This article is part of the “Understanding Options” series. The index page of the series can be found at http://www.sharetradingbyme.com/5/option-fundamentals/

Here are the main advantage of option as investment vehicle:

1. Option Can Be used as Insurance / Capital Protection

I would say this is the biggest thing about option. Let me illustrate with simple example: say you buy 1000 of Company XYZ’s stock for $25, hence your investment worth $25,000 at the time of buying. And something very terible happen and the stock is now worth only $5, meaning you loose $20,000 from this investment.

Now what if you buy the stock together with put option. Say you buy put option that give you right to sell at $25. Now, even the price is now $5, since you are guaranteed to be able to sell the stock at $25, then you will not loose that $20,000. In other word, your capital is protected.

Yes, there will be some cost involves, but that the same argument with the cost of your car insurance. The premium of insurance is charge every year regardless you make a claim or not.

But this factor is the one make sharemarket investment very unique. You cannot really buy a house and then buy an insurance that you will be guaranteed to sell at certain price, aren’t you ? Thanks to option, your investment in stock market can be “capital guaranteed” – you will not loss your capital! How good is that !

2. Option Can Be Used as Leverage.

With leverage, your investment goal can be achieved as higher speed. And option can do this leverage for you.

When you buy and hold a stock, for example that 1000 share of company XYZ above, you will want to sell it at higher price say you want to sell it when it reach $30 for $5 profit of $5000. So, your capital is $25000, you have profit of $5000 and that’s a return of 20%. Not bad return

But now, let say instead of buy stock, you buy a call option (that give you the right to buy at certain price) of XYZ at strike price of $25. It will cost you about $1 each, so you need to invest $1000. When the price reach $30, you simply exercise your option: buy at $25 and immediately sell it at $30 (current amrket price).

So, the effect is the same, you have profit of $5000 (of course less brokerage), but your capital is only $1000. So, the return is 500%. Imagine if you invest the whole $25,000 into this call option, then you make profit of $125,000. (500% return)

Yes, one thing really to consider is that option have expiry date, so if the price have not reached your price target before its expiry date, then you might loose the whole amount you invest on that option as the option could be expired worthless.

3. Option Can Be Used As Income Producing Activity

How about getting upfront income every moneth regardless of the movement of the market (because you received up-front payment already) ? Yes, this is possible with option. Instead of buying option, you can now “writing” option or selling it to other people. You become the “insurance company” discussed in point 1 above.

There are many strategy that you can apply to do option writing such as Covered Call, Naked Put, Credit Bull Put Spread, Condor, and other exotic strategy. SOme of these strategies require you not also write option also buy option to achieve specific goal.

4. Option Can be Used similar as Short Trading

Short trading is where you borrow stock from your broker, sell it now and when the price is go down, you buy from the market and return it to your broker. Basically making profit where the market down. This strategy is quite risky and highly regulated, but with option you just buy “put option” without any hassle at all.

With put option as already mention above, if the price went down from the strike price, you still have the right to sell on higher price.

By buying put option you will make profit if the price is going down, butt you are not exposed to the additional risk like Short Trading. Buying a call option and put option will carry the same risk.

But please don’t give up as yet ! Not until after reading this article. I will explain all basic and fundamental that you need to know about option in plain English as practical as possible.

This tutorial will be divided into several parts below:

• Part 1: Basic Of Options
  The basic understanding of Option including: the mechanism behind option trading, the type of an option. You need to fully understand this part before proceeding to other part.
• Part 2: Why Option is an Absolute Beauty
  Explain the crucial role and importance of option in the trading world, especially share market.
• Part 3: Around the money
  The clear explanation about ‘At The Money’, ‘In the Money’, ‘Out The Money’ and its importance
• Part 4: Transaction in Option Trading
  Explain the needed understanding before you do any option transaction in the share market.
• Part 5: The Summary of Option Fundamental
  A comparison side by side in a neat table to summarize all the basic option understanding.

On each part, there will be a multiple-choice quiz to help you check your understanding.

Note: should the link it’s not ready, please wait several days as I make some final editorial review.

1. Contract: Promise you must keep

Let us start with something simple, but it’s very important. What is a contract?

Well, contract is basically a legal promise or formal promise. The patrons of a contract promise something to each other. People break promise all the time, but if you put that promise into a contract, you cannot just break the promise without bearing the consequences.

For example: you want to buy a new car. Let say, this new car will only be available at the end of next month. You really like this car and it is your opinion that once this car is available next month, it will become such a hot car and the price might go up as too many people want it. So, you want to secure the price now. The dealer said that they will sell you the car for $30,000 if you pay 10% deposit now. Should you agreed, the dealer will ask you to sign a car sales contract outlining that they will sell the car for $30,000 next month once it become available, that you will put $3000 as deposit, and that you will pay the balance upon delivery.

Once that sales contract is signed, then you are obligated to buy that car next month and the dealer are obligated to sell it to you.

What if something happened and you decide to not go ahead with the purchase. Can you just change your mind like that without any consequences? Probably not. Maybe the dealer allows you to cancel the purchase, but they forfeited your deposit.

