A lot of people have been waiting for a correction for some time. Sure, the markets look stretched and a correction looks imminent. However, corrections will not happen just because we want it to happen.

I have also observed that corrections seldom happen when so many participants are eagerly waiting for them to happen.

In fact, tired of waiting, some global fund managers have started deploying their funds. If a fund manager is sitting on billions of dollars of cash delivering negligible returns, whereas the market is running away and other funds are performing well, would you expect him to be patient enough to wait for an extended period of time?

Investors today want instant returns and though what the fund manager might be doing is correct, he will be seen as a non-performer. This will, in turn, force him to invest and take the markets to high levels, as we are witnessing now.

On the other hand, there are many people who say they will invest when the market goes down. If the markets go down now, they will say to themselves, "See, I was right. I am a brilliant guy."

Their belief is reinforced when more global bears, who were hiding for some time, come out in the open and say the markets should correct further. Instead of investing when a correction happens, most people will wait for further lows, only to see the market has turned around.

Even when the turnaround happens, they believe this is a false alarm and the markets will go down for sure. However, when the markets do not go down but go up on sustained inflows, more and more players join in. You then see bigger institutions sitting on piles of cash joining the party, followed by the retail investors, which propels the indices to record levels.

Hence, I believe that more money is lost in waiting for corrections than in corrections themselves, because when a correction happens, very few have the conviction to invest or take advantage of it.

If you consider the last 18-24 months’ data, you will find that there are seven instances of more than a 10 per cent correction and four instances of a 20-plus per cent correction.

How many people had the courage to invest in the four instances when the correction was more than 20 per cent? I doubt if many did, as the leveraged ones were wiped out in the first sharp fall between January 14 and 22, 2008.

However, post the Lehman Brothers’ collapse and the credit freeze around the globe, there was a complete collapse of confidence, even though the markets corrected 43 per cent, from 14,900 on September 9 to around 8,451 on November 20, 2008.

The smart people, including the so-called savviest ones, just stayed out and did not invest on such severe corrections. In fact, they were howling on television on the Sensex going down to 6,000 and that it would take five years for the markets to reclaim 21,000.

This is because when a severe correction happens, our brains are wired to believe a further correction will happen and hence we should wait.

When the indices were on the way up in March 2009, the savviest ones again did a lot of number crunching and said it is a bear market rally and will soon fizzle. Again, people waited for correction, citing events such as poor earnings, and elections

The election was surely a game changer but even after the budget was presented, the markets corrected to 13,000-odd levels. Yet, how many people invested at these levels? The strategy was again to wait for a further correction all the way down to 10,000.

Relying on any prediction will do you no good, as no one really knows how the market will react even a day from now.

Just because the indices have run up so fast, so quickly, do not warrant a deeper correction than 20 per cent. However, when it comes to markets, anything is possible.

So, what should your strategy be?

Invest 10 per cent of your corpus on every 5 per cent correction.

If the correction goes above 10 per cent, and you have already deployed 20 per cent of your corpus, increase your investment to 10 per cent of the corpus or more.

If the correction has reached 20 per cent and you have put in close to 40-50 per cent, then you can look at investing much higher chunks at this point of time.

What if the market does not correct meaningfully? Start or continue to invest through Systematic Investment Plans. There is a stronger chance of removing emotions from your investing process through SIPs, as you will continue to buy at lower levels.

In fact, everyone wants corrections to happen so investments can happen at lower levels. However, just knowing something is no good if you cannot act on it.

Train your brain to follow the Nike tagline, ‘Just do it’, when corrections happen.

Source: Business Standard

Warren Buffett was born in Omaha , Nebraska . At an early age Buffett was known to have an extremely good sense of the business world. As a youngster, he read every book on business, the stock market, and economics, in the whole Omaha public library. At age 11, he began working at his father’s brokerage firm where he was able to have for the first time in his life direct access to financial markets. That year, he bought his first stock. He bought Cities Services for roughly 38 dollars a share. The stock moved upwards about 5% and he sold for a quick profit. At that time, Buffett learned his first real lesson in the stock market which was to hold onto a company until it reached its intrinsic value and later in life would adopt the strategy to buy and never sell which he frequently employs today. This has been commonly now referred to as the “Buy and Hold” method.

Buffett originally got into the University of Pennsylvania but later transferred to the University of Nebraska . There he discovered a book called the Intelligent Investor written by his future mentor Benjamin Graham. Ben Graham was an extremely conservative investor buying companies below their liquidation values. The way Graham came up with liquidation value was to find the net current asset value (current assets minus total liabilities minus preferred stock). If a company traded for 66% or less of net current asset value, Graham would buy the stock. This qualitative method works very well with small sums of money (1 million or less typically), and this is the strategy Buffett employed in his early investment partnership.

The other investor who had a major influence on Buffett was Phil Fisher, author of Common Stocks and Uncommon Profits. Fisher preached, unlike Graham, buying quality companies at good prices rather than poorly run businesses at very cheap prices. This for the most part is the strategy Buffett employs today as he tends to hold some of the greatest companies in the world in Berkshire Hathaway’s portfolio.

Buffett’s original purchase of Berkshire Hathaway was in 1962. Berkshire was originally a textile mill. He bought the stock with Ben Graham’s strategy in mind; he bought the stock below liquidation value. Unfortunately for Buffett, even with all his efforts to turn the company around, equity in the company would keep decreasing until the original Berkshire Hathaway was worth almost nothing. Luckily for Buffett he had taken the cash that the textile mill was making and investing it in other businesses, most notably insurance companies, Buffett turned a textile company with declining economics into the most notable holding company in the world.

So what stocks does Berkshire Hathaway currently own? As of the time of this writing Berkshire Hathaway’s top ten positions are Coca-Cola (KO), American Express (AXP), Wells Fargo (WFC), Procter & Gamble, Moody’s Corp, Johnson & Johnson (JNJ), Burlington North Santa Fe Corp (BNI), Wesco Financial Corp. (WSC) Financial, Anheuser-Busch (BUD), and the Washington Post (WPO).

