentioned earlier, bonds are “fixed-income securities”. Interestingly, governments can only raise investment through bonds, whereas companies have different options (e.g., issuing bonds, receiving bank loans, issuing equities in the market, and many others). A company’s decision on selecting the type of investment depends on its state and abilities as well as the method’s costs. Companies often seek assistance from large organizations with expertise (banks or large insurance companies) for selecting and raising capital.
Debentures: Debentures are very similar to bonds, but lack their specific physical guarantee (buildings, land, etc.) and are backed by credit or the issuer’s goodwill. With bonds, the credit recipient pledges a physical and tangible asset, like a building or land, in return for the borrowed money, and cedes the right to the creditor/lender to expropriate it to return the debt in the case of failure to make the dividend or principal payment. While the general public and even professionals in the capital market use the term government bonds, they are actually debentures, since governments never pledge a specific physical asset in return for the borrowed money, and the bonds’ interest and the principal payment is only backed by the government’s goodwill. The stronger and more stable a country, the greater its goodwill. In theory, governmental bonds are considered risk-free since governments can temporarily raise taxes to make interest payments to investors even in case of financial difficulties. A government’s inability to pay the governmental bonds’ principal or interest payment, known as sovereign default, is very unlikely and has occurred rarely in practice, and even when happened it wase later addressed in some way. Due to this difference with bonds, debentures that lack specific guarantees are also called unsecured bonds.
Treasury Bills: Treasury bills are short-term government bonds that are offered in thousand to million-dollar units. These are considered by many investors, including banks, insurance companies, and even micro-investors as near cash investments. Unlike common bonds, treasury bills do not pay interests during their ownership, but are sold at a discount and redeemed later at the so-called “face value” at the due date. Your profit is the difference between the purchase and sale price. For instance, Canada’s three-month treasury bills are sold at 98 CAD, and you as the purchaser can sell it for the redemption price of 100 CAD at a two-dollar difference. Treasury bills are auctioned through the Canadian Central Bank and Department of Finance every two weeks. These bills usually have a due date of three months, six months, or a year. They often have a relatively low interest but are effectively considered as slightly more profitable than cash due to their short-term maturation and governmental backing, which results in customers and serve as a substitute for temporarily parking money.
Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs): These are Canadian governmental bonds. Issuance of CSBs and CPBs were ceased in November 2017 due to lack of interest as well as numerous alternatives, yet if anyone still owns them and has not redeemed them, they can refer to the relevant institution to do so.
Real Return Bonds: Similar to normal bonds, real return bonds pay interest during and return the principal payment at the end of the contract. Unlike normal bonds, however, the interest rate is not fixed and is adjusted according to annual inflation. Therefore, if inflation increases, so will your rate of return (and vice-versa).
Provincial and Municipal Government Securities: Municipal or provincial government securities have the same conditions as government bonds (these are also debentures). The difference is that provincial governments are riskier than federal government, and less risky than municipalities. In general, the creditworthiness of each province (or municipality) depends on that province or region’s tax revenues. The more diverse the government’s tax resources, the more creditworthiness it will have. In the end, the creditworthiness difference of various governments (provincial, federal, and municipalities) will be represented in the interest rate of bonds. The bonds issued by the federal government will often pay the lowest interest (since they have low risk due to high income resources). As a result, provincial governments are forced to pay slightly higher interest than the federal government to make their bonds more appealing to the market. This is also the case for the bonds between various governments. For instance, due to its stability and relatively strong economy, the Canadian government pays a significantly lower interest for its bonds than i.e. the Venezuelan government (which has a higher risk). Finally, it is the investor who decides their risk level in return for interest level.