Now, imagine a contract like that, but it is up to you whether or not you want to proceed with your contract. That is: if you you want go ahead to purchase the car, you simply pay additional $27,000 (the balance), but if not, your deposit will be simply returned and no question asked.

Is there any contract like that ? Yes, introducing Option contract….

2. Option is Privilege.

Basically, Option is just a privilege or right. With ‘normal’ contract ,you are obligated to fulfill the contract, or otherwise face the consequences. But with option contract, you have the privilege to choose whether you want to fulfill the contract or just abandon the contract.

But in order to have this privilege, you need to pay the price. The price you need to pay to have this flexibility is referred as Option Premium or simply Premium. For example: we pay additional $1000 upfront to the car dealer as Premium to have that privilege.

When you buy an option, you buy the privilege by paying the premium. But only the privilege, not the ‘main merchandise’. In this example: $1000 premium that you pay to the car dealer only buys you the privilege to decide later whether or not to buy the car. But the car itself need separate $30,000.

In Option contract, the ‘main merchandise’ referred as “underlying asset” and could be virtually anything: share, property, warrant, future, block of land, car, etc. For example:

• Share option: the buyer and seller agrees to transact the shares at a certain price.
• Property option: the buyer and seller agrees to transact the property at a certain price.
• etc.

On the other hand, the agreed price of the underlying asset is referred as “strike price”

But a contract cannot be valid forever. It always has time limit referred as expiry date. After the expiry date has elapsed, the contract is no longer binding or simply “expired” or not valid anymore. This is also applied to option contract.

So, in the nutshell, Option Contract is simply a deal between buyer and seller where the buyer have the privilege to proceed or not to proceed the deal within certain time frame.

Now, who is the seller ? The seller is just general public. You can be a buyer now but then you can be a seller as well on other time.

Need to be very clear here that the seller is NOT the Stock Exchange or the Option Clearing House. Stock Exchange/Option Clearing House is just mediator and the umpire to make sure everybody play by the market rule.

3. Option’s Triad.

When we are talking about option, there are always 3 (three) major factors:

1. Underlying Asset: what will be transacted?
2. Strike Price : what is the agreed price?
3. Expiry Date : when the contract expired?

This triad constitutes the value of every option and it will always be defined in a option contract.

4. Option Type: Call Option and Put Option

Call Option

Call option is the right to buy an asset at certain strike price on or before certain expiry date.

If you have Call Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to buy Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the call option to buy the share? Yes. Because once you buy for $30 each, you can immediately sell for $40 each and making profit $10 each share.

On the other hand, let say the price in the market is only $25. Will you use your right from the call option to buy the share ? No. Because you can buy cheaper in the market why pay the higher price.

Put Option

Put option is the right to sell an asset at certain strike price on or before certain expiry date.

If you have Put Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to sell Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the put option to sell the share? No. Because it’s trading at $40 in the market, so you can sell it in the market for better price.

On the other hand, let say the price in the market is only $25. Will you use your right from the put option to sell the share ? Yes, of course! Because you cannot get $30 by selling in the market (the price is now $25), then it’s time to use the privilege from put option to sell it for $30 each.

5. Buy vs Sell, Buyer vs Seller

We know that for every transaction there will always be at least a buyer and a seller. That is: if you want to buy ’something’ (you are the buyer), there must be another party that want to sell that ’something’ (seller). Otherwise, there will be no transaction.

In other words, if it is a buy for you, it will be a sell for the other party and vice versa.

I need to emphasize this, as this is where the confusion starts. The definitions of call option and put option above are from buyer perspective.

So, if you buy a call option, you have the right to buy the asset on strike price before expiry date. And if you buy put option, you have the right to sell the asset on strike price before expiry date.

From seller perspective, if you sell a call option, you have to sell the asset on strike price only on or before expiry date should the buyer exercise his/her right. And if you sell a put option, you have to buy the asset on strike price only on or before expiry date should the buyer exercise his/her right.

Can you see know why this can be confusing ? If you start to, please stop here and try to re-read above passage until you grasp the understanding. Don’t continue if you still have any confusion, it will confuse you even more.

6. Option is Trade-able: introducing ‘Option Writer’

You are allowed to sell your option to other people. The characteristic of the option (Option Triad) will remain the same, but the premium may change.

Let take an example that you buy a call option for Microsoft share (so you can buy the share at certain price before expiry date should you decide to do so). But long before the expiry date, you already made up your mind that you will not want to buy the share. Since you will not use that privilege, probably somebody else can make use of this privilege. Then, you can simply sell your right back to the market. Now, you are no longer option- buyer, you become option-seller.

Now that you have sold your call option (where the buyer can buy the share should he decide to), what happen if the buyer wants to exercise his right? Remember, you don’t have the share, but now you sold an option that promise the share…. Where you can get the share ? The answer is: from Option Writer.

Option Writer is the first person who sell a option contract to the market.

In term of call option, call-option-writer is the one who actually own the underlying asset, ready to be sold, should the call-option-buyer decide to buy it.

In term of put option, put-option-writer is the one who actually ready to buy the underlying asset should the put-option-buyer decide to sell his/her underlying asset.