Coca-Cola (KO): 16.69%

In 1988 Warren Buffett started buying stock in the Coca-Cola (KO) company, eventually around 7% of the company. Today the company trades at 23x earnings and 7x book value. While this may sound expensive, it really is pretty intrinsically priced. Coca-Cola (KO) is a very high return on capital business meaning that it is an asset light business producing loads of cash. Coca-Cola (KO) has what Buffett would call an economic moat or a barrier to entry. Essentially, nobody can compete with Coca-Cola (KO) making it a rock solid business. The great thing about Coca-Cola (KO) is that it is still a growth business. As the population grows, more people drink coke. Therefore every year there are more coke drinkers. This is why it is so easy for Coca-Cola (KO) to grow their equity. It’s also the reason that Coca-Cola (KO) trades at such a high multiple to its book value. In conclusion, if you purchased Coca-Cola (KO) stock today you would in the long run do better than the stock market as it has a very maintainable high return on equity.

American Express (AXP): 14.87%

In 1964, Warren Buffett started acquiring shares of American Express (AXP). Due to a massive scandal, the company incurred a large one time loss which caused panic selling of American Express (AXP) stock. While the world was doubtful of American Express (AXP)’ prospects to survive, Buffett thought the contrary. To test his thesis, Buffett stood behind the counter of a restaurant and observed people using American Express (AXP) cards. Therefore he knew the company would survive as it’s main product, credit cards, were still being used. American Express (AXP)’ business is very easy to understand. Before credit cards they sold traveler’s checks. Now the largest part of their business is the credit card business. Credit card members pay a fee to be an American Express (AXP) customer. American Express (AXP) also takes a tiny cut of every transaction used with their card. American Express (AXP) is also a very maintainable high return on capital business. The more people in the world, the more people are using credit cards. American Express (AXP) essentially does nothing and makes money doing it. They are a money tree and will be a sound buy and hold investment for years to come. It is interesting to note that the guru Joel Greenblatt also has a position in the company.

Wells Fargo (WFC): 13.91%

In 2000, Berkshire Hathaway disclosed a stake in Wells Fargo (WFC). In 2005 he acquired more shares as many bank stocks including Wells Fargo (WFC) were out of favor and trading on the cheap side. Today Wells Fargo (WFC) is trading at its 5 year average p/e ratio of 14 and price to book ratio of 2.5. Investing in Wells Fargo (WFC) will probably do alright in the long run as the bank is run by some great management. Either way, it’s not screaming cheap, and it is probably intrinsically priced. Buffett increased his position by 50% in late in 2005 at a price of 28 dollars to 30 dollars a share. The current price today is roughly 35 dollars a share.

Procter & Gamble (PG): 10.98%

In 2005, Buffett was left holding Procter & Gamble shares when Procter & Gamble acquired Gilette (Buffett’s original holding) for 57 billion dollars. Proctor & Gamble (PG) sells everything from soap to random accessories. They are trading below their 5 year average price to book and price to earnings ratios but in the long run it won’t make much of a difference. Proctor & Gamble (PG) is a best of breed consumer staples business which will not be going away anytime soon. You will not lose money investing in Proctor & Gamble (PG) in the long run. It would make a sound investment for a buy and hold fund as well as an IRA.

Moody’s Corp (MCO): 5.18%

Moody’s Corp (MCO) is probably my favorite business in Berkshire’s portfolio. Proctor & Gamble (PG) is in the bond rating business. It’s very simple, easy to understand, best of breed, and has pre tax returns on capital of over 100%. This is one heck of a business. It’s best to look at this business as a money tree as it is extremely capital unintensive. At the moment it currently trades in line with it’s historic ratios but that might not be the case for long. They have some lawsuits playing out right now because Moody’s Corp (MCO) misgraded some bond issues. This could cause a temporary dip in the stock price, just as American Express (AXP) had one many years ago. Any bad news for Moody’s Corp (MCO) is good for investors as they can load up on shares. As for Warren Buffett, he originally disclosed his stake in 2002 yet hasn’t touched his shares recently.

Johnson & Johsnon (JNJ): 5.1%

In 2002, Warren Buffett disclosed his stake in Johnson & Johnson (JNJ). Johnson & Johnson (JNJ) is a pharmaceutical company in a sector that is totally unloved by general wall st. While 17x earnings and 12x cash flow isn’t a steal by any measure it is still relatively cheap for this company. For a company with high margins and a steady increase in net income, it is probably a good buy for any large-cap value portfolio managers. This is also a stable company with a proven track record, which should do pretty well for the years to come. In 2006, Buffett added 24 million shares to his original 2 million position at a price of 57.70 – 61.86. In 2007 he practically doubled his position at a price of around 60 dollars a share to about 67 dollars a share. He now owns 48.6 million shares. The current price is approximately 62 dollars a share.

Burlington North Santa Fe Corp (BNI): 4.85%

This year, Buffett disclosed a stake in the railroad company Burlington North Santa Fe Corp (BNI). The company unlike Buffett’s other holdings is extremely capital intensive. The industry for many years was a terrible industry to be in as the companies had no competitive advantage and the poor economics in the highly regulated industry made it tough to survive. Recently, with some regulatory laws being changed as well as high energy prices, railroad companies are at an advantage for the first time in over fifty years. Railroad companies can now carry freight more efficiently than trucking companies due to the high price of gasoline. This is very bad for trucking companies making it harder for them to stay in business. Therefore the railroad companies get more customers. Also, railcars have an average life of forty to fifty years. The last big boom was in the 1960’s meaning that the next 40 year cycle will be in the next few years. Burlington North Santa Fe Corp (BNI) with these economics and energy environment will make a very fine investment for the years to come. Buffett has even mentioned that with high energy prices railcars have a competitive advantage of over 4x that over trucking companies. In 2007 he has increased his shares from 34 million to 39 million shares. He bought his shares originally at 72 dollars to 83 dollars and then bought 5 million more shares the same year for 81.57. The current price today is around 87 dollars a share.