Corporate Bonds: As explained earlier, unlike governments, corporations have a wide selection of rasing capital, one of which is selling bonds. They can issue bonds, take loans, or offer some of their ownership through shares and receive payment. In general, companies are riskier than governments (since they are not linked to infinite tax revenues), and should attract investment through issuing and selling bonds with higher interest. Companies issue various types of bonds that are somewhat different from each other: Collateral trust bonds pledge stock bundles or a company’s financial assets instead of tangible physical assets (e.g., buildings). Equipment trust certificates are a type of bond in which the assets pledged are equipment (e.g., train wagons). Subordinated debentures are bonds that are positioned weaker than the company’s other bonds. For instance, during bankruptcies, the confiscated assets are first transferred to the original bondholders, and any remaining assets are transferred to subordinated debenture holders. Obviously, subordinated debentures need to pay a higher interest/revenue due to their higher risk than other bonds. Corporate notes are short-term payment notes that the company commits to pay the principal and interest payment on in return to the investor.
Mortgage Bonds: As you might have guessed, mortgage bonds are used for purchasing real estate in which the creditor (e.g., bank) will pledge the property in return for the loan extended to the debtor (individuals or organizations). As you can see, mortgages are no different than the aforesaid bonds. The credit recipients pledge their physical assets (real estate) in return for the money borrowed and pay the principal and interest over time. In fact, many banks or similar institutions bundle many mortgages and sell them to mutual funds. For instance, the bank A can bundle 3000 of its recent mortgages extended to individuals. If each mortgage in the bundle is worth 800,000 dollars on average and the average mortgage interest is 5%, the bundle will be worth 2.4 billion dollars and will give an annual interest of 5%. After collecting a suitable number of mortgages, banks often bundle them as mentioned and sell them to mutual funds or other investment funds. This sale is profitable for the bank as well as the investment funds that purchase it. The fund will have a source of income through which it can pay dividends to its members, and the bank will remove the extended loan from its balance sheet and make room to lend more mortgages (Note that if these banks do not sell the mortgages to third-party companies, these loans will stay in banks balance sheet and limits number of future mortgages that can be extended).
Floating-Rate Securities: Among various bonds, floating-rate securities have a floating rate of interest. This means that the interest rate changes according to inflation. Clearly, purchasing bonds during increasing inflation will result in higher interest, whereas falling inflation will reduce the interest below standard bonds.
Domestic, Foreign, and Eurobonds: These bonds are issued in another common currency or a geographic region outside Canada. These bonds are purchased when one is concerned about their national currency’s depreciation. For example, when you have discovered that the exchange rate of the Canadian dollar will be weaker than the other currencies in the upcoming years; acquiring a bond with the same interest rate in Euros will be beneficial.
Other than bonds, there are several other types of fixed-income securities.
Bankers’ Acceptances: It is a type of written instruction for payment that is issued by a company and guaranteed by a bank. For instance, the RBC bank guarantees and issues the bankers’ acceptance of company A. BAs are sold at a discount and can be redeemed at the stated price. These contracts are often short-term (30 to 90-days), but could be as high as 365 days. For example, Microsoft sells its BAs (90-days with a stated price of 10 million dollars) guaranteed by an American bank for 9900000, which can be redeemed after 90 days for the stated price. The buy and sale price difference (100,000 dollars in this example) is the return on investment. Since this investment instrument is guaranteed by a bank, its interest is only slightly higher than treasury bills or government bonds.
Commercial Paper: It is similar to bankers’ acceptance but is not guaranteed by the bank and its payment guarantee is merely the issuing company’s goodwill. Clearly, only companies with considerable credit rating can sell their commercial papers, and companies facing financial troubles will struggle to find buyers for their commercial paper. Commercial papers do not pay monthly interest, but are sold at a discount similar to bankers’ acceptances and can be redeemed at the due date for face value.
Term Deposits: Term deposits pay a guaranteed interest for a short period of time (usually under a year). Withdrawals before the due date are often subject to penalties.