The contract within the option is always between the writer and the latest buyer.If you sell your option, the contract of the privilege will be shift from you to your buyer. Since you are not the first person who sell the option, once you sell the option, you have nothing to do with that option anymore.

7. Option is Anonymous

Contrary to popular belief, when option contract is sold , neither the option-writer nor the option-buyer knows each other. Nobody knows to whom his option is being sold to and nobody knows from who this option from.

Option is anonymous. The buyer and the seller is just a number in the market. They don’t know each other. But they are all have to obey the market rule. The term in option contract is enforceable. This is the assurance from the Stock Exchange/Clearing House as the market authority. One of many ways to ensure everybody play by the rule for example is to make it compulsory for every option writer to provide some sort of security (cash or share) as collateral among many others things.

Trading Computer is Not Gaming Computer

While it’s natural that everybody wants the best , but one thing to remember that the requirement for trading computer is not that high compare to the computer for playing games.

Computer for games have to do a lot simultaneous 3D simulation (hence calculation) while producing detail audio effect and special efffect on the background with someone hitting the mouse or keyboard at 100km per hour (read: very fast). This is even harder requirement for those 3D technical computing for engineering, i.e: Autocad, or Mathematics.

Trading computer while still need to display real time data, it only does 2D graphics display and without the sound effect and the user only give execution maybe once every minute tops. So much much lower requirement of those gamers.

So, if you are a gamers and want to do trading as well, your computer is already twice as good. But if your son is a gamer, do NOT borrow the computer because you don’t know other stuff running behind. Get yourself a decent trading computer describe below.

The Ingredients of Trading Computer

Multi Monitor for Trading

Below is the guidelines that you might use for your trading need. Remember that I don’t know the specific requirement of your trading platform, so always refer to their user manual for final check. But here is the mainstream:

1. You need Multi Monitor: minimum 2 (two) of 19″ monitor. Widescreen monitor is better as the graph is usualy follow the aspect ratio of wide screen. Three (3) monitor is a little bit excessive as you only want to run: your trading execution platform, your charting software and internet browser (for checking news). Recommended: 2 LCD monitors of 22-24 inch display (widescreen). You don’t need the fastest one either (the one with lowest refresh rate). 3 computer? maybe no. You will find bracket for 3 monitors probably more expensive than the monitor itself. Just buy 2 and place it side by side on your table. No bracket necessary.
2. You need a lot of memory/RAM: while some recommending 2GB or better, I would say go broke and get the maximum. For 32-bit operating system: Windows XP, Vista 32-bit, Windows 7 32bit and similar the maximum is 4GB of memory (usually the system can use less than this). So aim for this. If you are with 64-bit operating system, go for at least 6GB. If you need some powerful item, memory is the one. Trading computer will have a lot of real time data that need to be stored somewhere. RAM is the best place rather than slower hard drive.
3. The CPU and its speed is not crucial: go for multiple core: core duo, quad core, I5 core or I7 core depends on your budget.
4. Hard disk: 500GB will last for good few years, so any additional just extra for your downloaded movie or song (nothing to do with trading)
5. Graphics Card: you don’t need the fastest high end graphics card. A cheap card that support dual monitor with at least 512MB memory will be more than enough.
6. You HAVE TO have backup broadband connection. Your main connection should be at least ADSL or cable broadband, but additionally you need to have backup connection ready to connect within 30 seconds. While internet connection is getting robust these days, some fault is still possible, so if it’s gone, you need to be able to re-connect to internet within 30s and just hope nothing really significant happened. Recommended: those mobile 3G broadband connection: even 1 GB plan per month should be enough.
7. Do not use wireless router for your network connection. Repeat: DO NOT use wireless network connection between your computer and your router/modem. I cannot stress enough. Ask for good CAT6 Ethernet cable. Using wireless connection not only give you additional delay as the computer and the router need to do hand shacking in encryption environment, but also make you prone to disturbance from your environment. For example if your geek neighbor decided to experiment with new wi-fi equipment, you are prone for any disturbance. Using cable eliminate this risk very very significantly.
8. Do not use wireless keyboard nor mouse. While it’s fancy, using wireless keyboard/mouse add to your latency time (your realtime-ness) and put additional burden for your computer to maintain the connection. Recommended: wired keyboard and wired laser optical mouse.
9. Invest on Uninterrupted Power Supply(UPS). This days this item you can get less than $100. Even the cheapest is enough. Connect your router and computer and monitor on UPS, if there is power interruption, at least you can immediately exit from the trade before the battery run out a few minutes later.
10. Backup Computer: a small netbook/laptop or even old computer will do. The idea is just to have your execution platform there (the charting program is not necessary). Always have it on and ready when you are trading. So if your main computer for some reason decide to crash, your old computer will be your savior, at least you can exit straight away. You need to just 1 click from login to your execution platform on your old computer.
11. Do not run any unnecessary program: your Yahoo Messenger, Twitter client or open Facebook account. Windows Update, Antivirus Update and other automatic update need to be pause during your trading. This is not only a distraction to your trading, it can occupy some of the bandwidth of your internet connection. If you want some gentle music, play it with your CD player/ipod, don’t let your computer play it – it require decompressing the data coding that require a lot of computing power.