Wesco Financial Corp. (WSC): 4.56%

Warren Buffett’s partner, Charlie Munger, runs Wesco Financial Corp. (WSC) Financial. Wesco Financial Corp. (WSC) is essentially a mini Berkshire so to speak and has holdings in Coca-Cola (KO) as well as a few other companies. They also have a furniture rental, steel, and insurance subsidiary. This company is extremely well managed and Berkshire owns 80% of the company. There are rumors that if they ever trade at book value Berkshire will buy them out. At a premium to book value today the shares aren’t cheap nor expensive. Looking at this company quarter to quarter is meaningless as earnings are sporadic. But with great management this company will strive. Munger is also a genius at capital allocation and should do very well for shareholders in the long run. He has publicly stated he believes the company should not be worth more than book value.

Anheuser- Busch (BUD): 3.12%

Berkshire announced a stake in the company in 2005 as shown in their 2005 annual report. Anheuser-Busch (BUD) is the producer of Budweiser, which is America’s best selling beer as well as the official beer sponsor of the Super bowl. The company has massive returns on equity and is the Coca-Cola (KO) of the beer industry. In September of 2006, Berkshire announced that they sold a portion of their Anheuser stake. At 20x earnings and 10x book value, the company is not cheap by any measure. I would choose many other companies before making an investment in the “King Of Beers”. Buffett originally bought shares at 44 dollars to 46 dollars. He reduced his shares by 4% 3 months later in September 2005 for 42 dollars – 45 dollars and then sold another 16% of his shares the same months for 44 dollars – 49 dollars. The current price today is 52 dollars a share.

The Washington Post (WPO): 2.29%

The Washington Post (WPO) was one of Berkshire’s first core holdings. He originally bought into the company below liquidation value. While The Washington Post (WPO) is still a core holding of Berkshire’s portfolio I would not buy a share. Buffett has publicly stated that at the time he bought the Post it was an impenetrable business. Now the internet has started to slowly kill the newspaper industry and Buffett believes that newspaper economics are in an everlasting decline.

Of course that’s not all the companies in Berkshire’s portfolio. Some other interesting companies to look at our Conoco Phillips (COP) and Tyco (TYC) which are both sum of the parts plays. And then you have Union Pacific (UNP) and Norfolk Southern (NSC) which are two other railroads he owns. The most interesting holding in his portfolio has to be Comdisco Holdings (CDCO) which is a liquidation arbitrage play.

Source: Guru Focus

The next half of the battle begins now – starting with the legal aspects and procedures involved in starting a business.

The next step for you would be to form a legal business entity. For doing so, it is important that you are aware of the types of business entities in India so that you can decide which one is most suitable for your needs.

1) Sole Proprietorship:

This is the most common type of business entity. Sole proprietorship means that theres a sole owner who funds and operates the business. It is the simplest form of business entities – relatively formality free, no rules about records you are required to keep, no requirement of having your accounts audited and no requirement of filing financial information to the registrar of companies. In short, there is no legal distinction between you and your business.

Pros:

• Very easy to setup and start your business
• Relatively formality free. So, less time spent upfront in legal procedures
• No public disclosure of your finances required
• You keep all the profits – no sharing of profits with others – since there arent any shareholders

Cons:

• Personal liability. If you go bankrupt, creditors get the right to your possessions – house, property etc.
• Very difficult to get investment from VC’s, angels etc.

2) Partnerships:

Partnership is a type of business entity, where you partner with other individuals to own and run the business. On a higher level, they can be viewed as collection of sole proprietors. By partnering with other individuals, you get access to a bigger pool of capital, skills and other resources to fund and run your business. All partners contribute capital equally, share profits and losses equally and have an equal say in business decisions.

Pros:

• Access to larger pool of resources and capital
• You do not have the confidence to start the business on your own and need some one to shoulder the responsibility
• Access to complementary skills. For example, if you are a geek, you may partner with someone with a marketing/management background to balance out the odds

Cons:

• If your partner makes a business mistake, without your knowledge or consent, and it adversely affects your business, you are equally liable to bear the consequences – even though you had no role to play in the mistake
• If your partner goes bankrupt, his share in the business can be seized by his creditors. Although you are not liable for his personal debts, your business may be put into jeopardy

Because of the drawbacks related to partnerships, it is very important that you trust the person before considering to make him a business partner. It is generally a good idea to have a legal document that highlights the partnership agreement between partners – the profit sharing, duration of partnership, admitting-expelling additional partners, dissolving the partnership etc.

3) Limited Liability Company:

This type of business entity is most common and preferred type while starting a company. A limited liability company is a separate legal entity from its founders, shareholders and mangers. The liability of the shareholders is limited to the paid-unpaid capital that is issued as part of the company. Thus, in case of bankruptcy, personal assets of the founders/mangers is not affected. A limited liability company needs to keep record of accounts, audit their records and file an annual report on return with the registrar of companies.

Pros:

• Founders financial liabilities are limited
• Proper structuring of the company management – for example, who will be the managing director etc.
• Easy to get funding from VC’s and other sources – by selling a stake (shares) in the company
• Additional members / directors can be added to the company structure
• Selling the company is a relatively easy (legally) because of the legal incorporation records, financial records, annual returns etc. have already been filed

Cons:

• Time and effort required to complete the initial incorporation
• Additional overhead of keeping records, having those records audited and filing annual reports
• Double taxation (not sure to what extent this is valid in India). So, the revenues that your company earns are taxed at the corporate level and then the individual shareholders are taxed at the personal level for the income they make from the revenue

Source: Startup Dunia

If you are a senior executive at a startup company and you don’t understand how stock dilution works, you may be on the path to a painful lesson. Don’t learn about equity dilution the hard way. Understand stock dilution before you sign your employment agreement and you’ll be happy you did.