Guaranteed Investment Certificates (GIC): Guaranteed investment certificates or GICs are the most popular type of fixed-income investment among lower-risk individuals. The principal and interest payments are guaranteed by the bank or the issuing institution. As you can tell, these guarantees are not cost-free. In fact, due to these guarantees, the GIC interest rates are only slightly above savings accounts and rarely exceeds one or two percent in Canada. The GIC rate depends on the interbank rate announced by the government. During the 2020 pandemic with the interest rate at its lowest level, most GICs pay close to half a percent in interest. Regardless, note that if you have significant sums of money, you have room to bargain and ask for higher interest, but don’t expect an interest rate equal to inflation.
There are two main types of GICs, namely cashable and non-redeemable GICs. Cashable (redeemable) GICs can be cashed whenever you wish at interest for the number of days it was held. Non-redeemable GICs, however, should be kept until the due date (In other words, they are locked long-term). As a result of these restrictions, the interest considered for redeemable GICs is often lower than non-redeemable GICs. Furthermore, GICs can have various features:
Escalating-rate GIC: The interest/profit received over the contract period increases over time. For example, it could be 0.8% in the first year, 1% in the second year, and 1.5% in the third year.
Laddered GIC: The investment is divided into equal parts, and you have the option to redeem it at the due date or reinvest. For example, a 4-year 100,000-dollar GIC is divided into four equal parts of 25,000 each. At the end of every year, you have the option to redeem some of the matured payments or reinvest. These types of GICs help in avoiding allocating all of your money for a long time and provide a chance to use the investment money for another activity or reinvestment every once in a while.
Installment GIC: With installment GICs, the main contribution is made first, and the investment grows through a predetermined contribution plan in installments (e.g., monthly).
Index-linked GIC: This GIC type is favored by those who are not satisfied with their GIC returns but also have a low risk appetite. The GIC interest depends on the performance of another investment, such as equities, but the principal payment will be guaranteed. Once again, note that because of the existing guarantee, the resulting interest is always lower than the underlying investment and there is a possibility of receiving no profit, but the principal payment will remain safe.Index-linked GICs often have three to five-year time frames, or even higher.
For example, if you purchase a one-year 1% standard 100,000-dollar GIC, you know that you will have 101,000 dollars at the end of the year (100,000 principal payment in addition to 1% interest of 1,000 dollars).
However, in a GIC linked to the equities market (e.g., linked to the Canadian stock market index), if the index does not change or even falls compared to the time of GIC purchase, you will still receive your principal payment (100,000 dollars). However, if the index has grown by 15%, you will receive your principal payment in addition to some of the 15%. Note that with linked GICs, the bank/issuing institution will never pay your interest in full proportionate to underlying asset (since it has insured your principal payment and accepted all the negative market risk, and demands a percentage of the interest in return). Therefore, the interest of these GICs will always be a part of the profits of the instruments linked to it. This part is known as the participation rate (Sometimes, an interest ceiling is defined instead of a percentage and is called the participation cap).
For example, assume that you are purchasing 100,000 dollars of annual index-linked GIC linked to the American stock index with a participation rate of 50%. After three years, one of the three following events may occur:
– The American stock market suffers a crisis and the index falls: You will only receive your principal payment of 100,000 dollars.
– The stock market doesn’t change: You will only receive your principal payment of 100,000 dollars.
– The stock market has a good three years and grows by 20%: You receive 100,000 dollars in addition to 50% of the resulting 20% profit, or 10% (10,000 dollars), for a total of 110,000 dollars.
In any case, if you think the GIC interest is low and you also lack the courage to invest in the stock market (since maintaining your capital value matters to you), index-linked GICs are useful solutions.
Interest-rate linked GIC: It is similar to the aforementioned option, but different in that the interest rate changes according to the bank’s interest rate. This means that you will receive a higher profit if the interest rate rises, but a lower profit if it falls.
