Mike

About fifteen years ago, my first stock broker told me a story that happened to him almost twenty five years earlier.  I can’t remember all the details, so it can’t be verified.  He swore it was true, and if you can’t trust your stock broker who can you trust?

To make this point, I’d like to share the story the best I can remember.  It takes place when my broker started in business, in the early 1960’s.  He had some clients wanting to buy stock in a company he had never traded before, but the name was familiar.  In doing research about the company, he discovered a new company had bought the “corporate shell” of an older, out of business company.  (It is a long and difficult process to turn a company into a publicly traded company.  Many times it is easier to merge into the “shell” of an abandoned company, and fill it with your own “slug.”)

This “new” stock hadn’t traded for years, maybe even decades, but now had volume and an increasing price.  Why was this company familiar?

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My broker told of being at his childhood home and realizing the reason for the stock’s familiarity.  He remembered, his parents had lost a fair amount of money in the “old” company years earlier.  All that was left of the monumental loss was the reminder his father had framed and hung on the wall… the stock certificate.

The story goes, he took the certificate off the wall, sold it to his client.  Giving his widowed mother the money and earning a large commission from his satisfied client.  If I remember the story correctly, the new company went the way of the old, it once more became a shell.

The moral of the story; If you own a stock long enough it may come back from the dead.

With an option, there is no after life, no reincarnation!  One funeral is all it gets.  If your option dies, you don’t get a certificate to hang on your wall.  All you have left is the trade confirmation from your broker and the memory of the money in your account.

Options are a fixed time investment.  After expiration, they cease to exist.  When buying options, you need to be right, and right on time.  Stock prices go up, they go down and they stay the same, but time always passes.

The nice thing about time, it’s consistent.  Time’s passage is an integral part of an option’s price.

Time Value and Time Decay:

Option prices can have two elements, Intrinsic value and Time value.  Intrinsic value is equity, a “down payment on the stock.”  Time value is potential.

If an option has time remaining, the stock has the capability to move.  Consider time value as possible movement value.  At expiration, there is no time, there is no potential.  The “Greek” term Theta measures the time value decay of an option.

The Laws of option pricing are constant.  The Laws regarding time value include; “The At the Money Option ALWAYS has the highest time value.”  “Time value drops the further In or Out of the Money the option moves.”  “Time value decays at its square root.”

My goal is to help people become better traders.  It is less a goal to teach which stocks to trade, and more a goal to teach identifying situations, and matching strategies to those situations.  If you know ahead a stock’s price is rocketing to the moon, it’s easy, just bet the farm.  However, if you’re not sure, you don’t know if a stock will soar, but you have sound fundamental information and technical analysis to help reasonably know the direction of price, you can learn to develop successful strategies.

I would like to think, I can give information worthwhile to read, worthwhile to learn, and more important, worthwhile to trade.

Most investors do not understand the difference between price and value.  Value is what a stock should be worth.  Price is the last trade of record.  The key to successful investing is finding undervalued and overvalued stocks whose price becomes more in line with their value.  This is also called reversion to the mean.

The daily opinion poll, known as the market, determines price.  Like the political climate in America today, the financial climate is often a confusing and changing environment.  Bill Clinton and Amazon.Com have a lot in common.  Contrary to long time expert opinions, both are scoring amazingly high in the public opinion polls.  Trying to call their early demise might be the biggest mistake of the end of the 20th century.

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My major problem is that I am a one man army.  Attacked on all flanks and seriously out gunned.  I had to develop a hand to hand combat method of investing… Trench Warfare.  I knew my weaknesses (market predictions) and my strengths (logic, mathematics, analysis, and experience).  I would pick my battles and my battlefields…Options.

I hate stocks.  Their valuations are one dimensional…PRICE.  Stocks don’t know time.  This is evidenced by one of the oldest forms of Technical Analysis: Point and Figure Charting.  Options on the other hand are multi-dimensional.

Option pricing is based on the values derived from the Nobel Prize winning Black-Scholes formula.  Options are derivatives.  That is they have no value in and of themselves, their values are derived from something else.