Let’s say, for example, that you signed up to be COO of a startup company and the CEO founder offered you 5% of the company. The CEO says there’s no funding in the bank yet, so you’ll have to sign up for a low salary — $50,000 per year.

But he assures you that he’s had conversations with venture capitalists and there’s a sense that if things go right, the company might one day sell for $100 million.

Hmmm, you think. 5% — not bad. If we sell this thing for $100 million, I will walk away with $5 million.

WRONG!

Your math failed to take into account stock dilution. That’s the effect the issuance of new equity shares has on the existing shareholders.

Let’s go back to our example and see how stock dilution works in action.

You take the job and get 5% of the company.

Odds are you don’t get it all at once — it’s probably subject to a vesting schedule and it might only be stock options — but that’s not really relevant to our equity dilution lesson.

How much is 5% of your pre-funding company worth?

Not much. In fact, until there’s a funding round you don’t really know what it’s worth.

A funding round is important to entrepreneurs and their employees because it’s a milestone that values the underlying stock of the company.

So, let’s say that a year after you’ve been working as the COO of the company, you and the CEO are finally able to land a funding round.

The funders says they will give you $700,000 in capital for 35% of the company.

What exactly does that mean?

It means that the total valuation of the company after they put their money in will be equal to $700,000/.35, or $2,000,000.

In VC terminology, that’s the post-money valuation. The pre-money valuation is therefore $1,300,000. That’s the post-money valuation minus the value of the cash that is coming into the business as part of the funding round.

So, after the funding round, the valuation is $2,000,000 and you had 5% equity in the company, so now you’re equity stake is worth $100,000, right?

WRONG!

Equity dilution knocks down your percentage stake in the business.

Here’s how equity dilution works in this scenario.

Let’s say there were 1,000,000 issued shares prior to the funding round. In order for the new investors to get a 35% equity stake, they need to be issued new shares.

How many shares?

It’s a simple algebra problem. Let x be the number of new shares that need to be issued. The equation becomes:

x / (1,000,000 + x) = .35

Solving for x implies that 538,462 new shares must be issued to the investors.

The math says that it should be 538,461.5 but there’s no such thing as half a share so we round up. Believe me, investors won’t round down. If there’s something on the table to be taken, they will likely grab it.

So, now the total number of shares in the company is 1,538,462. What your percentage equity stake in the company?

Well, you were allocated 5% of the 1,000,000 shares so you had 50,000 equity shares before the funding round.

After the funding round, you still have 50,000 shares.

So, now, your diluted equity stake in the company is 50,000/1,538,462, or 3.25%.

How much is it worth?

The answer is simply .0325 x $2,000,000. That’s your percentage equity stake times the post-money valuation. As it turns out, your stake is worth $65,000, not $100,000 as you might have thought.

If the company were to sell for $100 million now, after the first round of venture funding is in the bank, you 3.25% stake would be worth $3.25 million, not the $5 million you thought you’d get before you learned about equity dilution.

Notice that there was an easier way to figure out your post-dilution equity stake. You gave away 35% of the company in the financing round, so your 5% was knocked down by a .65 dilution factor — that’s what you got to keep, in effect. So, 5% times .065 gives you the 3.25%. It’s the same answer, but it’s a quick way of calculating the effect of dilution on your equity stake.

Mind you, this is just your first round of dilution. If the company has to do a second round and gives away 40% of the company to new investors, then you’ve got to knock your 3.25% equity stake down by a .60 dilution factor. After that second round, your ownership stake will be down to 1.95%.

Is that good or bad? It depends.

If the post-money valuation on the second financing round is $1 billion, your stake is only worth $19,500,000. Not bad!

If the post-money valuation on the second round is $2,500,000, then your equity stake is only worth $40,950. Given the salary cut you took to get in on the action for this startup, this is a pretty miserable scenario.

Adding insult to injury is the fact that your equity stake’s valuation is not real — it’s just a paper value. In a startup company there’s usually no liquidity unless there’s an exit event of some kind — for example, maybe the company goes public or the company is sold to an acquiring company. At that time, you finally get to know what your stock is really worth.

What’s the moral of the story?

Well, for starters, you can see that somebody who doesn’t understand equity dilution is going to be overly optimistic about their likely take in a startup. They may be more willing to take a lower salary than they should be, or more willing to take a lower equity stake than they should be.

Now that you understand equity dilution, you won’t make that mistake. You’ll properly evaluate potential outcomes and likely funding scenarios and their dilutionary effect on your stake.

Based on your equity dilution analysis, we hope you’ll make smart decisions. Good luck!

Source: Gaebler

Bubbles are also embarrassing for the economics profession. It’s not that we have no idea what causes bubbles to form, it’s that we have too many ideas for comfort.

Some explanations are psychological. Some point out that many bubbles have been stoked not by markets but by governments. There is even a school of thought that some famous bubbles weren’t bubbles at all.

The psychological explanation is the easiest to explain: People get carried away. They hear stories of their neighbors getting rich and they want a piece of the action. They figure, somehow, that the price of stocks (1929) or dot-com start-ups (1999) or real estate (2006) can only go up.

A symptom of this crowd psychology is that the typical investor displays exquisitely bad timing. The economist Ilia Dichev of the University of Michigan has recently calculated "dollar-weighted" returns for major stock indexes; this is a way of adjusting for investors rushing into the market at certain times.
It turns out that "dollar-weighted" returns are substantially lower than "buy and hold" returns. In other words, investors flood in when the market is near its peak, tending to buy high and sell low. The herd instinct seems to cost us money.

That is awkward for economists, because mainstream economic models do not really encompass "herd instinct" as a variable. Still, some economists are teaming up with psychologists and even neurophysiologists in the search for an answer.

Cambridge economist John Coates is one of them. He used to manage a Wall Street trading desk and was struck by the way the (male) traders changed as the dot-com bubble inflated. They would pump their arms, yell, leave pornography around the office and in general behave as though they were high on something. It turns out that they were: It was testosterone.