In general, note that the bond interest rate depends on the issuer’s risk and financial stituation. Governments have the strongest position, and highly-indebted and risky companies are the worst-case scenario. For instance, if the Canadian government’s bonds yield 2% interest, the bonds of famous Canadian companies with healthy finances yield 3.5%, and companies with unhealthy finances and the possibility of non-payment yield 10%. The higher an organization’s risk, the higher it needs to set the interest to entice investors to purchase bonds. Given these explanations, it is important to know the risk of companies as it determines which interest rate is preferable at which potential risk level. Independent institutions such as Moody’s Canada Inc and the Standard and Poor’s Bond Rating carefully evaluate financial statements to determine the risk and credit of companies. A rating system has been devised for this purpose. For example, the ratings from best to worst are AAA, AA, or A, BBB, BB, or BB, and CCC, CC, or C. The higher a company’s rating, the higher its ability to pay lower interest in return for its bonds, since its bonds always find buyers due to public trust and proven payment ability. Lower rated companies can only encourage investors to purchase bonds by offering higher interest rates. Like all investors, organizational bond buyers look for maximum profit, but high profit comes with high risk, and investors will logically not put all of their eggs in one basket. They often buy a mix of high and low-risk bonds (Lower-risk purchases have lower interest but are intended to protect and insure capital, and higher-risk purchases have a higher risk of non-payment but are necessary to increase the overall investment profit/interest.)
After a brief introduction to various fixed-income securities, it is now time for equity securities or shares. Equity is the most important investment instrument for individuals and organizations. Historically, equity interest – over the long-term – is higher than the interest of fixed-income securities like bonds and the inflation rate. “Equities” are in the portfolio of many micro-investors, mutual funds, and provincial or federal pension funds. The main difference between “stocks” and fixed-income securities like bonds is that buying shares amount to purchasing part of the organization in question and sharing in its profits and losses to the same extent. On bonds – or fixed-income securities in general – the exact interest that one will receive in return for the initial investment is known. Equities, however, are more complex, since there are two types of income from equities. The first is the company’s dividends, and the second is the profit from increasing stock price or the loss from a reduced price. Until equities are sold, the profits/losses caused by increasing/decreasing stock price only occur on paper and change every day.
From the buyer’s standpoint, the main differences between bonds and shares are as follows:
Bondholders and owners are creditors and will be the first in line to receive money in the case of a bankruptcy. In fact, in cases of bankruptcy and liquidation in which all of a company’s assets are sold and liquidated, the first people to receive money are the creditors or bond-holders. Finally, after the money of all bondholders is settled, any remaining cash will be divided between the company’s stockholders. In many actual cases, when a public company goes bankrupt, the shareholders receive no money and effectively lose their entire investment (it drops to zero).
Note that unlike bonds in which interest payment to creditors is legally mandated (in case of non-payment, the creditor has the right to seize assets), there are no legal obligations for paying annual dividends from a company’s net income, and it depends on the board’s decision. For many years, the board may decide to refrain from paying dividends due to unsound conditions or to reinvest the income on growing the company. However, the absence of year-end dividends is not necessarily a bad thing. For example, large technology companies that grow rapidly reinvest most of their income instead of paying dividends, since they achieve much higher growth and return of capital. Ultimately, the reinvestment affects the share price.
In general, there are two types of shares, namely common and preferred shares.
Common shares are familiar to most people. They are securities that represent ownership and claim over part of a company and its income and assets. Owners of common shares know that they have a right to vote at annual meetings and can participate in selecting the board of directors, and they will receive dividends as shareholders. By selecting the board of directors and having a right to vote in meetings, common shareholders effectively determine and control the company’s policies. The price of common shares rise and fall according to the company’s condition, and could reach zero if the company is liquidated.
