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Closed-End Funds Questions

What are structured products?

A structured product is typically a pre-packaged investment fund designed to provide exposure to a specific asset class or sector with certain tax or yield characteristics. The return may be derived from a basket of securities, a single security, derivatives, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps or forward contracts. In Canada, the primary categories of structured products include closed-end funds which include investment trusts and split share corporations, exchange traded funds (“ETFs”) and notes. Structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend. Structured products can be an attractive addition to your portfolio as they give you the flexibility to tailor an investment structure to meet your specific financial objectives—taking into consideration such factors as your goals, risk tolerance and time horizon.

What are closed-end funds?

A closed-end fund (“CEF”) is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO). Securities of the fund are listed on a stock exchange and trade like a stock. The stock prices of a closed-end fund fluctuate according to market forces (supply and demand) as well as the changing values of the securities in the fund's holdings Closed-end funds include investment funds, typically structured as a trust and split share corporations which are structured as mutual fund corporations. Despite the name similarities, a closed-end fund has little in common with a conventional mutual fund, which is technically known as an open-end fund.

What is a Split Share Corporation?

The “split share” structure is unique type of financial structured product. The split share structure allows the risk-reward component of common shares to be broken down into two components and then allocated differently for investors who are more or less risk averse.

A split share corporation will hold common shares of one or more issuers, typically a portfolio of common shares (based on a sector or industry). The corporation then issues two classes of shares - capital shares and preferred shares. For preferred shareholders, the objective is to generate fixed cumulative preferential dividends and to return the original investment. For capital shareholders, the objective is to increase investors' participation in any capital appreciation (or depreciation) in the underlying portfolio shares and to benefit from any increase in the dividends paid on the portfolio shares. With the use of leverage, the capital shareholders can realize a greater proportionate change in the value of the capital shares vs. the underlying common share (e.g. $1 increase in the common share price translates into a $1.50 increase in the capital shares).

Using this structure, a portfolio of regular common shares can be divided into capital shares that have a higher level of risk than the underlying common shares and preferred shares that exhibit lower risk than the underlying common shares. Therefore, the distinction between the class of shares issued by a split share corporation is very important.

How are closed end funds different from Open –Ended Funds (Mutual Funds)?

Closed-end funds differ from conventional mutual funds in a number of respects, most notably as follows: (a) while the securities of a fund may be surrendered at any time for redemption, the redemption price is payable monthly whereas the securities of most conventional mutual funds are redeemable daily; (b) the securities of a closed-end fund have a stock exchange listing whereas the securities of most conventional mutual funds do not; and (c) unlike most conventional mutual funds, the securities of a closed-end fund are not offered on a continuous basis. In addition, closed-end funds offer greater flexibility in the use of leverage, derivatives or sector concentration.

What is the Management Expense Ratio (MER)?

Each fund will have a slightly different management expense ratio depending on the management fee and the size of the fund. Generally, the MER is comprised of up to three amounts being the management fee, the operating expenses of the fund and possibly a trailer or service fee payable to the dealers whose clients own securities of the fund. The management fee is expressed as an annual percentage of the net asset value of the fund and is calculated and paid monthly. The operating expenses of the fund are spread equally across all outstanding capital securities of a fund and include such items as audit fee, custody fees, annual report mailing costs, website maintenance, IRC fees and others. Since these fees are primarily fixed costs regardless of the size of the fund, larger funds will be able to spread these costs over a greater asset base and in percentage terms will be lower than for smaller funds. Some funds include a trailer or service fee which is payable to the dealers and is typically 0.30% or 0.40% annually of net asset value. All in, the MER may vary from 1.30% per annum to just under 2.0% per annum. Other expenses that may cause the MER to increase in a year include security holder meetings or follow-on offerings.

Why do they tend to trade at a discount to NAV?

Lack of advertising and research, implied discount until the next annual redemption at NAV, yield loss through dividend reductions, and general investor interest, along with investor sentiment issues, are probably the biggest reasons behind why some closed-end funds trade at discounts to their underlying portfolio values. Since closed-end funds do not receive the same sort of publicity as regular mutual funds, they tend to trade at prices below their NAV. Investor sentiment for a particular sector or investment style of a closed-end fund can also push a fund to a discount or premium. If investors believe that a fund’s investment objective is likely to underperform others or decline significantly, they may be willing to sell the fund at a deep discount to avoid larger future losses. Conversely, buyers of a closed-end fund may be willing to actually pay more than NAV (a premium) if they are upbeat about the prospects of that given sector.