Many male animals–bulls, hares, rutting stags and the like–fight with sexual rivals. The winner experiences a surge of testosterone, which makes him more aggressive and more likely to take risks. In the short run that tends to mean that winners keep winning; in the long run, they take too many risks.

Dr. Coates wondered if profitable traders were also running on testosterone, and a few saliva samples later it appears that he is right. Profitable trading days boost testosterone levels and tend to encourage more risk-taking, more wins and more testosterone.
When the risks didn’t pay off, the testosterone ebbed away to be replaced by a stress hormone, cortisol. The whole process seems likely to exaggerate peaks and troughs.

These psychological explanations are likely to help us understand what goes on as bubbles form and how they might be prevented. Yet they make me nervous: It is too easy to blame a bubble on the mob psychology of the market when a closer look at most bubbles reveals that there is much more to the story than that.

For example, one famous early "mania" was the Mississippi bubble, in which countless investors poured their money into the Compagnie des Indes in France in 1720, and lost it. Yet there was more going on than a free-market frenzy: The government could hardly have been more closely involved.

The Compagnie des Indes had effectively taken over the French Treasury and legal monopolies on French trade with much of the rest of the world (including Louisiana–hence "Mississippi bubble"). Investors were hardly insane to think that such a political machine might be profitable, especially since the king of France personally held many of the shares. But the king sold out near the top in 1720; within two years, the Compagnie was bankrupt and its political power dismantled.

The government played its own part in the current credit crunch, too. For all the scapegoating of deregulation, thoughtful commentators also point to the Federal Reserve’s policy of cheap money, and Fannie and Freddie’s enormous appetite for junk mortgages–urged all the way by politicians trying to make credit available to poor and risky borrowers. Market psychology was part of the story, but not the whole story.

The idea that ordinary people have a tendency to be caught up in investment manias is a powerful one, thanks in part to Charles Mackay, author in 1841 of the evergreen book Extraordinary Popular Delusions and the Madness of Crowds. Mackay’s most memorable example was the notorious Dutch tulip bubble of 1637, in which–absurdity!–tulip bulbs changed hands for the price of a house.

It is the quintessential case study of financial hysteria, but it’s not clear that there was ever an important tulip bubble. Rare tulip flowers–we now know that their intricate patterning is caused by a virus–were worth huge sums to wealthy Parisian gentlemen trying to impress the ladies. Bulbs were the assets that produced these floral gems, like geese that laid golden eggs. Their value was no fantasy.

Peter Garber, a historian of economic bubbles, points out that a single bulb could, over time, be used to produce many more bulbs. The price of the bulbs would, of course, fall as more were cultivated. A modern analogy would the first copy of a Hollywood film: the final copies may circulate for a few dollars, but the original is worth tens of millions.

Garber points out that rare flower breeds still change hands for hundreds of thousands of dollars. Perhaps we shouldn’t be quite so sure that the tulipmania really was a mania.

Economists are going to have to get better at understanding why bubbles form from a heady mix of fraud, greed, perverse incentives, mob psychology and government incompetence. What we should never forget is that underneath the apparent hysteria, there is often a cold rationality to it all.

An aggressive investor will take a shorter time period to achieve the desired result as his risk attitude should reward him with a higher rate of return, given a dynamic portfolio investment style and a well drawn up investment philosophy.

For any reasonable portfolio management exercise to be meaningful, you must have at least $50,000 to start with. If you’re looking at a portfolio of shares or unit trusts, $50,000 will be a good starting point. As for property investment, $50,000 should be sufficient in most cases for down payments.

Where the money should be invested will very much depend on the prevailing market cycles and opportunities. However, this will have to change throughout the portfolio management process, which is fundamentally based on your investment philosophy and the changes in your financial statements and life goals.

However, always take into account two things when investing; a well-correlated portfolio and the market cycles. Having all monies in the same asset class at any one time may not be prudent, so, the other area to look out for is the equity market. For more disciplined and market savvy investors, investing your money in stocks can help to double your initial capital.

It’s advisable to put only a small allocation of just 20% of your available funds into carefully chosen stocks. Pick the ones that have good net tangible assets and price-earnings ratios. Study the highest and lowest prices for these stocks over the past one year and discuss what price levels will be prudent for a buy and sell.

Another option to look at is unit trust funds. Choose the fund house based on the umbrella of funds available to you for the purpose of portfolio management. Two factors are important to determine that a fund performs; your investment strategy and who is managing your funds directly and indirectly. However, of course there are risks in unit trust investments too, though less when compared with direct stock investing

On the other hand, the conservative investor should be more patient as he will need more time to grow his money. Conservative investments like fixed deposits, bonds, money market or income-yielding instruments have yields below one’s personal inflation index and thus may not be a meaningful tool for wealth accumulation over the long term.

Choose a well-managed balanced unit trust fund that has a combination of fixed income securities and equities and is dynamically aligned to suit the various events and market cycles over time.

Consider opting for a regular savings plan using the balanced fund as a base to invest, as this will help smooth out the volatility of events and cycles over time. There are many regular savings plans available in unit trust funds but be careful when choosing one. When you invest regularly, you may push the dollar cost upwards or downwards and if the fund you choose is a highly aggressive one, the upward and downward dollar costing exercises may eventually prove to be less effective than investing regularly in a more stable fund like a balanced fund.

Last but not least, you may also want to look out for opportunities in some direct stable and established stocks that provide high dividend yields. These yields will provide a cushion against market and specific risks, which will not worry you too much as a conservative investor. Some unit trust funds have their core holdings only in high dividend-yielding stocks and they may prove to be of good value in your portfolio.

Fortunately, there are several simple strategies that you can use to protect yourself from downside risk in both bull and bear markets. In this article we will cover sell stops, sell stop limits, buy stops and buy stop limits, as well as tips and techniques you can use to place them effectively in any type of market.