I am hoping the guidelines above can save you thousands of dollar that you probably better use it for trading capital. Tell your computer shop that you know what you one. Check at least Ebay to see the current rough price. I would say fulfilling criteria above, you can get a decent trading computer with 2 monitor at below A$1500. Yes, not that expensive, really.

Nov 2009 price: $199 each for monitor (AOC 24″), 1.5TB HDD+Windows7 $229 , intel i5 750 cpu+gigabyte p55-ud3+4gb corsair for i5 1600c9+logitech mx revolution $590,800VA UPS $85, Powercolor HD4650 1GB Graphics card dual monitor $53 and plus casing+keyboard+cd. (All price is in Australian dollar, price from http://fluidtek.com.au.)

(I am sorry, I am not that familiar with Mac computer. But you can hopefully still get some kind of picture about it. As far as I know, only some popular trading software fully support Mac – check your software provider first)

Should you have any question , feel free to ask on comment section below.

How About Laptop for Trading Computer?

While technically a good laptop is also suitable for trading, but you will get the bank for your buck if you aim for desktop computer. Beside laptop suffers the scalability problem (you cannot or very difficult to upgrade in later day). And one big non technical problem: since laptop is portable, user tend to stuff everything that can be install and save into the laptop render it stuffed and sluggish for excellent trading computer.

Until then, Happy Day Trading ! See you in a trading room !

Indicator, Gut Feeling, Supernatural and Random Events….

Going Up? Really !?

Say in one beautiful morning, all technical indicators indicates stock XYZ  will go up, Dow Jones future also bullish, the sky is clear blue, the mood is brilliant, the psychics also say it will go up, planet Jupiter and Saturn are also in alignment and your gut also saying it will be up today. Will it go up as predicted ?

Let’s remember that the price movement is determine mainly by the number of seller and buyer. If there are too many buyer, the price will go up. If there are more seller than buyer, the price will go down. (Read How The Price Moves in Market if you need more illustration)

Therefore, any of these can happen:

• Mr Jones decides to buy that chateux in French
  Mr Jones is long term investor of company XYZ and hold as much as $10million worth of XYZ stock. Today he just found out that that chateux in France where he spen the holiday last Christmas is on the market for sale. He need $10 million immediately to secure the chateux that he always wanted. So he call the broker: “Sell all $10 million of my XYZ stock, today !”
  Can the price now go down with suddenly $10million additional share to be sold at once ? Of course it’e possible
• Some lunatics just flown a plane crashing into World Trade Center
  (sound familiar?) Yes, major catasrophy will trigger panic selling where people just happy to sold at any price. Will  the price still go up ?
• CEO of  XYZ company has just been arrested for defrauding the company for $100 million. He just made public apology. Will the price still go up ?
• Earthquake of 8 richter scale has demolished XYZ company’s headquarter. Will the price still  go up ?
• etc, etc

Yes, some random events will always take place at any time in the market. Some will have no or little effect to the price, but some will have significant effect. Since these randoms events also cannot be controlled by nobody, then the particular result of something cannot really be substantiated

Predicting the Market

The business of predicting the market is multi million dollar business these days. Are we saying that all of them is just a lie ? No. Forecasting / market opinion is just forecasting. What likely to be happen, but not what will be happen.

Countless of people have made their fortune following such prediction, so it has its own merit. So the prediction is not just come up from thin air, but it’s from quite valid analysis.

The point is

Whatever system or indicator or secret method that you apply to predict the market, you need to have a plan just in case it is not happening as expected. As long as you realize the fact that some random event can distort the best analysis, and you have trading plan that covers this matter, then you will be on your way on share trading success.

So, next time the indicator let s you down, just remember Mr Jones….

Hope this helps

Ex-Dividend Date & Record Date

If a company declare that they will give the shareholder dividend, beside the amount of dividend, the company will also announce a “Record Date“. This is the date that you need to be recorded already on their book in order for the company to pay you the dividend. (Otherwise the dividend will be given to the previous shareholder).

When you are purchasing a stock or share, there will be a few days before that purchase is settled.  Meaning if you purchase a stock via your broker today, there will be a few day before your name registered/recorded on company’s book.  So, depending on your stock exchange “Ex-Dividend Date” or simply “ex-date” is a few days before the record date (in Australia:4 days before Record Date). This is actually the first day that you are not eligible for that dividend. Or in other word, you need to buy the stock/share before the Ex-Dividend Date in order to be given dividend on that time.

Because of this, Ex-Dividend Date is the most important date for investor and trader when it comes to dividend.