Discounts benefit the investor on a yield basis and possibly on the capital gains side. A discount is simply another way of saying that you can buy a dollar’s worth of assets for something less. For example, a fund trading at a 20% discount from NAV is giving an investor $1.00’s worth of underlying assets for only $0.80. Closed-end bond funds at discounts let an investor purchase $1.00 of income-producing assets for something less. The cash flow coming off of the closed-end portfolio is based on its NAV, not what the market price is. Therefore, the effect on an investor’s yield of purchasing a closed-end fund at a discount is similar to buying bonds at discounts; the yield is enhanced. For example, let’s say a closed-end fund that invests in U.S. government mortgage securities is paying $0.75 per year. If this fund has a $10 net asset value, then the fund is yielding 7.5% on NAV ($0.75 divided by the $10 NAV). Now let’s assume this fund can be purchased in the aftermarket for a discount of 15%. This discount would translate into a price of $8.50. The $0.75 annual cash flow remains the same, but instead of paying the $10 NAV, an investor is purchasing the fund at the market price of $8.50. The yield therefore is 8.82% ($0.75 divided by $8.50). An extra 1.32% (132 basis points) is being contributed by the discount alone.

This is important because it means that discounts may enhance the yield over what the portfolio is actually earning, which allows a closed-end investor to realize a higher yield than an identical product priced at NAV. Investors attempting to get the same yield from products at NAV will have to increase their implicit investment risk by using longer maturities or lower credit quality, or by using other methods such as leverage or derivatives. The discount contributes “free yield” with less stress on the underlying portfolio than a similarly yielding product priced at net asset value or above. However, there is no assurance that discounted funds will appreciate to their NAV.

What are the advantages of closed end funds?

Closed-end funds offer many advantages over traditional open-ended or mutual funds.

Portfolio concentration – Closed-end funds often have more concentrated portfolios with very specific sector allocations than might be found in mutual funds. A CEF portfolio may incorporate ten or fewer securities and sometimes only one security in the portfolio while overlaying some structure to provide attributes not available in a mutual fund such as tax re-characterization, option writing or leverage.

Lower Expense Ratios - Closed-end funds do not incur ongoing costs associated with distributing their shares as do many mutual funds; thus, the expense ratios of closed-end funds are often less than those of mutual funds. Over time, a lower expense ratio provides a boost to investment performance.

No Minimums - Closed-end funds do not impose amounts on purchases or sales, as most mutual funds do.

Low or no cash position – Closed-end funds do not accept new money from investors on a regular basis, and typically only have annual redemptions to fund. This allows funds to stay fully invested within their investment parameters. Without the need to carry a cash position in order to facilitate daily redemptions or reinvest new money, net yield should be higher (a cash position may lower the overall net yield of the portfolio as these liquid investments, such as money-market accounts, will typically earn yields lower than the rest of the portfolio).

Fixed asset bases that allow leveraging programs - The fixed capital structure of closed-end funds allows them to efficiently borrow money or issue senior securities (preferred stock) to enhance yield and/or performance, otherwise known as leveraging. What most leveraging strategies have in common is borrowing based on short-term interest rates, thus paying a floating interest rate, and then investing the proceeds in their given investment objective, usually longer-term bonds or high yielding equities that yield a higher rate than their borrowing costs. A positive yield spread between the investment rate and the borrowing rate increases a fund’s earnings, allowing the fund to increase its dividend payout to shareholders.

Potential opportunity to purchase assets at a discount to their underlying net asset value - Finally, one of the most important components of closed-end fixed income investing is the potential ability to purchase funds at a discount to their NAV. The NAV of a closed-end fund is the same calculation as that of a regular, open-end mutual fund (the current market value of all of the securities a fund owns, minus any outstanding liabilities of the fund company, all divided by the number of outstanding shares). In essence, it is the liquidation value of a fund, i.e. what each share of the fund would be worth to an investor (after paying off any liabilities such as salaries, rent, etc.) if all the securities within the portfolio were liquidated today. Investors in an open-end mutual fund who want to sell their shares can do so by selling them back to the investment company at NAV. Because closed-end funds trade on a stock exchange, the price they are bought and sold for is not NAV; it is the going market price of their stock. This price is determined by an interaction of buyers and sellers.

What are the tax implications of distributions?

Distributions from a fund may have significant tax benefits which result in higher after-tax cash flow than if the income had been earned outside of the fund. Each fund will generally earn dividends on portfolio securities, interest income on cash balances and option premium income which is generally taxed as capital gains. Capital gains and losses will also be recognized as portfolio securities are traded during a year. Many closed-end funds pay out a greater amount in distributions than is being earned in dividend or interest income, relying on capital gains or option premiums to bridge the gap. Any portion of a distribution that is considered a return of capital for tax purposes is not included in an investor’s taxable income for a year, but will reduce the adjusted cost base of the units, by the amount received. The reduction in the adjusted cost base of the units is ultimately taxed as a capital gain when the units are sold for investors who hold their units as capital property. If a return of capital would reduce the adjusted cost base below zero, that amount is taxed as a capital gain. Some funds may have existing tax pools which may allow a significant portion of the distributions to be a return of capital for tax purposes.

What are some of the risks of a closed-end fund?

No assurance on achieve fund objectives - There is no assurance that a fund will be able to achieve any distribution or capital preservation objectives. There is no assurance that a fund will be able to pay distributions. The funds available for distribution to investors will vary according to, among other things, the dividends and distributions paid on the securities in each fund’s portfolio, the level of option premiums received and the value of the securities comprising each fund’s portfolio.