Sounds scary, doesn’t it?  Aren’t derivatives responsible for breaking a British Bank?  Actually it was a young rogue trader in Singapore misusing derivatives that broke the long time institution.  If he knew some of things I plan on teaching, history could have been different.

I intend to take a complicated mathematical equation and give you the basics to successfully trade with this information.

You will learn how options are valued.  The components are simple; Time, Price, Potential, Dividends, and Interest Rates.

Time:  The one true constant.  Stocks go up, stocks go down, stocks stay the same, TIME passes.  The value of time does not decay linearly.  For true math heads only… Time Value decays at its square root.

Price:  Not only the price of the stock, but the difference of the Strike price versus the Stock price.

Potential:  Known as Volatility, measured in Standard Deviations.

Dividends:  Applicable only to stocks that pay dividends.

Interest Rates:  Short term risk free rate of borrowing.

These Mathematical counterparts have Greek terms.  This adds to the difficulty experienced by seasoned Stock Brokers as well as neophyte investors.

Time Decay-Theta, Price movement-Delta and Gamma, Potential-Vega, Interest Rates-Rho.

Strategies include almost every kind of spread imaginable, and some only a veteran such as myself could dream up.  They will include:

Bull Spreads, Bear Spreads, Put Spreads, Call Spreads, Credit Spreads, Debit Spreads, Calendar Spreads, Ratio Spreads, Back Spreads, Butterfly Spreads, Condor Spreads, Anticipation Spreads, Subsidy Spreads, Straddles, Strangles Combinations, Time Diagonals, Synthetic positions and Position Trading.

If risk can be minimized or hedged away, there is a spread that can do it.

Sounds Great?  Well it’s meaningless if you can’t trade it.

The public opinion poll on Advanced Micro Devices (AMD) recently shown a less that happy result.  The price gapped down.  Not unlike many other stocks have done.

If you look at a long term chart of AMD you will see exactly why you don’t want to be a “long term buy and holder”.  This is a high tech company and the price hasn’t moved much?  Actually it has moved nicely, up and down!  Is now the proverbial Low from “Buy Low-Sell High”?  I don’t know.  But I can trade on the possibility.

AMD is almost a commodity.  They manufacture CPU’s to compete with Intel (INTC).  With consumers wanting less and less expensive computers, one would think things would be well for AMD.  However, Intel wants not only a bigger market, but bigger market share.  They have come out with cheaper chips to compete with AMD.  Chips that allow box manufactures the low entry price with the familiar Intel Inside logo.

We’ll enter a Position Trade, buying a long term call and selling short term calls against it.  We’ll look at a number of hedged positions where we buy and sell risk, buy and sell time decay and buy and sell potential.  It will cost us a certain amount of money to enter this trade and then a certain amount of money to maintain this trade.  The key to Position Trading is to have less money in the trade as time goes on and more profit potential.  It is money management.

Percentage movement is meaningless in stocks.  Own 1000 shares of a $10 stock and you have the same $10,000 tied up as owning 500 shares of a $20 stock.  The same $10,000 buys you 100 shares of a $100 stock.  If any of these stocks move up 10%, a $10,000 position would increase to $11,000.

Percentage movement for option is essential.  Stocks need to make decent price moves in order for its options to have their prices affected.

Strike price choices on a $10 stock maybe limited to $7.50, $10, and $12.50.  Going two strikes In or Out of The Money (ITM, OTM) would add the $5 and $15.  Both of which are 50% from the current price.

The $20 stock would have $17.50, $20 and $22.50 strike prices.  If two strikes In or Out of The Money (ITM, OTM) are available, they would only be 25% from being At The Money (ATM).

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The $100 stock’s strike price availability would all be closer in terms of a percentage.  The $90 and $110 choices would be two In or Out (ITM, OTM), yet they would only be 10% In or Out (ITM, OTM).

If a $100 stock moves 10%, it will pass through two strike prices.  If it moves 10% down, it would pass through the $95 and $90 strikes.  If it moved up, it passes through the $105 and the $110 strikes.

If a $20 stock moves 10% it comes close to moving one strike.  It would still be $0.50 away from either the $17.50 or the $22.50.  Close, but not close enough.