Typical Price Action on Ex-Dividend Date

The typical behavior of stock price on ex-dividend date is quite unique:

1. The price will usually open at starting price go down by the amount of the dividend. It’s not 100% always, an it is also not 100% exactly the same as dividend value, but approximately close. The logic is: when company is giving say 50c as dividend per share, it is actually taking out that 50c from company value as cash and giving it to the shareholder. So the overall company value on the market will be less.For example: company XYZ have 20 million share with price at $10. So total company value (market capitalization) is $200 million. If the company gives 15 cents dividend to shareholder, then the value of the company is literally down by 15c x 20 million share = $3 million down. Hence the price per share is equal to $9.85.
2. If the dividend is significantly high (compare to the stock-price or relative to the industry standard) it’s not unusual for the stock to rally a day before ex-date to compensate for item (1) above

Let see some real graph from real market price about this typical guidelines:

WITH STRONG MARKET SENTIMENT

• Home Depot (HD): Ex-Date: 1-Sep-2009 for 22c dividend. It closes $27,29 on 31-Aug-2009 to open 26c lower on ex-date. It closed even lower. Dow Jones Industrial Index (DJIA) closed 181 points lower, S&P500 closed 21 points lower.
  

  HD-Home Depot ex date 1 Sep 2009

  Price gap was formed on Ex-Date but the market sentiment of bearish day have more prominent effect after opening (Dow Jones ended down 181 points). This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• United Parcel Service (UPS): Ex-Date: 20-Aug-2009 for 45c dividend. Price were opened only 10c lower on ex-date, went to low  $52.24 before rally 67cents to end up $52.91 on that day. DJIA was up 71 points, S&P500 closed 11 points higher.
  

  UPS ex date:20-Aug-2009

  The price just went down 10 cents on the opening of ex-dividend date having push upward by market bullish sentiment. This follows marginally the typical price behavior on ex-date. The price is also follow the market sentiment as it went up from low on the day fuel by strong bullish market sentiment.

• Coca Cola (KO): Ex-date 9-Sep-2009 for dividend of 41 cents (3.08% yield). With DJIA up 51 points and S&P500 closed 8 points higher, KO open $50.13 (down 45 cents from $50.58) before rally strongly to $51.74 for $1.16 up
  

  Coca Cola-KO ex date 11-Sep-2009

  This follows the typical price behavour on ex-date, and rally even stronger than the overall market.

• Microsoft (MSFT): Ex-Date:18-Aug-2009 for 13c dividend. It open 4c higher. DJIA closed 83 points higher, S&P500 closed 9points higher.
  

  Microsoft (MSFT) ex-date 18-Aug-2009

  With strong upward pressure from the market, the ex-date price ended up higher. The price on ex-date also follows the market sentiment.

• Boeing Co (BA): Ex-Date: 5-Aug-2009 for 42c dividend. The ex-date open 53c lower from closing $44.16 before going back up. DJIA closed 34 points lower that date, S&P500 closed 3 points lower.
  

  Boeing-BA ex-date 5-Aug-2009

  The price was down larger than dividend value. This follows the typical price behavour on ex-date. The price on ex-date also follows the market sentiment.

WITHOUT/MINIMAL MARKET SENTIMENT

Let’s see more example with more neutral market:

• Glaxo Smith Kline (GSK): ex-date 29-Jul-2009 for 46c dividend. It closed $38.69 the day before and open down 21 cents at $38.48 before close 30 cents lower. Dow Jones Industrial Index was only 22 points down, S&P500 closed 3 points lower.
  

  Glaxo Kline Smith - GSK ex date 29-Jul-2009

  The price is gaped down on ex-date and close  down on that day. This follows marginally the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• McGraw Hill (MHP): Ex-date: 24-Aug-2009 for dividend of 22 cents (3.45% yield). Price close a day before at $29.67 but open 4cents lower $29.63 only to rally and close $1.04 higher. DJIA only went up 3 points higher, S&P500 closed 1 points lower.
  

  McGraw Hill-MHP ex date 24-Aug-2009

  The price opened at ex-date marginally lower but perform a strong rally despite neutral overall market sentiment.

• Qualcomm Inc (QCOM): Ex-Date:26-Aug-2009 for 17cents dividend. It closed on 25 Aug at $46.99 and open at exactly the same price the next day on ex-date. It rallied 54cents higher to close the day. DJIA only up 5 points, S&P500 closed 1 points higher.
  

  Qualcomm QCOM ex-date 26-Aug-2009

  The price did not go down on ex-date and even rally strongly even-though the Dow Jones index show some neutralit. The price on ex-date also follows the market sentiment.

• IBM: Ex-Date: 6 Aug-2009 for 55c dividend. It closes $118.47 a day earlier and finish the ex-date at $1.09 lower. DJIA closed 21 points lower, S&P500 closed 7 points lower.
  

  IBM ex date 6-Aug-2009

  With the strong market downward push, the price gap on ex-date was push further down. This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• BHP Billiton (BHP): Ex-Date:2-Sep-2009 for 82c dividend (2.49% yield). It open $60.45 from $61.43 previous close (down 98 cents) before close $60.87 on ex-date. DJIA was down 25 points, S&P500 closed 1 points lower.
  

  BHP Billiton ex-date 2-Sep-2009

  The price gapped down on ex-date and follow the sentiment of the market down, but manage to finish higher than the open. This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

Conclusion

From examples above all the stock (except MSFT and QCOM) were following the typical behavior describe above: the price drop on opening compare to the previous days before continue moving with market sentiment. But the overall market sentiment (Dow Jones index or broader S&P500 index) as a whole is still the dominant force to the exact movement of the price.

The Spread

The spread is simply the difference between “Ask” price and “Bid” price. Or in other word, the difference between selling price and buying price.