Fluctuations in Net Asset Value - NAV per security will vary as the value of the securities in the fund’s portfolio varies. At any time, the issuers in the portfolio may decide to decrease or discontinue the payment of distributions on their securities. The fund has no control over the factors that affect the issuers in its portfolio, such as fluctuations in interest rates, changes in management or strategic direction, achievement of strategic goals, mergers, acquisitions and divestitures and changes in dividend and distribution policies. An investment in the securities does not constitute an investment in the securities of the issuers in the fund’s portfolio. Investors will not own the securities held by the fund and will not have any voting or other rights with respect to such securities.

Trading at a discount – Securities may trade at, above or at a discount to the net asset value per security. Securities that trade at a discount to the net asset value per security may offer an opportunity to enhance the yield in an investor’s portfolio however; trading liquidity may be hindered for funds trading at a significant discount. Funds offer an annual redemption at net asset value per security to minimize trading at a discount.

Use of derivatives - Derivative transactions involve the risk of the possible default by the other party to the transaction (whether a clearing corporation in the case of exchange-traded instruments or other third party in the case of over-the-counter instruments) in that it may be unable to meet its obligations. This risk is minimized by using well multiple regarded counter-parties for over-the-counter options.

Significant redemptions - While the annual redemption right provides securityholders the option of annual liquidity, there can be no assurance that it will reduce trading discounts. If a significant number of securities are redeemed, the trading liquidity of the securities could be significantly reduced. In addition, the expenses of a fund would be spread among fewer securities potentially resulting in lower NAV per security.

Concentration risk – A fund may invest in a limited number of securities or in a specific sector that will have a different risk profile than the overall market and may not be diversified. While this is generally viewed as beneficial for those investors seeking a specific asset allocation, it is important to ensure the fund is part of a diversified portfolio to reduce risk.

Exposure to foreign currencies – Some funds may purchase securities in foreign currencies thereby exposing the fund to foreign exchange risk if not hedged back to the Canadian dollar. Most funds are hedged back to the Canadian dollar to preserve the return in Canadian dollars.

Use of leverage to enhance returns - A leveraging strategy increases the volatility of a fund’s net asset value (NAV) by essentially magnifying the gains or losses of the fund’s portfolio holdings. There is a high likelihood that this increased volatility will impact the market price of the fund in the same fashion. In addition, there are two primary situations in which a leverage-enhanced yield is negatively affected – a flattening yield curve and an inverted yield curve. In both situations, the spread between the investment rate of the fund and the borrowing costs of leverage decreases, increasing the probability for dividend reductions. On the other hand, if this spread widens, there is a greater chance for dividend increases. Leverage is neither good nor bad; it is just an additional component of fund analysis and must be properly understood in order to evaluate a fund’s prospects.

What is a redemption?

In addition to daily trading on the stock exchange a redemption feature offers another liquidity alternative whereby investors can put their units back to the fund on an annual basis typically for proceeds equal to the net asset value per unit or share of the fund, less any costs incurred to fund the redemption. Many funds also offer a monthly redemption feature though these are typically at a discount to the net asset value or market price. Redemption are sometimes referred to as retraction features and the two terms are generally used interchangeably though technically a retraction is at the option of the holder (investor) while a redemption is at the option of the fund, such as the redemption of units on the termination of a fund.

What is leverage?

Leverage is a means of amplifying the returns on a portfolio in an effort to generate better returns than the portfolio would generate without leverage. The most common form of leverage, also known as gearing, is bank debt whereby the fund borrows money from the bank and invests the proceeds in additional securities for the portfolio. For example, if a fund can borrow 15% of its net assets of say $100 million, the total invested portfolio would have a value of approximately $115 million, offset by a liability to the bank of $15 million. Income and capital gains would be earned on the total portfolio of $115 million less the interest cost of the loan to the bank. It is important to note that while this can be beneficial to the fund (and investors) when markets are doing well, leverage will also amplify negative returns on the portfolio since the loan outstanding to the bank remains the same even when the value of the securities in the portfolio go down. Other forms of leverage include short selling and split share corporations. In a short sale, the fund borrows securities from an outside source, sells them in the market and reinvests the proceeds in additional securities in the portfolio, referred to as the long position. The leverage component in a split share corporation comes from the preferred shares which have a specified par value and pay out a pre-determined coupon to holders in the form of dividends or interest payments. The Class A shares are then considered to be leveraged investments. In each scenario, the fund incurs a cost of leverage being interest payments to the bank, borrowing costs to lenders of securities in a short sale or distribution payments to preferred shareholders in a split share corporation. It is also important to note that as the value of the total portfolio increases the amount of leverage declines (since the value of the loan or other liability outstanding as a percentage of the total portfolio declines) and conversely as the total portfolio declines in value, the amount of leverage increases.

Why do I receive the annual report even though I have asked my broker not to send me anything?

Securities legislation requires a manager of a fund to send the annual report to all securityholders as of a specific date (the record date). Investors do have the ability to op-out of receiving the semi-annual report. All of the annual reports are available on our website typically posted by the end of March in each year while the semi-annual reports are posted in early August.

What is a rights offering?

