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

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.

Domestically, the month began with the much awaited, though ‘limited’ key interest rate cuts by RBI to support the economic slowdown being witnessed; reflected in the declining export numbers and weak IIP numbers. At the same time, sector specific numbers – cement dispatches, auto sales, telecom subscribers gave markets reason enough for support. Advance tax payout’s flowing in seemed to be a mixed bag – Banking companies paid higher taxes in the 4th advance tax installment. Amongst others, Reliance Industries (RIL) and TCS paid lower taxes. Company specific news flows added to overall positive sentiment: RIL being ready to begin gas supplies from the KG basin, launch of the Nano by Tata Motors. The global optimism has seen FII’s turn net buyers over the month. Short covering besides a temporary weakening of dollar took the index over the 10000 mark before profit booking pulled the indices down.

Globally, the markets continued to remain cautious on account of the increasing woes on the health of the global financial system, triggered by AIG’s quarterly loss, the largest in US corporate history. Optimism gradually had emerged, post the ‘Geithner Plan’ being initiated in the US, intending to mop off up to USD 1 tn of toxic assets on the books of banks. This, supported by indications of some profitability by financial giants Citi and JP Morgan for the CY09 this far, aided by a surge in US housing and durable goods data added to the buoyancy. These factors acting together have seen a rally stemming in equity markets, indicating some revival in the global risk appetite.

Going ahead, we continue to expect the market to remain choppy over the three months with Elections being the biggest event holding back the markets participants. We continue to recommend investments into equities on a staggered basis over the next 6 months.

As you probably know almost all global markets (especially the emerging markets) are correcting and all of them have corrected sharply. It doesn’t matter whether you are from India or China or USA, the recent fall in stocks would have affected you.

I’m sure that you must be in a panic situation now even I’m in a panic situation. So that made me to write this blog post. I started investing in Stock Market back in 2005. But I didn’t make any significant amount of returns. In fact I have booked losses several times in range of 5 to 20% and then quit the stock market for some time. But I decided to enter stocks again back in January and started building a portfolio. I started with Mutual Funds too but when the markets fell sharply. I asked myself “Why should I invest in Mutual Funds when the Stock Market is attractive?” that made me to invest directly in stocks. And I began to buy quality stocks on every dip. The result: the stock market crash never ended it and it’s falling day by day. And I’m sitting at a loss of 10%.

But should I sell and book the losses and get out of the market? I entered the market with a long term perspective and that made me to stay in the market.

When I first started investing in stock I was a short term player. Whenever a stock in my portfolio moves up 5 to 10% I book my profits and some of them even jumped 50% in less than a month, I booked my profits. While some of them dropped 10 to 20% and I booked my losses and got out from the markets. I lost more money than I gained from the market. That made me to quit stock market. But I used to watch the stocks whenever I get time but didn’t invested in stocks for a long time, not because they dropped 20% or I booked my losses. It’s because the same stocks began to move up very sharply with the market in less than a month the stocks which I sold off were up by over 20% my acquired price. And in six months some of them shot up by 100% and some by 500% and some by 1000%. And I learned a great lesson!

Now, many of you might have actually lost their patience and sleep. The situation is even worse for me and others who entered the stock market in the past two months. Your losses could be anywhere between 10% to 50%.

But now I am not that panic or I have decided not to panic will continue to hold all my quality stocks.

1. Stop Listening To Stock Market Analysts

Almost all stock market analysts in the media confuse you instead of giving a solution. Some will say the market will move up from next month onwards and some will say we are in a bear market and so on. So stop listening to them as you wont get any relief from their words. Have faith in yourself! Peace and hope are all within you. It doesn’t mean to buy a stupid company and hold that for long. I suggest you to study the market thoroughly and do your home work and analysis. Pick stocks which are fundamentally strong and if some analysts are recommending the same stock then consider that as a plus point. Don’t buy stocks only because of someone’s recommendation.

2. Don’t Look At Your Portfolio Every Single Minute

Another big mistake investors make is that they used to track their portfolio every single minute and seconds. A fall makes then feel worse and a slight rise in stock prices makes them feel better or happy. But this should be discontinued. How about tracking the fundamentals of the company when they announce their quarterly results? If your company is growing – then be happy. If they are reporting losses continuously then exit from that stock. Sooner or later the prices of your shares will settle around its fundamental value. And please stop following rumors about fundamentally strong companies.

Suppose you hold a Fixed Deposit (or Certificate of Deposit) with a bank then would you look at its value daily? Absolutely no, use that same principle when you invest in stock market.

3. Be Patient

It’s very common that you invest all your money at once instead of investing the same in a systematic manner. So chances are that you running out of cash when the stock market corrects sharply. But even then be patient and continue to hold your stocks.

4. Speak To Actual Investors Who Have Experience

Instead of interacting with analysts or stock brokers, speak with real investors who have been in the market for long time and ask about how they have survived in the market and how they have created their wealth.

 5. Stop Following Crazy Tips By Others

Stop following Hot tips which promise you to make you a millionaire in months. Yes it could really be a hot tip for Billionaires who would end up as millionaires in case they do follow the tip.

6. Understand The Market Cycles

Every and every asset class has a cycle whether its Stock Market or Real Estate or Gold or Silver all move in cycles. Realize the fact that no asset class will go only in one direction. If you go back to its history then you can see several instances when stocks prices have actually moved up and down. But over the longer period of time every asset class will reward its investors.

Stock markets, mutual funds, real estate all move in cycles. Please realize that nothing can keep going up forever in a single direction. There will be phases when prices will come down and again move up. If you go back into history you will see several instances when stock prices came down, however over a period of time quality companies always reward investors. Understand market cycles, and don’t become a slave to them.

7. Follow The ‘Guru’

Warren Buffett is an American investor, businessperson and philanthropist. He is the richest person in the world according to Forbes Magazine with an estimated current net worth of around US$62 Billion. He known as the world’s greatest investor or “Oracle of Omaha”. If you are an investor then the Wikipedia article of Warren Buffett is a must read.

He simply invested in quality stocks which have some value for longer term. He invested in Gillette, for the simple reason that he believed that men won’t stop shaving. So it makes sense to follow him. He entered the stock market when he was just eleven. He bought three shares of Cities Service at $38 per share, and shortly after buying the stock it fell to $27 per share. But he held his shares and sold for $40 per share when it was rebounded. But he regretted for that as the Cities Services shares shot up to $200. So that taught him one of the basic lessons of investing “patience is a virtue”.

Happy Investing!