For example: your brokerage fee is flat $10. And you want to buy 1,000 stock XYZ which is trading at $25 at the moment. And opening your trading platform, you will see that the “Ask” price is probably at $24,9 and the “Bid” price is at $25.10. Meaning you will have to buy at $25.10 instead of $25. Then, since you buy 1,000 pieces of stock, this innocent $0.10 difference is add up to $100!  So, now your actual brokerage is not $10, but $110.

To give you more vivid illustration, let’s imagine that you buy these 1,000 stock then immediately sell it again at the same price. Your expectation probably you will lose $20 (which is the brokerage of “buy” plus brokerage for “sell”). Let’s see the table below:

Wow! Do you see that ? Buy a stock and sell it at the same price with brokerage $10 each will not cost you just $20, but “thanks” to spread, the cost goes up to $220 (or 4110 each transaction). This is the real / actual cost that you need to pay.

The spread itself depends on the stock. If the stocks is quite liquid and popular (means the volume of transaction is high), then usually the spread is smaller compare to other stock of smaller company with less liquidity.

Other way to see this

If you don’t want to be upset, of course you can see this hidden cost with different view… instead of see the price in the example above as $25, you can see it as $25.1… So, you’re buying at $25.1 (not $25.0) and selling at $24.9 (not $25.0). With this perspective, yes, the brokerage is now $20 only and the other $200 is a result of lost trade.

Which one you prefer is up to you, just beware that if you set a target say $30.0 to sell a stock, then the actual price still need to go beyond $30 to overcome this spread.

What will happen

Because the spread is not really obvious (that’s why I call it “hidden cost”) and cannot really be compared from broker to broker unless you have multiple trading platform at the same time, it will not be a surprise that in the near future, the brokerage company will advertise “Free brokerage” when actually they make money more on the spread. (This actually already happening in forex transaction where the brokerage firm just “charge” the spread)

What is Diversification

Simply put, diversification is spreading your money to more than 1 type of investment. In term of stock / share trading, diversification could be investing in more than 1 stock, investing more than 1 type of industry, investing big, medium and small size company, etc.

Diversification Reduces Risk

Let see how and why diversification can reduce the risk. For example you have $10,000 to invest in stock market. And you want to invest in stock of company XYZ. What is the risk ? The risk is when the price of XYZ stock goes down. Now, let us simulate what happen if the stock go down by 50%:

1. Without diversification: you only buy XYZ stock, so all $10,000 is invested in this stock. If the stock goes down to 50% then the value of your stock is now $5000. (You have lost $5,000)
2. Diversification with 2 stocks: Let see if you do some diversification and instead of only investing in 1 stock, you invest in 2 different stocks: $5000 XYZ stock and $5000 other stock. So, let say the price of the other stock did not change, then if XYZ is 50% down, then your XYZ stock now worth only $2500, total value of your portfolio is $7500. (You have lost $2,500)Now, compare to (1), by using diversification, you have already reduce your risk by 50%. Now you only lost $2500 instead of $5000.
3. Diversification with 4 stocks:Let see further what happen if you do diversification with 4 stocks: $2500 XYZ stock, $2500 stock A, $2500 stock B, and $2500 stock C. With XYZ down 50% and other stays the same, you now incur a lost of only $1250.
4. Diversification with 100 stocks: If you do further diversification and invest in 100 stocks ($100 each), by the similar calculation, you will get that you only lost $50 for exactly the same events.

Clearly, by using diversification, we can see that risk have been distributed and the exposure of each item is reduced.

Diversification Limits Profit

Now, let see the flip scenario: what if the XYZ stock increase by 100% , yes, it doubles. Also we want to see the transaction cost – if each transaction cost us $10, what’s the correlation with diversification.

1. Without diversification:You only buy XYZ stock, hence the transaction cost is $10. The stocks has doubled in value, then your portfolio is now worth $20,000. A nice profit of $10,000. After transaction cost: $9,990 profit.
2. Diversification with 2 stocks: You buy 2 stocks, then your transaction cost is $20. The XYZ is now valued at $10,000 (asumming the other stock stays the same), then the portfolio is valued at $15,000. A profit of $5000. After transaction cost: $4,980 profit.
3. Diversification with 4 stocks: With 4 stocks, the transaction cost is $40. Total portfolio is $12,500 or a profit of $2,500. After transaction cost: $2,460 profit.
4. Diversification with 100 stocks: With 100 stocks, the transaction cost is now $1000. The total portfolio is now $9900+$200= $10,100. After transaction cost: $900 lost.

So, from this example we can see the transaction cost is going up in parallel with the number of diversification that we did. And the profit ? The more diversification we did, the less profit we got.

What To Do

The general wisdom is that we need to balance between minimizing risk and maximizing profit. It’s not really a good experience having your stock pick hit a jackpot and the stock doubles in value, but because of too much diversification you even cannot profit from it (see condition no (4) above).

So how many is enough ? It’s all depend on the size of your capital. The general rule that might be suitable for you is that you should not lost more than 5% of your total portfolio for any single transaction.  So, in this case, with $10,000 capital you should not lost more than $500 for any transaction. So if you want to tolerate 50% drop in value, that will be the $500. So, the value for each portfolio will be $1000. Or you will do diversification with 10 stocks.