This is an offering whereby current holders of the fund are given the "right" to purchase additional securities in proportion to their current holdings, at a stated price. The offering price is generally established at the net asset value per security at the time of the offering, plus some premium to cover the costs of the issue, so the offering is not dilutive to the existing holders at the time the rights offering is made. A rights offering generally has a time to expiry of less than six months, whereas a warrant offering has a time to expiry of greater than six months. Rights and warrants typically trade on the exchange from the date of the issuance to the expiry date. The trading price will be a function of the time remaining to expiry and the intrinsic value of the right or warrant. Dilution to the net asset value of the existing securities will occur if the net asset value per security rises above the exercise price. In this instance you should see two net asset value per security disclosed, the basic NAV which does not reflect the impact of any dilution and a diluted NAV, which will be lower and reflects the impact on the NAV per security as if the rights have been exercised. A right issue gives investors the ability to purchase additional units of a fund on a low cost basis and provides the fund with additional capital that can be used to take advantage of attractive investment opportunities. A larger fund also has greater liquidity in the market with greater trading volume and the management expense ratio (MER) of the fund will be lower as operating expenses are spread over a greater number of securities. Since rights and warrants expire worthless after the expiry date holders are reminded to exercise or sell their right or warrant before they expire.

What is a warrant?

A warrant is similar to a right, however the term of the warrant, being the time from the issue of the security to the expiry date, is generally greater than six months for a warrant but less than six months for a right. Otherwise both issues are similar in form and function.

How often are the NAVs per security calculated, when do they get updated?

Net asset value per security is calculated on a weekly basis as of the close of business on Thursday and is generally posted on the website at the close of business on Friday. If the last day of a month falls during the week on a day other than Thursday, the NAVs per share are calculated as of the last day of the month for that week and the regular weekly calculation on Thursdays is resumed the following week. The NAV per security for more recent funds is calculated daily and posted on the website prior to the market opening on the following day.

What is a diluted NAV?

The diluted net asset value per security assumes the exercise of all outstanding warrants or rights if the net asset value per security on the valuation date is in excess of the warrant exercise price. Total net assets would be increased by the amount of cash received (all warrants outstanding multiplied by the warrant exercise price, less costs) from exercise of the warrants and total units outstanding would be increased by the number of units issued pursuant to the exercise of the warrants. If the net asset value per security on the valuation date is less than the warrant exercise price, the basic and diluted net asset value per security will be the same.

When does the distribution get taken off the reported NAV?

Distributions are taken out of the net asset value of the fund on the ex-distribution date which is two business days prior to the record date. The record date for our funds is generally the 15th of the month the distribution is paid.

How do I update for address changes?

Unlike mutual funds, closed-end funds and their managers cannot track who owns the individual securities of the fund. Securities of a closed-end fund are typically book-entry only which means investor records are maintained electronically by the individual broker/dealers whose clients own and trade the securities. Each broker/dealer has an account with CDS Clearing and Depository Services Inc. (“CDS”) which tracks the total amount of securities held by each respective broker/dealer. The fund only has one registered holder being CDS. Any change in address must be addressed to your respective broker/dealer who maintains your account.

What is the Adjusted Cost Base of my investments?

Since the fund does not have any knowledge of when you bought your securities or what you paid for them it is impossible for the manager to determine your individual adjusted cost base. Generally, the adjusted cost base or ACB of your securities will be the weighted average cost you paid for the securities less any return of capital distributions you received. The tax allocation of distributions paid during a year is available on the website towards the end of March every year on a per security basis.

What happens when the fund approaches its termination date?

If the investment thesis of the fund still makes sense it is likely that the manager will put forward a proposal to the security holders to extend the term of the fund. This involves the issuance of an Information Circular and a security holder meeting at which all security holders may vote on the extension. Often, the manager includes other changes to the fund to bring it in line with current practice in the industry, such as amending redemption features, adjusting for changes in the tax laws or amendments permitting different investments in the fund. Investors are generally given the right to exit the investment on the same terms as if the fund were being terminated if they so desire. This means that no investor is disadvantaged by virtue of the extension.

Are these funds suitable for me?

Each investor must consider suitability from their own perspective giving consideration to such things as their level of risk tolerance, desired level of income, asset allocation and overall exposure within their entire portfolio, investment knowledge and comfort with investment products. We recommend that investors speak regularly with their investment advisors as market conditions can change the risk profile of funds over time and each investor’s needs and circumstances change.

Option Questions

What is an option?

An option is simply an agreement between two investors to enter into a transaction in the future under certain circumstances. The future transaction is either buying or selling an underlying asset, usually a security. Some options trade on an exchange, such as the Montreal Exchange, or the Chicago Board Options Exchange, while others trade ‘over the counter.’ For options that trade on an exchange, the ‘circumstances’ of this future trade are defined and standardized so that many investors can easily trade the same option. For example, two investors (A & B) may agree to trade 100 shares of Company XYZ at $25 anytime in the next month. One of the investors (Investor A) agrees to sell the shares at $25 if the other investor (Investor B) wants to buy them at $25. Investor B now has the right to buy shares of XYZ from investor A and must pay investor A for that right; this is ‘price’ of the option and also referred to as ‘the option premium.’ Investor A has the potential obligation to sell 100 shares of XYZ at $25 and receives this premium for accepting this obligation.