Preferred shares, however, are somewhat different. Although they are considered “shares”, they mostly resemble bonds. These shares are often sold at a fixed price with a guaranteed interest paid by the company relative to its price. They are usually offered when common shares have no buyers, or the company tries to avoid issuing new common shares that would dilute the ownership percentage of old shareholders. Preferred share is a type of stock ownership in which the owner has a stronger claim on the company’s assets and profits than common shareholders. The interest that preferred shareholders receive annually can be guaranteed, which would mandate the company to make regular interest payments to preferred shareholders. Likewise, most preferred shareholders have a higher priority of receiving profits than common shareholders, which means that the company divides its year-end profits at the stated percentage first between preferred shareholders, and then distribute the remainder among common shareholders. In return, preferred shareholders are often denied voting rights in meetings. The price of preferred shares is not correlated with the company’s common share price and does not grow accordingly (Note that the preferred share price doesn’t fluctuate due to the constant and specified allocated profit regardless of the company’s performance, and the company’s growth, progress, and increased revenue is not a cause for a higher preferred share price as it will not receive a higher interest.) In fact, like bonds, the preferred share price depends on the interbank interest rate. Keep in mind that although the preferred shares’ interest payment is not as legally obliging as bonds, failure to make payments will have consequences, including the loss of goodwill in the stock market, which harms companies in the long-term. Therefore, companies always do their best to pay the interest promised to their preferred shareholders. If the company repeatedly fails to pay interest on preferred shares, preferred shareholders will be given a right to vote.
Example: Assume company A has two types of shares.
The common share currently priced at 20 dollars, which pays a 4-dollar interest per share at the end of the year, and the preferred share of 22 dollars which pays a 7-dollar interest (higher than the common share).
If the company works tirelessly, it may double its common share price to 40 dollars in two years, in which case common shareholders will receive 4 dollars per share and double their investment. That is with 50 shares (totaling 1000 dollars), their value would grow to 2000 dollars and the shareholder would receive 400 dollars in dividends. In total, the 1000 dollars would become 2400 dollars.
However, this would be inconsequential on the preferred share price. The preferred share would remain at 22 dollars after two years due to its fixed dividend, and the person would receive 636 dollars in dividend for a total of 1636 dollars. Although it appears that the preferred shareholder has suffered a loss, the preferred shareholder would receive a higher profit if the opposite were to happen (falling share price) as their 7-dollar dividend would be guaranteed for each share, and if the company was in a bad condition, the common shareholders would not receive a dividend and would have their stock price fall.
· Summary: The priority of dividend payment among investors is as follows: First, bondholders, second, preferred shareholders, and last, common shareholders.
*Note: I wanted to point out that although I have tried here to do a brief introduction to common and preferred shares, there are many points and details related to each share type’s features that are much more diverse than the few paragraphs given above, and the general introduction to just one could take hundreds of pages. Therefore, never settle on these explanations for decisions, and always consult your financial advisor before making any decisions.
Derivatives: Derivatives are securities whose value depends on one or several assets that are derived from it. Derivatives are often very complex financial products used by large investment institutions to increase profitability and balance risk. The underlying capital of a derivatives could consist of financial capital (shares or bonds), foreign currency, futures contracts, an index, or even inflation. In general, derivatives are divided into two categories:
1- Options
2- Forwards
Both of these are signed between a seller and a buyer, and both are time-specific.
1- Options
There are two types of options, namely, call options and put options.
Call options allow the buyer to purchase a specific number of the underlying capital at the currently agreed-upon price. If asked, the call option seller is tasked with selling the particular number of underlying capital at the agreed-upon price.
(For example, option is used when you think a stock will rise sharply but lack the funds to make the purchase, or you are not 100% sure and purchase the call option instead that is less expensive).
Put options allow the buyer to sell a specific number of the underlying capital at the currently agreed-upon price. If asked, the put option seller is obliged with purchasing the particular number of underlying capital at the agreed-upon price.
(For example, it is used when you think your capital may depreciate rapidly but you are not certain. Therefore, similar to an insurance contract, you buy put option contract at a specified price. If your stock price falls below the put option, you have the option to activate the contract and force the other party to purchase your shares at the agreed-upon price, which is higher than the market price. In other words, you have insured your share’s depreciation to a certain extent by paying a price.)