You may want to vary your level of risk as well. For example 50% drop for blue chip companies maybe already very significant, but for small caps companies probably it’s still within the expected volatility. So, you need to work out your overal plan according to the type of the portfolio and your exit strategy.

If you have higher capital, you probably could make more diversification because:
(1) the proportion of transaction cost will be smaller
(2) you will be able to buy higher quantity of stock that will multiply the profit (and also loss) of the investment

Conclusion

You need to do diversification to reduce your exposure to certain risk associated with each item of your portfolio. But you need to do it so that you minimize your transaction cost and make sure any significant profit will give significant boost to the overall portfolio.

Happy Diversifying !

Let see exactly what happen on the example below.

Let say, you have $10,000 to invest and decide to open a margin loan account with interest rate of 5% and the LVR (Loan to Value Ratio) is 50%. (This means if you have $10,000 then the lender will lend you another $10,000. So in total you will have $20,000 for the investment – the loan is 50% of the otal value). Let’s also assume that the stock you want to buy is $25 each. Then:

Yes, It Accelerates Profit

Now, let see what happen if the stock price is now $40 after 2 years. (increase $15 or 60%)

As described on table above, without borrowing we make 60% profit from 60% price increase. But with borrowing of 50% LVR, we make 110% profit from the exactly the same price movement and time. Even after paying interest… So, with gearing we definitely getting a lot better result and it inded accelerates our profit.

But, It Also Multiply Loss

Then we compare if the price was down by the same amount (decrease $15 or 60%)

This is the situation you need to understand fully. Without borrowing you lose $6,000 of your money (but still have $4000 in hand from the proceed of the share at $10 each). But with borrowing, the proceed of the sales is only 800 * $10 = $8,000. Remember that your starting capital is $10,000 and you have another $10,000 from the lender. That’s mean, you need to add extra $2,000 from your own pocket just to pay off the money you borrowed . Beside that, the original $10,000 is now gone (loss). To make it even worse, you also need to pay that $1000 interest.

So, you’re not only loss of all your initial investment, you also need to pay additional money just to close your trade.

Conclusion

Borrowing money to invest is double-edged sword, it can give you benefit but also give you a disaster.

But as soon as you realize this fact, then we can go to the next level: what we can do about it ? Can we still make use of the benefit of the leverage without having to carry such big risk ?

Fortunately, the answer is yes, we can ! So,  we can enjoy the advantage of the money we borrow that will accelerates the profit as shown on above calculation, but when the price move against our expectation, the capital is protected (preserved): that is in this example, you don’t have to lose even the $10,000 should the price go down as example above.

How exactly we can do it ? You will find it on other article in this website talking about hedging / risk management.

Have a good day!

Remember in share market related trading (including option trading), if the price go up it does not mean that you always make money. All depends on the strategy. Some strategy requires the price to go down in order to make profit. Other strategy will produce profit if the price goes up.  Another strategy make you money only if the price stays the same. Because of this, the Profit Loss Chart (PLC) become very useful tools. Let’s have a look more detail.

The PLC Chart

On the left is a graph that contains a PLC. The vertical line/axis on the left represents the profit (or loss) – it’s a profit if it’s above zero, it’s a loss when below zero. The zero is where the horizontal line intersects.

The horizontal line/axis represents price. Go to the left is lower price. Go to the right is higher price.

The notch on the horizontal line is initial price (the price when we start do the trading)

The blue line is the Profit Loss Chart/PLC itself.

Let see a little bit more detail about the graph and how we interpreted it into an elegant understanding.

• The green area is profit area
• The red area is loss area
• The starting price is $20
• The breakeven is on $25
• If the price at $30 there will be profit of $200
• If the price is less than $20 there is constant loss of $100
• So, when we start at $20, we immediately at loss position ($100 loss). That ‘loss’ is due to the capital cost (buying the option), brokerage cost, or other cost.
• If the price keep going down, luckily, we don’t make additional loss (the blue line on the left of $20 is on loss area)
• If the price going up from $20 to $25, we are getting to the break even point
• Only if the price is higher than $25, we are on profitable area. If it’s $30 then it’s $200 profit.
• So, from all of those point we can conclude that this kind of trading is bullish, meaning it needs the price to go up in order to make money, but it’s protected from the downturn (not making any more loss)
• This PLC is real one. It’s the PLC for buying call option.

So, just by looking this simple picture, a lot can be derived from it.