What does ‘writing options’ mean?

With regards to options, ‘writing’ is another name for ‘selling.’ An investor does not have to own an option to be an option writer. When someone writes an option it is important to note that they are obligated to perform in the event the option is exercised.

How are Options different from Futures?

Options and Futures may appear to have similarities, but they are quite different. In Futures, the buyer and the seller have the obligation to either ‘make’ or ‘take’ delivery of some underlying asset in the future. With Options, the buyer of the option has the ‘right’ to make (using Puts) or take (using Calls) delivery of some underlying asset, but not the obligation. The seller (or ‘writer’) of that option, therefore, has a potential obligation to make (using Calls) or take (using Puts) delivery of the asset.

What is a call option?

A call option contract gives the holder the right to buy and obliges the writer to sell a specified number of shares at a specified strike price, any time before its expiry date.

What is a covered call?

One option strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call, also known as a buy-write strategy. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred by the trader will be partially offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put. This relationship is known as put-call parity.

Are there any covered call indices?

A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500 Buy-Write Index (NYSE: BXM).

What is a put option?

A put option contract gives the holder the right to sell and obliges the writer to buy a specified number of shares at a specified strike price, any time before its expiry date.

What factors determine the price of an option?

The price of the underlying asset - If the price of the underlying asset goes up, the value of a call with also go up, while the value of a put will decline, assuming nothing else changes.

The strike price - If the strike price is higher, a call option will be worth less and a put option will be worth more. Any dividend on the underlying asset during the life of the call - Dividends impact the price of an option because they impact the price of the underlying asset. Generally, a stock price will decline by the amount of the dividend on the day it trades ‘ex-dividend.’ If this date occurs during the life an option it will be taken into account when determining the option price. Higher dividends will reduce the price of a call and increase the price of a put, other things being equal.

The time to expiration - Other things being equal, any option (call or put) will be worth more if the time to expiration is longer because that extra time increases the opportunity for the option to become more profitable.

Interest Rates - Interest rates affect the prices of Calls and Puts because investors have choices about how to invest their money. In the simplest case, an investor can either buy 100 shares of stock for $X, or buy a call on 100 shares of stock at much less than $X and invest the difference in a risk-free asset like treasury bills. If the rate on treasury bills is high, the call buyer will be willing to pay more for that call because of the extra return received on the t-bills. So, higher interest rates cause call prices to rise. If interest rates go up it makes the value of investing in t-bills relatively better than the value of 100 shares at a fixed price, so, higher rates will cause put prices to fall. Similarly, lower rates will cause call price to fall and put prices to rise.

Volatility - Volatility is the way we quantify the variations in the price of a security. If we expect volatility to be high during the life of an option, this increases the probability that our option position will be profitable. This impact is the same whether the option is a call or a put.

What is the Black-Scholes model?

The Black–Scholes model is a widely used option pricing model developed by Fischer Black and Myron Scholes in 1973. The model can be used to calculate the theoretical value of an option based on the current price of the underlying security, the strike price and term of the option, prevailing interest rates and the volatility of the price of the underlying security. Many empirical tests have shown the Black-Scholes price is “fairly close” to the observed prices, although there are well-known discrepancies such as the “option smirk”.

Why is volatility so significant?

While volatility is not always the largest component in a given option’s price, it is perhaps the most critical determinant. All the other factors used to determine the option price are known, or at least fairly certain. We know the price of underlying stock now, we know the strike price, we know the time to expiry, we can be quite certain about any dividend especially if it has already been declared, and, we can be relatively confident about the level of interest rates over short periods of time. The one thing we do not have any certainty about is how volatile the stock will be over the next week, month or year. We can look at how volatile it has been recently as a proxy, however, this will have limited value in times of great uncertainty.

As indicated previously, volatility is one of the inputs used to determine the price of an option in pricing models. If we observe the price of an option traded in the market, we can use this same model to ‘solve’ for the volatility input because all the other inputs are relatively certain. This number is referred to as the ‘implied volatility’ because it indicates how volatile the option buyer expects the underlying asset to be, implied by the price he is willing to pay for that option.

Apart from changes in the stock itself, changes in expectations are likely to have the biggest impact on option prices from one day to the next.

What is implied volatility?

The implied volatility of an option contract is the volatility of the price of the underlying security based on the market price of the option. Another way to think of it is solving for the volatility part of the pricing equation using all other known factors in the equation, including the price of the option. Since options are traded in the market, the implied volatility is the market’s expectation of future volatility and not historical volatility. Often financial literature will highlight the 30-day historical volatility of a security which should not be confused with the implied volatility which is future expectations of volatility in the security.

Options are referred to as ‘a wasting asset,’ why would I want to trade them?

It is true that if nothing else changes, an option will be worth less tomorrow than it is worth today. However, the passage of time is only one factor in determining the price of an option. Other factors, such as the expected change in price of the underlying asset, can have a much bigger impact on the value of an option. Some strategies, such as ‘covered writing,’ take advantage of this characteristic.