A 10% move on a $10 stock doesn’t get the price much closer at all to the next strike price.  Less expensive priced stocks need bigger percentage movements.

The significance of strike price distance versus stock prices as terms of a percentage should be clearer.  All equal percentage price movements affect all stocks equally, they do not affect options the same.  A 10% move is a big thing to options on high priced stocks, but lower priced stocks require larger percentage moves to affect their options.

If a stock’s price is too low, you may consider buying the stock as opposed to trading options on it.  You should certainly rule out trading Out of The Money (OTM) options on them.  Match the strategy to the stock price.

Margin requirements vary on plays.  Buying options requires the money to pay for them.  Buying stock either requires full payment, or you may purchase them on margin.  (Check with your broker for specific margin requirements.)  Generally speaking stocks need to be around $5 minimum in price to be optionable.  In such case the typical margin is 50%.  That is, you need to have half the money available, your broker will loan you the other half.

When you sell options, you will need to put something up as collateral.  With Covered Calls, the most often sold option, the collateral is the stock the option is written against.  You either need to pay for the stock in full, or buy it on margin.  By putting up only 50% of the cost and selling the option and receiving 100% of the premium you may more than double your return.

Naked Puts have more aggressive margin still.    Many brokers only require 25% security for the value of the stock.  Successful Naked Put selling may have less commissions than Covered Calls.  Naked Puts done right cost one commission versus Covered Calls three.

Always run through different strategies and pick the best one depending on your risk tolerance, account size and your expected move in the asset.

Profits from stock trading come by buying low and selling high.  Profits fuel capitalism.  Profits built America.  Corporate profits come from buying low and selling high.  Every successful business is based on this simple concept.

The main difference between corporate profits and investing profits is, the adding of value.  McDonalds buys potatoes low and sells them high.  They add value by peeling, cutting and frying these potatoes; then selling them as french-fries.  The basic concept remains buy low/sell high.

Investors don’t add value.  They can’t dip their stock certificates in chocolate and have fancier more valuable shares.  A share is a share, is a share.  All shares are equal.

Buying low and selling high requires valuations.  How else would you know if something is high or low.  You can’t trade using 20/20 hindsight.  You need to know what something is worth and what it should be worth.  Not just stock or option valuations, but for anything.

There are rules of thumb for everything.  Example, something is only worth what someone is willing to sell it at or pay for it.  Price measures value.  To measure the value of a stock at any time look at the last price traded.  It is the most current match of a willing buyer and a willing seller.  Trades require buyers and sellers.  With every trade, you truly have both opinions.  Prices move based on supply and demand.  More buyers cause increasing prices, more sellers and prices decline.

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Free Appraisals

Antique dealers earn their living through their knowledge.  Buying and selling provides their income, but their knowledge allows their transactions.  They need to verify authenticity, rate condition, know market values and marketability.  They use this insight to buy low/sell high.

Many antique dealers supplement their antique trading profits by offering appraisals.  Often before insuring certain items, insurance policies will require professional written appraisals stating value.  In the worse case scenario of a claim, a written appraisal saves untold amounts of grief.

Some antiques are too large or delicate to transit, so the appraiser must travel to inspect them.  Time cost money.  The appraisers need to charge for their time.  None of this is done for free, well almost nothing.  Many people seeking appraisals are doing so to value their item for sale.  Loss leader appraisal services generate antiques coming through the doors.  Many dealers offer appraisal services as a means to buy.

An antique dealer friend of mine told me a story of a client who didn’t want to pay for his services, but wanted them just the same.  He explained how this person had a “valuable” piece of antique furniture.  When told of the cost of the appraisal, including the travel time to come look at it, the client asked for a free appraisal over the phone.  The antique dealer was used to people trying to avoid paying for his services and played a little game with any skin-flints.

Hold It Up To The Phone

He told them to bring the phone near the piece to be able to better describe it.  Then he asked to have the phone held closer so he could see the item better.  He asked to have the phone moved around the piece very systematically.  The phone was placed inside every nook and cranny.  Upon completion, the antique dealer announced the piece looked counterfeit.  The person became so concerned.  Was he sure?  Well only in person could he know.