A simple example: Assume you are monitoring a bank’s shares for months, but have heard the news that it could be merged in the upcoming months with a larger bank, and the shareholders will suddenly enjoy a significant price increase. At the same time, you are not 100% certain and do not wish to involve 100,000 dollars of your money in the investment directly to share in the possibly massive profits. What you can do is to purchase a call option for that bank’s shares. Assume that the bank’s stock price today is 20 dollars. A buyer could purchase a call option to buy the bank’s stock for 22 dollars at any point in the next four months. The call option seller is obliged to sell that bank’s share to the call option buyer for 22 dollars. Assume that the entire contract is for 5000 shares and the call option seller asks the buyer for 2 dollars per share (serving as an example with no particular calculation).
If you pay careful attention to the contract’s terms, you might perceive it as a bet. The seller receives a payment for the call option, and in return commits to transfer the bank’s shares in the agreed-upon quantity to the buyer for 22 dollars at any point in the next four months. The call option seller hopes that the stock price does not exceed 22 dollars, which would oblige them to transfer the corresponding shares and pocket the 2 dollars. The call option buyer, however, hopes otherwise. The buyer hopes that the stock price exceeds 22 dollars by as much as possible to receive it from the other party for 22 dollars. In general, these contracts are a bet on the relevant stock’s future.
So far, the option’s buyer has paid 2 dollars out of pocket for the share that is currently 20 dollars. This means that if the share’s price fails to exceed 22 dollars in the next four months, there is no interest for the seller to deliver the shares.
Finally, if the share’s price exceeds 22 dollars over the next four months, the call option buyer will activate the contract and receive the share from the seller at 22 dollars. Note that if the share’s price ends up between 22 and 24 dollars, the call option buyer will activate the contract but at a loss (For example, if it reaches 23 dollars, it will buy it from the call option seller for 22 dollars and sell it for 23 dollars on the market. In this case, the profit is one dollar, but since the contract was purchased for 2 dollars per share, the final loss will be one dollar per share).
If, however, the share price exceeds 24 dollars as predicted – 40 dollars for example – the call option buyer will certainly activate it. The 40-dollar share is purchased at 22-dollars and sold at 40-dollars. Assuming a 2-dollar payment for the contract, the buyer will pocket a total of 16 dollars per share (the current price of 40 dollars minus 22 dollars for contract price and 2 dollars for the contract cost).
Keep in mind that to activate this contract, the call option buyer only needs 5000 shares multiplied by 2 dollars, or 10,000 dollars, whereas purchasing whole shares at 20 dollars would take the cost to 100,000 dollars for 5000 shares.
Important Note: Using options serves as leverage. If you have purchased 100,000 dollars (for 5000 shares) at 20 dollars per share and sold it at 40 dollars, your profit would be 100% (your 100,000 dollars would become 200,000 dollars).
If, however, you decided to do this through the two-dollar call option per share, you would only need to put in 10,000 dollars and your profit of 16 dollars multiplied by 5000 shares would equal 80,000 dollars or 800%!
In the meantime, keep in mind that although using options has significant profit upside, it also has the same significant loss downside. In this example, if the share price was to fall contrary to your prediction (e.g., 15 dollars), you would only lose 25,000 dollars or 25% had you purchased direct shares, but your loss would take your entire 10,000 dollars or 100% had you taken the option route. In the worst-case scenario, call option buyers are at risk of losing their entire investment, whereas call option sellers should note that their risk is infinite (since a share price could theoretically grow infinitely, and they would have to purchase the share no matter the price and transfer it to the call option buyer.)
Put option contracts are similar to call options in which the seller guarantees to purchase the share at the agreed-upon price at the put option buyer’s request.
Regardless, I will refrain from mentioning more details for the purposes of this article. A relatively comprehensive explanation of options could require hundreds of pages, which is outside the scope of this introductory article.