Aren’t options risky?

Not necessarily. Some strategies can involve a lot of risk, while other strategies can actually reduce an investor’s risk. Options are often used to ‘hedge’ the risk associated with a portfolio of assets. It is very important to understand the rights and obligations associated with an option to correctly determine the risk.

What is ‘Covered Writing?’

This is a type of risk-reducing strategy using options. For example, an investor who owns shares of XYZ Corp can sell (‘write’) call options on the same company. As long the quantity of Calls written does not exceed the quantity of shares held by that investor, the written option position is referred to as ‘covered.’ It is covered because if the call options are exercised, the seller can simply deliver the shares already held. If Calls are sold when shares are not held, the position is referred to as ‘naked’ and carries significant risk because the call seller may have to purchase shares at a much higher price to meet his obligations if the option is exercised.

What is a protective put?

Buying a protective put involves buying one put contract for every 100 shares of underlying stock already owned or simultaneously purchased. This put guarantees the owner the right, but not the obligation, to sell the shares at the strike price at any time until the option expires, no matter how low the stock declines in value. And just as with other forms of insurance the investor pays a premium for this protection - the premium paid for the put.

The buyer of a protective put retains the profit potential on the stock as long as the price of the underlying stock continues to rise. However, purchasing a protective put in effect increases the purchase price of the stock by the premium paid for the option contract. When the underlying shares are ultimately sold, whether by exercising the put after a stock price decline or by simply selling the shares after a stock increase, the net price received will be the sale price less the put premium paid. The break-even point for this strategy at expiration can be calculated in advance as the stock's purchase price plus the put premium paid.

Another benefit of the protective put is that the investor is in total control of the sale of the protected shares. Since the protection provided is a long option position, whether or not the put is exercised, and the underlying shares sold, is entirely up to the investor. If the underlying stock has declined below the put's strike price before it expires, and the put is in-the-money with intrinsic value, the put may be sold instead of exercised and the shares retained. Regardless of the investor's decision at option expiration, during the lifetime of the put contract the investor continues to receive any dividends paid to stockholders as long as the underlying shares are owned.

How do Puts protect value in the portfolio?

A protective put is a portfolio strategy where an investor buys shares of a stock and, at the same time enough put options to cover those shares. This is a form of hedge or insurance on the invested stock in case it declines in value. The buyer of a put protects himself from a drop in the stock price below the strike price of the put since the put allows him to sell the stock at the strike price which would be above the stock price if the put was in the money. In the event the put is not exercised the investor has only lost the cost of the put. A put by itself has limited upside or potential gain, which occurs when the stock becomes worthless. By combining a put with shares of the stock, the resulting portfolio has potentially unlimited upside(due to the theoretical upside in a stock), while limiting downside due to the protective nature of the puts. Of course this is offset by the cost of the puts.

What is a strike price?

The strike price is the price at which the option holder can buy (call option) or sell (put option) the underlying stock.

What is the option premium?

The option premium is the price the buyer pays the seller for the rights conveyed by the option contract. It is the price of the option

What is the difference between at-the-money, in-the-money and out-of-the-money options?

An option is "at-the-money" when the underlying stock price is identical or relatively close to the option strike price. A call option is "in-the-money" when the underlying stock price is higher than the strike price. A call option is "out-of-the-money" when the underlying stock price is lower than the strike price. A put option is "in-the-money" when the underlying stock price is lower than the strike price. A put option is "out-of-the-money" when the price of the underlying is higher than the strike price.

What is the contract size of a stock option?

The contract size of an option contract (the number of underlying securities covered by the option) is 100 shares, unless adjusted for a special event such as a stock split, reverse stock split or consolidation

What is open interest?

Open interest represents the total number of options contracts on a particular share that have not yet been closed or exercised. This is an important concept, but it has no direct impact on the price of an option. An opening transaction increases the open interest whereas a liquidating transaction reduces it. The greater the open interest, the more liquidity in the market, therefore the easier it is to take or dispose of a position.

What does “exercising” mean?

Exercising an option is the process by which holders execute their right to buy (in the case of a call option) or sell (in the case of a put option) according to the terms specified in the contract

What does “being assigned” mean?

An assignment takes place when a holder exercises an option. Option writers each receive an exercise notice that obliges them to sell (in the case of a call option) or buy (in the case of a put option) the shares at the stipulated strike price.

What is the difference between American and European options?

American options allow the holder to exercise the option at any time during the life of the option. With European options, on the other hand, the holder can only exercise the option on its expiry date. S&P Canada 60 Index options (SXO) are European style. All stock options traded on MX are American style, which gives investors more flexibility. However, this extra privilege comes at a price that is built into the option premium, which is why the value of American options is usually higher than the value of European options

What is the expiry date?

The expiry date is the date on which the option and the right to exercise it cease to exist. Options expire at noon on the Saturday following the third Friday of the expiry month (last trading day).