Knowledge also provides professional stock traders with their living.  And unlike antique dealers, they give free appraisals.  Every time they buy or sell, they state their opinion on what that particular stock is worth at that very moment.

The last trade gives the universally accepted valuation of a stock.  Whether one share or one million shares exchanged hands, the last recorded trade sets the value of all existing shares.  This skew allows profit potential.  Volume is a key to stock and option traders.  Price movements on low volume don’t confirm valuation changes as well as large volume moves.

The market capitalization of a company is figured by multiplying the number of shares outstanding by the current price of the stock.  Theoretically, if a stock trades millions of shares at a level, then trades one last share at a much different level, the market cap is based on this last share.

This is the problem with after hours trading.  The spreads are wide, with volume low.  Valuations swing wildly as trades take place from low bids to outrageous offers.  The willing buyers want to steal stock.  The willing sellers want a small fortune.  Until after hours trading gets tight bid/ask spreads, think of it like unscrupulous antique dealers trying to underpay ignorant owners or overcharge non-knowledgeable collectors.

Unlike businesses that add value, traders need to mine equity.  Investors need to use knowledge, experience and research to find gold mine stocks.  Not literal gold mining companies, but value waiting to be pulled out.  Gold in the ground is worthless until someone stakes a claim, commits resources to extract the value.

In business, the key is not to be part of the crowd, but to know the direction of the crowd.  Don’t be a follower; try to be a leader.  If you can’t beat ‘em, DON’T join ‘em!  You should watch the crowd.  Don’t join in their herd mind-set, least you join a band of lemmings parading over a cliff.  Crowds may be right in the middle, but they’re wrong at the ends.  They buy high and sell low, the exact opposite of successful trading.

The crowd watches CNBC and so do the experts.  Go into most brokerage offices and/or trading rooms across this country and chances are they will have a TV tuned to CNBC.  Not because it’s their best source of information on the market, but because it’s their best source of info on the trading public.

CNBC only reports the news they don’t make it, or do they?  They have no bearing on prices, or do they?  Have you heard of the “CNBC Effect?”  The “CNBC Effect” takes place when the crowd reacts to the information shared with them via CNBC.  Viewers watch and listen for tidbits of information, any tip construed or otherwise, any reason to buy or sell.

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If you watched long enough, you’ve seen a CEO give a stellar interview.  Soon on the streaming ticker tape flowing across the bottom of the screen, you see the stock increase in frequency and price.  Or you might have seen a CFO stutter when asked about future earnings or worse still, accounting irregularities.  Shortly there after that stock may trade much lower in price on higher volume.

Can option traders use CNBC to their advantage?  The answer is yes!  But you need the big picture.  Some of the details may seem old hat or trivial.  When finished looping off in opposite directions, it ties nice and neatly into a bow.

Stocks are one-dimensional; price.  Options have many components: price, time and potential.  Compared to potential, price and time are easy math. Potential is a difficult concept to understand.  (Older Options 101 columns go into option pricing in greater detail.)

Volatility measures potential.  Higher potential moves in either direction produce higher Volatility.  Higher Volatility equals higher option prices.  Higher option prices mean higher potential moves, or so the formula says.  In actuality, higher option prices indicate higher Implied Volatility, but not greater potential.

Volatility comes in four different flavors.  Implied Volatility gives novice option traders a sour taste.  Another way to look at Implied Volatility is to consider it as supply and demand.  More buyers, Implied Volatility increases.  Fewer buyers and/or more sellers, Implied Volatility drops.  True potential has nothing to do with it.  There is a skew between actual and assumed probabilities, a mathematical edge. 

Option traders don’t need stock prices to move if they have correctly bet on option pricing components.  The “CNBC Effect” can and does often change Implied Volatility without ever changing stock prices.  Do not assume the additional exposure of stocks featured on CNBC will increase their Implied Volatility!  But don’t be surprised if it happens.

Being aware of the trading environment transforms option trading from betting to investing.  Anticipating future changes based on previous tendencies increases profitability.  Knowing what to expect and not being blind-sided decreases losses.  Avoiding crowds help avoid stampede disease, being trampled.

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