Sell Stops and Buy Stops Cap Losses

One way to protect your downside in the markets is through the use of sell stops and sell stop limit orders. A sell stop order, often referred to as a stop-loss order, is an order to sell a stock once it reaches a certain price. If the stock reaches the stop price, the order is then executed and shares are sold at the market price for the stock. When the order is to sell, the stop is always placed below the stock’s market price.

A stop-limit order is an order to sell a stock once a specific price is reached, as long as the price does not fall below the limit specified by the investor. If the stock reaches the stop price, the order is converted to a limit order. The benefit of the limit order is that you have more control over the price at which the sell will be executed.

With both types of orders, if the stock doesn’t reach the specified stop price then the order will not be filled.

Putting Stops in Place

The proper use of sell stop and sell stop limits are a key to protecting your investments. These tools keep the decision-making process simple and unemotional — even when the market is in turmoil. They also help prevent you from rethinking when to take profits and when to jump ship on fast-sinking stocks.

While there is no magic number or percentage used to set stop orders, generally there are two common methods used to place them:

1. Place the stop price below the support level. You can identify a support level by looking at a chart and finding the lowest points for the stock and previous points where it stopped dropping. A break below this point would generally mean that there is a possibility the stock could head lower.

2. Place your stop price 5-15% below your purchase price, depending on your level of comfort. This will prevent you from riding the stock all the way down and help you keep your losses manageable. Also, just knowing what your downside is allows you to determine (and prepare for) a worst-case scenario.

In addition, you can adjust your stops upward as the stock moves up by looking at the point where it stopped dropping previously and then setting the sell stop or sell stop limit just below that level.

How to Avoid Being Stopped Out

When a stock falls to the sell stop price that you set and your shares are sold, this is referred to as being ’stopped out’. So, while sell stop and sell stop limit orders are a good way to keep you on the right side of the markets, there will be times when you can hit the sell stop or sell stop limit just before the stock starts another ascent.

How can you avoid this? As a general rule, you want to avoid placing stops at round numbers such as $36 because many traders place their stop orders at the round numbers.

Once the stock hits this round number, it triggers one last round of selling. The key to choosing a more successful stop is to place your order at an odd number with enough room to account for the last potential round of selling.

For example, if many traders have their sell stops in at $34, you should place your sell stop at $34.15 to provide enough room for a round of sell orders to go through without triggering your sell stop and incurring an unnecessary loss for you.

While you can’t determine exactly where other traders will place their stops, attempting to account for this will help decrease the chances that you will be stopped out on a temporary drop.

For Short Sellers: Buy Stop and Buy Stop Limit Orders

If you are playing the short side of the market, a buy stop order or buy stop limit order can be used to protect your downside if a position moves against you.

Buy stop orders and  buy stop limit orders can be used to protect a profit or loss on short sales.

A short sale is the act of selling a stock that you don’t own with the goal of buying the stock back at a lower price to make a profit. It the stock rises, you buy it back at a higher price to create a loss. A buy stop order is used to limit a loss or protect a profit on a short sale and is entered above the market price. When the stock reaches this price, the trade is executed at the market price.

A buy stop limit order is an order to buy a stock once a particular price is reached, at which point the order converts to a limit order. The buy order will only be executed at the specified limit price or better.

Setting Up Buy Stops and Buy Stop Limits

Like sell stops and sell stop limits, placing buy stops and buy stop limits can be tricky. Fortunately, there are general rules that apply to where they should be placed:

1. You can place them just above the resistance level of a stock. This is the point where a stock has trouble moving higher. This level forms when investors purchase large amounts of the stock just before a decline with the idea to sell it when it hits that point again.

2. You can place them about 10-15% above where you initiated the short sale if the position is volatile. These can also be adjusted downward to protect profits by looking at the highest point the stock reached on the previous rally. (For related reading, see How can I determine a stock’s next resistance level or target price?)

How to Avoid Hitting the Buy Stops or Buy Stop Limits

Like with sell stops, you want to avoid hitting your buy stop and having the position drop off once the short position is covered (you have bought the shares back at a higher price).

A lot of the same techniques that you use on sell stops and sell stop limits can also be applied in this instance. These include avoiding round numbers and instead placing buy stops and buy stop limits at odd numbers.

When your stock does hit the buy stop or buy stop limit, you have a couple of options.

1. Watch and see how the stock trades.

2. Go back in and place another buy stop or buy stop limit to protect your downside on the short (this is a bold move).

However, what you choose to do at this stage really depends on your overall level of comfort.

Conclusion

It is clear that by using sell stops, sell stop limits, buy stops and buy stop limits, traders can protect themselves from volatile markets and prevent massive portfolio losses. That said, you should adapt the way you use these tools to your comfort level. If you use them prudently, they should keep you on the right side of the markets.

But if you don’t know how to take advantage of that movement, you might be left in the dust. If this sounds like you, then maybe it’s time to consider using options to play your next move. This article will explore some simple factors that you must consider if you plan to trade options to take advantage of stock movements.

Option Pricing

Before venturing into the world of trading options, investors should have a good understanding of the factors that determine the value of an option. These include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates and cash dividends paid.

There are several options pricing models that use these parameters to determine the fair market value of the option. Of these, the Black-Scholes model is the most widely used. In many ways, options are just like any other investment in that you need to understand what determines their price in order to use them to take advantage of moves the market.

Main Drivers of an Option’s Price

Let’s start with the primary drivers of the price of an option: current stock price, intrinsic value, time to expiration or time value, and volatility. The current stock price is fairly obvious. The movement of the price of the stock up or down has a direct – although not equal – effect on the price of the option.

As the price of a stock rises, the more likely the price of a call option will rise and the price of a put option will fall. If the stock price goes down, then the reverse will most likely happen to the price of the calls and puts.