Warrant Questions

What is a warrant

A warrant is a security that gives the holder the right to purchase securities from the issuer at a specified price within a certain time frame. Warrants are typically offered directly by the issuer, and when exercised, require the issuer to issue new securities. Warrants trade on the market separate from the underlying security. Of note, warrant holders have the opportunity to acquire the respective securities at a price potentially lower than the market price.

How are warrants valued

The value of a warrant can be broken into two components, intrinsic value and time value. Intrinsic value is the amount by which the market price of the underlying security exceeds the subscription price of the warrant. Even when warrants are out of the money (i.e. no intrinsic value), they still may have what is known as time value, which is related to the market’s view of the potential for the warrants to become “in the money”, prior to expiry. The longer the time period until expiry, and the more volatile the underlying security, the higher the time value will be.

Why did I receive warrants in my account?

If you did not buy any warrants on the exchange it is likely you received the warrants by virtue of your ownership of some other security upon which warrants were issued. Funds that issue warrants must file a preliminary prospectus that outlines some of the details of the offering and then follow-up with a final prospectus that fills in all the details once it has been approved (“receipted”) by the respective securities commission. The securities commission is not assessing the merits of the offering but simply that the issuer has fulfilled all the filing requirements in order to issue the warrants.

What is the tax implication of receiving a warrant?

Generally, there is no tax implication upon receipt of a warrant. Therefore, if you sell your warrant in the market you will have a capital gain equal to the proceeds of the sale. Investors who purchase warrants in the market and subsequently sell them will have capital gain (or loss) equal to the proceeds from the sale less the cost to purchase the warrant. If warrants are exercised, the cost base of the warrants will be the exercise price plus the cost to purchase the warrant, if bought in the market.

How do I exercise warrants and what I am entitled to with such exercise?

To exercise a warrant (or a right) a holder of the warrant must instruct their investment advisor to exercise all or a portion of their warrants prior to the expiry date. Most investment dealers will have an earlier cut-off date (typically two days prior to the expiry date) in order to allow for sufficient time to process the request, so please check with your investment advisor. Securities purchased pursuant to the exercise of a warrant should be deposited in your account within a few days.

Why can’t American residents exercise warrants or rights?

As a Canadian issuer the fund is prohibited by the SEC from issuing securities to residents of the United States of America. This includes the warrants or rights themselves and any securities issued pursuant to the exercise of a right or warrant. Generally, warrants or rights issued to a resident of the United States of America will be held in their dealer’s account and not delivered to the individual investor’s account. The warrants or rights should then be sold in the market and the proceeds from the sale delivered to the US holder’s account. Accordingly, no subscriptions will be accepted from any person, his agent, who appears to be, or whom, the fund has reason to believe is a resident of the United States. Security holders whose recorded addresses are outside of Canada (but not in the United States) are generally permitted to subscribe for securities pursuant to a warrant or rights offering.

Can I trade my warrant?

Yes, warrants (or rights) trade on the exchange on which the securities of the fund are listed (typically the Toronto Stock Exchange). Note however, that warrants cease trading after the expiry date.

What happens to my warrants on the expiry date?

Warrants will cease trading on the expiry date (typically around noon) and if not exercised will be worthless.