More Examples

Let see some more examples:

• When we start, immediately we are in profit already. (This will be refered as ‘credit’ strategy – since it start with some credit (money) in the pocket).
• If the price go up, it will give some additional profit only until certain price and it will go flat (no more additional profit.
• If the price go down, it will go down proportionally with the price
• So this strategy need the price to go higher just a bit to maximize the process, but we will make a loss if the price go down
• This is a strategy named “Buy Write” (or also known as “Covered Call” or “Share Renting”)

• When we start, we slightly in a bit of loss. (This could be due to some brokerage cost or other cost)
• If the price go up the profit also go up proportionally
• If the price go down the profit also go down proportionally
• We will reach break even point if the price just go up a little
• So this strategy need the price to go higher (bullish strategy) in order to make profit/
• This is the PLC for normal stock trading

• When we start, we are at the peak of our loss
• The profit go up when the price go up
• Also , the profit go up when the price godown
• In other word, as long as the price move from the starting point, doesn’t matter go up or down, we will start making progress toward profit. We just want the market to move the price. Usually this is good for a volatile market
• This is the strategy call “Straddle”. This strategy involves buying both put option and call option at the same strike price.

• When we start we are at the maximum profit.
• If the price go down, the loss will increase as well but it will be capped (no more loss after reach certain loss)
• If the price go up, it will not change any profit
• The break even is reached if the price go down a little bit.
• So this strategy also require the market to go up in order to maintain the profit (bullish strategy)
• This is a strategy called “Credit Bull Put Spread”. This involves writing put option near or at the money and buying another put option further out of the money.

• When we start, we are at the peak of our loss. This is due to cost that incurred at the start of the trading, including brokerage cost and the capital itself.
• If the price go up, the loss stays the same (increase in price will not putting more loss)
• If the price go down, the profit is increasing proportionally with the price
• The break even is also reached if the price go down a little bit.
• So, this strategy requiring the market to go down in order to make profit (bearish strategy)
• This is PLC for buying put option

Conclusion

The Profit Loss Chart is handy tool to see whether a strategy is requiring a down market, up market or neutral market. It can show elegantly where the maximum profit is, when we start losing money as well as the break even point.

Margin: a distance from the edge

In printing/word processor, you can see the similar resemblances in understanding “margin”. Margin is a vacant space left as a ‘border’ between the edge of the paper and the content. That is also somehow similar to “margin” in trading, it’s a space between the end of your account and the real profit.

Margin Lending / Margin Loan

Margin Lending or Margin Loan is the most popular form for of borrowing money to invest. It’s one of the easiest loan to be granted by a lender. Hence, it’s also the easiest for trader to get a leverage on his/her account. Usually margin lending / margin loan is only available for stock / share.

The way it works is simple. For every stock, the lender will define a percentage that they want to lend money on. For example: say for BHP stock you can get 75% lending (different percentage for different stock), means if the stock price is $30 and you want to buy 1000 of them (total 1000x$30 = $30k), they will lend you 75% of 30k = $22.5k, and you need to come up with the rest ($7.5k).

Margin Loan Illustration

This 75% is the maximum percentage. So if the day after you buy, the stock go down to $28, then the total value is only $28k. You have borrowed $22.5k, hence your equity is $28k – $22k = $5.5k. Then from the original $30k, your 5.5k is only 18%, means they lend you $81.7% which is bigger than 75% maximum. Unfortunately in this situation you will get “margin call” to ask you to deposit at least another $2k to make the ratio back to 75%.

Furthermore, you need to pay the interest of this loan. If the interest rate is 8% p.a, then the total interest you need to pay is 8% x $22k = 1.76k per year or $147 per month

To illustrate (see picture above), imagine a margin loan is like a bucket. Based on the percentage, the lender put their money into the bucket, and you put your money in the bucket. The rule is that the bucket need to be full all the time. Hence if the price go down (the red tap above opens), your part of the money will be drained to the market and you have to keep the bucket full by deposit more money. If the price go up, the market will pour the money into the bucket and the money will drip into your ‘profit’ bucket.

Margin Trading

The other form of lending for trading is what we call “margin trading”. This is the lending where the lender will lend you 100% of the amount. But they will ask some percentage as collateral or security deposit or “margin”. This kind of trading usually available on high leverage trading such index trading / e-minis or forex trading or commodity trading.

Let’s use the same example above. You want to buy 100 share of BHP with $30 each. And say, the lender ask you to provide 25% margin. Then the lender come up with full $30k, and you put 7.5k in the account as collateral.

Margin Trading Illustration

So if the price again goes down $2 the next day, you need to top up your account by $2k just exactly like the margin lending.

The difference is on the interest. Since you borrow the whole amount, then you will pay 8% x $30k = $2.4k per year or $200 per month

To illustrate (see picture on the right), also imagine a margin trading is like a bucket. Based on the percentage, you will be asked to provide your money as collateral and the lender just sit on it. Then the lender put their money to fill the whole bucket. Again, the rule is that the bucket need to be full all the time. Hence if the price go down (the red tap opens), you need to replace the lender money straight away and maintain the bucket full. If the price go up, the market will pour the money into the bucket and the money will also drip into your ‘profit’ bucket.

Usually if the account is used for day trading (buy and sell within the same day – no overnight position), the trader does not need to pay interest, just the collateral. This is one of the factor why this kind of trading such as e-minis trading become very popular (Got high leverage without have to pay the interest).

Conclusion

On both margin loan and margin trading, the borrower (you) have to come up with additional money if the price go down to maintain the ratio. If the price go up, the excess money become the profit.

The only difference between margin lending and margin trading is that the borrower (you) will have to pay more interest on margin trading since the lender lent the whole amount (100%)