Intrinsic Value

Intrinsic value is the value that any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option’s price that is not lost due to the passage of time. The following equations can be used to calculate the intrinsic value of a call or put option:

Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price

Put Option Intrinsic Value = Put Strike Price – Underlying Stock’s Current Price

The intrinsic value of an option reflects the effective financial advantage that would result from the immediate exercise of that option. Basically, it is an option’s minimum value. Options trading at the money or out of the money have no intrinsic value.
For example, let’s say General Electric (GE) stock is selling at $34.80. The GE 30 call option would have an intrinsic value of $4.80 ($34.80 – $30 = $4.80) because the option holder can exercise his option to buy GE shares at $30 and then turn around and automatically sell them in the market for $34.80 – a profit of $4.80.

In a different example, the GE 35 call option would have an intrinsic value of zero ($34.80 – $35 = -$0.20) because the intrinsic value cannot be negative. It is also important to note that intrinsic value also works in the same way for a put option.

For example, a GE 30 put option would have an intrinsic value of zero ($30 – $34.80 = -$4.80) because the intrinsic value cannot be negative. On the other hand, a GE 35 put option would have an intrinsic value of $0.20 ($35 – $34.80 = $0.20).

Time Value

The time value of options is the amount by which the price of any option exceeds the intrinsic value. It is directly related to how much time an option has until it expires as well as the volatility of the stock. The formula for calculating the time value of an option is:

Time Value = Option Price – Intrinsic Value

The more time an option has until it expires, the greater the chance it will end up in the money. The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life.

This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option. Time value is often referred to as extrinsic value.

Time value is basically the risk premium that the option seller requires to provide the option buyer the right to buy/sell the stock up to the date the option expires. It is like an insurance premium of the option; the higher the risk, the higher the cost to buy the option.
Looking again at the example from above, if GE is trading at $34.80 and the one-month to expiration GE 30 call option is trading at $5, the time value of the option is $0.20 ($5.00 – $4.80 = $0.20).

Meanwhile, with GE trading at $34.80, a GE 30 call option trading at $6.85 with nine months to expiration has a time value of $2.05. ($6.85 – $4.80 = $2.05). Notice that the intrinsic value is the same and all the difference in the price of the same strike price option is the time value.
An option’s time value is also highly dependent on the volatility in that the market expects the stock will display up to expiration. For stocks where the market does not expect the stock to move much, the option’s time value will be relatively low.

The opposite is true for more volatile stocks or those with a high beta, due primarily to the uncertainty of the price of the stock before the option expires. In the table below, you can see the GE example that has already been discussed. It shows the trading price of GE, several strike prices and the intrinsic and time values for the call and put options.
General Electric is considered a stock with low volatility with a beta of 0.49 for this example.

Figure 1: General Electric (GE)

Amazon.com Inc. (AMZN) is a much more volatile stock with a beta of 3.47 (see Figure 2). Compare the GE 35 call option with nine months to expiration with the AMZN 40 call option with nine months to expiration. GE has only $0.20 to move up before it is at the money, while AMZN has $1.30 to move up before it is at the money.

The time value of these options is $3.70 for GE and $7.50 for AMZN, indicating a significant premium on the AMZN option due to the volatile nature of the AMZN stock.

Figure 2: Amazon.com (AMZN)

This makes – an option seller of GE will not expect to get a substantial premium because the buyers do not expect the price of the stock to move significantly.

On the other hand, the seller of an AMZN option can expect to receive a higher premium due to the volatile nature of the AMZN stock. Basically, when the market believes a stock will be very volatile, the time value of the option rises.

On the other hand, when the market believes a stock will be less volatile, the time value of the option falls. It is this expectation by the market of a stock’s future volatility that is key to the price of options.

The effect of volatility is mostly subjective and it is difficult to quantify. Fortunately, there are several calculators that can be used to help estimate volatility. To make this even more interesting, there are also several types of volatility – with implied and historical being the most noted.

When investors look at the volatility in the past, it is called either historical volatility or statistical volatility. Historical Volatility helps you determine the possible magnitude of future moves of the underlying stock. Statistically, two-thirds of all occurrences of a stock price will happen within plus or minus one standard deviation of the stocks’ move over a set time period.

Historical volatility looks back in time to show how volatile the market has been. This helps options investors to determine which exercise price is most appropriate to choose for the particular strategy they have in mind.
Implied volatility is what is implied by the current market prices and is used with the theoretical models. It helps to set the current price of an existing option and assists option players to assess the potential of an option trade. Implied volatility measures what option traders expect future volatility will be.

As such, implied volatility is an indicator of the current sentiment of the market. This sentiment will be reflected in the price of the options helping options traders to assess the future volatility of the option and the stock based on current option prices.

The Bottom Line

A stock investor who is interested in using options to capture a potential move in a stock must understand how options are priced. Besides the underlying price of the stock, the key determinates of the price of an option are its intrinsic value – the amount by which the strike price of an option is in-the-money – and its time value.

Time value is related to how much time an option has until it expires and the option’s volatility. Volatility is of particular interest to a stock trader wishing to use options to gain an added advantage. Historical volatility provides the investor a relative perspective of how volatility impacts options prices, while current option pricing provides the implied volatility that the market currently expects in the future.

Knowing the current and expected volatility that is in the price of an option is essential for any investor that wants to take advantage of the movement of a stock’s price.

As a long time investor, Hans Wagner was able to retire at 55 by following a disciplined process using sound investment principles. After his children and their friends graduated from college, Hans began helping them to invest in the stock market. Soon, friends and acquaintances also began to seek advice, so Hans created a website, Trading Online Markets, which provides information on investing topics, along with sample portfolios that consistently beat the market.

Source: Investopedia

An Introduction to Stock Options

Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options to hedge against a price decline, to lock in a future purchase price, or to speculate on the future price of a stock. Employees may also receive stock options through an employee compensation plan. For employees, stock options represent the potential for growth in value and the possibility that the increase in value will be taxed at a favorable capital-gains tax rate.

The Basics of Stock Options

A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years, until the expiration date. If not exercised on or before the expiration date, the option expires.

Options come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.