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Term Definition
Adjusted Cost Base or ACB The average cost per unit of an investor’s securities.
ADRs American Depository Receipts issued by a depository that evidence a beneficial interest in securities of an issuer that are held on deposit by the depository.
Alpha The excess return of the fund, adjusted for risk, relative to the return of a benchmark.
at-the-money in relation to a call option, means a call option with a strike price equal to the current market price of the underlying security and, in relation to a put option, means a put option with a strike price equal to the current market price of the underlying security.
Beta The measure of an equity or portfolio’s historical volatility compared to the market as a whole over a given period. It is a tool investors can use to assess the risk profile of potential investments, relative to the overall market.
Black-Scholes Model a widely used option pricing model developed by Fischer Black and Myron Scholes in 1973. The model can be used to calculate the theoretical value of an option based on the current price of the underlying security, the strike price and term of the option, prevailing interest rates and the volatility of the price of the underlying security.
business day any day on which the Toronto Stock Exchange and The New York Stock Exchange are open for business.
Buy-Write Another term for covered call writing. The investment manager buys a portfolio of common shares and writes calls on them.
call option the right, but not the obligation, of the option holder to buy a security from the seller of the option at a specified price at any time during a specified time period or at expiry.
cash equivalents means, and for the purposes of “cash cover” and “cash-covered put option”, “cash” as used therein means:
  • cash on deposit at the Fund’s custodian;
  • an evidence of indebtedness that has a remaining term to maturity of 365 days or less and that is issued, or fully and unconditionally guaranteed as to principal and interest, by:
  • any of the Federal or Provincial Governments of Canada; or
  • the Government of the United States; or
  • a Canadian financial institution;
  • provided that, in the case of (ii) and (iii), such evidence of indebtedness has a rating of at least R-1 (mid) by DBRS Limited or the equivalent rating from another approved rating organization; or
  • other cash cover as defined in NI 81-102.
cash-covered put option a put option entered into in circumstances where the seller of the put option holds cash equivalents or other acceptable cash cover (as defined in NI 81-102) sufficient to acquire the securities underlying the option at the strike price throughout the term of the option.
covered call option a call option entered into in circumstances where the seller of the call option holds the underlying security throughout the term of the option.
CRA Canada Revenue Agency.
Current Yield The most recently reported monthly or quarterly per unit or common share distribution or dividend for that issuer multiplied by 12 in the case of issuers that make monthly distributions or dividends and by four in the case of issuers that make quarterly distributions or dividends and divided by the closing price per unit or common share of such issuer on such date.
Distribution Date The date on which cash distributions are paid by the fund, which for all Strathbridge funds is the last business day of the month.
Ex-Distribution Date The day on or after which new units purchased on the stock exchange will not receive that month’s distribution.
in-the-money in relation to a call option, means a call option with a strike price less than the current market price of the underlying security and, in relation to a put option, means a put option with a strike price greater than the current market price of the underlying security.
Intrinsic Value The amount by which the market price of an underlying security exceeds the subscription price of the warrant related to that security.
NAV per Unit in general, the NAV of the Fund divided by the number of Units then outstanding. See “Calculation of Net Asset Value – Calculation of Net Asset Value and NAV per Unit”.
Net Asset Value or NAV The net asset value of the Trust, as determined by subtracting the aggregate amount of the liabilities of the Trust from the Total Assets and as more particularly set forth in the Declaration of Trust.
Net Asset Value or NAV the net asset value of a fund which, on any date, will be equal to the difference between the aggregate value of the assets of the fund and the aggregate value of the liabilities of the fund on that date.
NI 81-102 National Instrument 81-102 – Mutual Funds (or any successor policy, rule or national instrument), as it may be amended from time to time.
Nymex New York Mercantile Exchange, the largest physical commodity futures exchange.
option premium the purchase price of an option.
Options Options are agreements between two parties for a specified time period (up to the expiry date) that give holders the right, not the obligation, to buy or sell a specified number of shares, usually a lot of 100, at a pre-determined price (exercise or strike price). You can buy or sell options just like shares.
out-of-the-money in relation to a call option, means a call option with a strike price greater than the current market price of the underlying security and, in relation to a put option, means a put option with a strike price less than the current market price of the underlying security.
Premium/Discount The amount in percentage terms by which the market price differs from the net asset value per unit. A market price in excess of the NAV per unit is trading at a premium whereas a market price less than the NAV per unit is trading at a discount.
put option the right, but not the obligation, of the option holder to sell a security to the seller of the option at a specified price at any time during a specified time period or at expiry.
Record Date The date on which a holder of a security will be entitled to receive a benefit. Typically refers to a distribution, though may also refer to voting rights pertaining to a scheduled security holder meeting.
REITs Real Estate Investment Trusts.
Selling volatility Selling volatility is a term used to describe the process of writing options and receiving the option premium.
SIFT Rules provisions of the Tax Act applicable to “SIFT trusts” and “SIFT partnerships” (within the meaning thereof).
strike price in relation to a call option, means the price specified in the option that must be paid by the option holder to acquire the underlying security or, in relation to a put option, the price at which the option holder may sell the underlying security.
Tax Act means the Income Tax Act (Canada) and the regulations thereunder.
Taxable Capital Gain A realized capital gain upon the disposition of an Canoe Unit, upon which a Unitholder will be required to include in computing the Unitholder's income one-half of any such capital gain.
Time Value The market’s view of the potential for a warrant to become “in the money” prior to expiry.  The longer the time period until expiry, and the more volatile the underlying security, the higher the time value will be.
Total Assets The aggregate value of the assets of the fund as determined in accordance with the terms of the constating documents.
VIX or Volatility Index The Chicago Board Options Exchange Market Volatility Index (symbol: VIX) is a popular measure of the implied volatility of S&P 500 index options.  It represents one measure of the market's expectation of stock market volatility over the next 30 day period. 
volatility in respect of the price of a security, is a numerical measure of the tendency of the price to vary over time.
Warrant A security that gives the holder the right to purchase securities from the issuer at a specified price within a certain time frame.
WTI West Texas Intermediate, a crude oil benchmark.
Useful Links
Canadian Securities Institute
International Forum for Investor Education (IFIE)
OSC Investor Education section
Montreal Option Exchange Education Sections
Option Strategies Guide
Options Industry Council
Canada Revenue Agency
CDS Tax Posting
Business News Network
Canadian Investor Protection Fund
Canadian Securities Administrators
Globe Investor
Stock Exchange
Toronto Stock Exchange
Securities Commission
Alberta Securities Commission
Autorité des marchés financiers
British Columbia Securities Commission
Government of Yukon Securities Registrar
Manitoba Securities Commission
New Brunswick Securities Commission
Newfoundland Securities Commission
Northwest Territories Securities Commission
Nova Scotia Securities Commission
Ontario Securities Commission
Prince Edward Island Securities Office
Saskatchewan Financial Services Commission
Bank of Canada
Canadian Bankers Association
Canadian Capital Markets Association


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