2- Forwards
Many of you could have heard something in line of “The Brent crude price for January contract…” for many years. A forward contract is one in which the contract buyer is obliged to purchase the product under contract from the forward contract seller at the currently agreed-upon price. Unlike option contracts, both sides of these contracts are “obliged” to make the deal. The underlying goods linked to forward contracts are divided into two general groups, namely financial instruments like equities, bonds, etc., and commodity instruments like precious metals (gold, etc.), crude oil, wheat, corn, and others.
In forward contracts, the parties usually don’t exchange anything at the start of the contract, and the seller delivers the product to the buyer and receives the payment at today’s agreed price, or the parties settle the difference with today’s agreed price in cash. Most of these contracts are traded outside the stock exchange between large financial institutions.
Example: Assume a Toronto brewery requires 100 tons of wheat every year. Wheat price varies throughout the year, but the brewery cannot change its price every day. Therefore, it signs a forward contract for 100 tons of barley to be delivered the next January at the agreed-upon price, e.g. 10 dollars per kilogram. If the price of barley exceeds 10 dollars on the due date for any reason, the brewery asks the contract seller to deliver the barley in Montreal for the agreed-upon price or to pay the difference so that it can purchase it elsewhere. These forward contracts serve as insurance for both sides, the barley producer and seller. The barley seller is assured that there is a buyer for the product at the minimum guaranteed price no matter what happens, and the buyer (brewery) is assured that the barley purchase price will not exceed a specific amount.
You may find it interesting that forward contracts for products reach their due date at a specific time in the future and have a specific location for delivery, which could or could not suit the buyer. In this example, for instance, the Toronto brewery is located near Montreal, and if it chooses to, it can request the product’s (barley) forward contract seller on the due date. If, however, the brewery is in Vancouver, it would probably request the price difference instead of the product to make sure that it could purchase its required barley from nearby Vancouver. Had the price increased, the contract and the market price difference would make up for the market price (since the seller would sell the product in the open market instead of the price set by the market, and would pay the difference to the Vancouver brewery). Forward contracts can be traded (sold or transferred) before the due date, but a physical exchange is necessary if one side demands so at the due date. That means that the product would be delivered at the specified location and the buyer would receive it.
The previous example illustrated the main purpose of forward contracts. In practice, many forward contract traders are individual investors or institutions that require no wheat, barley, or the like! In fact, many of the forward contracts traded on the financial and stock markets are traded for the traders’ profit, who often accept their profits or losses a few days before the due date and leave the contract to not physically receive the product. Many of the companies that require the product under contract could do the same and receive the price difference instead of the product to purchase the original product from their trusted supplier. They are just interested in fixing a price for their intended product using the contract.
Forward contracts are often traded over-the-counter and between large financial institutions like banks, but standardized forward contracts are offered in the stock market and are called futures contracts. With futures contracts traded on the stock exchange, the parties need to deposit the payment in a shared account as collateral assurance. This account is checked every day, and one party is required to charge the account according to the product’s price changes. The important point for you as an investor is that you should refrain from trading if you are unaware of the underlying contract since you could lose much more than you have put in. In these contracts (traded on the stock exchange), the money involved accounts for 3 to 10% of the contract total. Therefore, the price reduction could be much greater than your initial deposit on the due date. Unfortunately, there have been irreversible losses in trading such contracts due to a lack of understanding about their function. For example, individuals who purchase futures contracts from the market based on oil price hoping that the oil price would increase and yield a profit. These individuals are unaware that these so-called ETFs based on futures contracts are not the same as purchasing shares of oil companies but the product itself and have an expiration date, and if they hold the contract until the due date, they have to go to the port and receive the oil in person! There have been cases in which people have rushed to sell their contracts at the final hours of the due date to avoid the physical delivery, which have even turned the stock linked to the futures contract negative.