A call option is valuable to the extent that the exercise price is below the market value of the underlying stock. For example, if a stock is trading at $100 per share and you hold a call option entitling you to buy the stock at $72 per share, your option has an immediate value to you of $100 – $72 = $28, before taking into account any tax consequences or transaction fees.

A put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with a strike price of $90 and the stock price moves to $80, you may choose to exercise the option and sell the underlying stock at $90 for an immediate unrealized per share gain of $90 – $80 = $10.

With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk — if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received.

Components of an Option’s Value

Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The price of an option at any given time is based on several factors, including the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.

Intrinsic value — the intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive.

Volatility — part of an option’s value reflects the volatility of the underlying security. If a stock price is highly volatile, there is a relatively greater chance that the option will be "in the money" at expiration, and therefore, the option will carry a higher premium than an option on a less a volatile stock.

Time value — the more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the value of the option. Time value diminishes as the expiration date of the option approaches.

Interest rates — the option premium is a cash payment that can be invested by the option seller to generate interest income. Higher interest rates present opportunities for potentially greater earnings on the option premium.

Intrinsic value, volatility, and time value can significantly affect an option’s market value. An option with an exercise price above the current market value of the underlying security may still have considerable potential value.

For example, if you hold a call option with an exercise price of $72 and the current share price is $65, your option would generate a loss if it were exercised today. However, as stated above, option contracts typically are valid for months or years, until the stated expiration date. The time value of the call option is the potential that the share price will rise over time and eventually exceed the option exercise price.

Employee Stock Options

Employee stock options are call options granted by an employer as part of an employee compensation plan. There are two main types of employee stock options: incentive stock options and nonqualified stock options. Incentive stock options offer special income tax benefits to the employee.

An incentive stock option (ISO) must meet a number of criteria to qualify for favorable tax treatment. As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. The tax is applied at the sale of the stock. If you don’t meet the one-year holding-period requirement, the transaction is considered a "disqualifying disposition" and your gains are taxed as ordinary income.

A nonqualified stock option (NSO) is an option that doesn’t meet the ISO criteria. Gains on NSOs are taxed as ordinary income at the time of exercise.

OPTION TERMINOLOGY

Call option – An option that gives the option buyer the right to purchase the underlying security.

Exercise date – The date by which the option must be exercised.

Expiration date – The date that the option will expire (same as the exercise date).

Intrinsic value – The difference between the strike price and the current price of the underlying security.

Premium – An upfront fee paid by the option buyer to the option seller.

Put option – An option that gives the option buyer the right to sell the underlying security.

Strike price – The stated price at which the underlying security can be purchased or sold (also called the exercise price).

Time value – The component of an option’s price that reflects the time left to expiration.

Volatility – The tendency of the underlying security to fluctuate in price.

Consider Option Strategies Carefully

Options are leveraged investments that can offer significant potential advantages and risks. As part of an overall investment strategy, put and call options may offer opportunities to temporarily alter the risk/return characteristics of a portfolio. Before investing in options, it is important to thoroughly understand the potential risks and benefits. You should consult a qualified tax advisor as to how option transactions may affect your tax situation. If you are an employee and have received stock options as employee compensation, you will want to carefully consider how exercise of your options may affect your cash flow and tax liability.

Summary

• An option is a contract entitling the option purchaser to buy or sell the underlying stock at the stated exercise price. A call option gives the holder the right to buy the underlying stock; a put option gives the holder the right to sell the underlying stock.
• The option purchaser’s risk on the option is limited to the premium paid; the option seller’s risk on the option is potentially unlimited.
• A call option is valuable to the extent that the exercise price is below the market value of the underlying stock at the time you choose to exercise the option by buying shares. The time value of the option is the potential that the share price will rise over time and eventually exceed the option exercise price.
• Employee stock options may be tax-qualified incentive stock options (ISOs) or nonqualified stock options (NSOs). If shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. If you don’t meet the one-year holding-period requirement, the transaction is considered a disqualifying disposition and your gains are taxed as ordinary income.
• Before implementing an investment strategy using options or before entering into any equity arrangements with an employer, consult your tax advisor.

Checklist

• Check the current share prices of the stocks associated with your stock options.
• Confirm that you’ve met holding-period requirements before using employee stock options in order to qualify for more favorable tax treatment.
• Conduct a comprehensive investment portfolio review to make sure that your options are part of a well-diversified overall asset allocation.
• Consider meeting with a tax advisor or financial professional to understand how your options could affect your tax and investment strategies.

Source: Yahoo! Finance

What does Market Capitalization mean?

Formula: Market price * Outstanding shares

Market capitalization is the total market value of all the company’s outstanding shares. It is calculated by multiplying the company’s total outstanding shares by the current market price of stock. This figure is used to determine the company’s size compared to sales or total asset figures. Based on the market capitalization stocks of large, medium and small companies are referred to as large-cap, mid-cap, and small-cap, respectively.

What does Book Value per share Means?

Formula: Net worth / Number of outstanding shares.

Book value of a share enables us to compare the market value and understand whether or not the stock in overvalued or undervalued. In a bull run you would find the stock to trade significantly higher than the book value. However in a bear phase the stock market value would either be close to book value or under the book value. If stock price is under the book value than it means that the company is undervalued and might be an attractive buy.

What does Return on Capital Employed (ROCE) Means?

Formula: EBIT / Capital Employed *100

ROCE ratio gives us an idea about the efficiency and profitability of a company’s capital investments. Higher the ROCE is always better as it needs to be above the rate at which the company borrows. A rise in borrowing cost would impact the ROCE and there by reduce shareholders’ earnings. In order to find the average ROCE one needs to take the average of opening and closing capital employed for the time period.

What does Return on Equity (ROE) Means?

Formula: PAT / Net worth

ROE is also known as Return on Net worth. ROE is total returns which the equity shareholders get out of the total net earnings of the company. It measures the company’s profitability by revealing how much profit a company generates with the money shareholders have invested. Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Net worth does not include preference shares.