Asset Turnover Ratio
Asset Turnover Ratio
Working Capital Ratio
Working Capital Ratio
Debt Ratio
Debt Ratio
Interest Coverage Ratio
Interest Coverage Ratio
Debt to Income
Debt to Income
Debt to Equity
Debt to Equity
Current Debt
Current Debt
Debt Leverage
Debt Leverage
Debt Interest
Debt Interest
Shareholder Equity
Shareholders Equity
Preference Shares
Preference shares are a means by which a company can raise capital without increasing its debt or diluting the voting rights of existing shareholders.
Preference shares carry a fixed dividend but, unlike debt holders, preference share holders cannot take legal action against a company that fails to pay the expected dividend. If no dividend is paid to preference shareholders, however, company law says that no dividend may be paid to holders of any other shares either. Also, if no dividend is paid, preference shareholders acquire normal voting rights.
Preference shareholders are always first in the queue for dividend payments and, should a company declare bankruptcy, preference shareholders have priority over common stockholders for any asset distribution.
Convertible Preference Shares
Cumulative Preference Shares
Participating Preference Shares
Redeemable Preference Shares
Rights Issue
A rights issue is an issue of new shares which existing shareholders are offered in proportion to their current holding.
Rights issues are undertaken by companies who wish to raise capital. Companies often choose to do this when their debt to equity ratio has grown too high. The injection of fresh money increases company equity.
The new shares are often issued at a discount to the prevailing market price.
Shareholders may choose to subscribe to the rights issue or not. If they choose not to subscribe, their holding of the company will be diluted when the new shares are issued. For example, a shareholder might hold 1,000 shares of a company’s total of 1,000,000 shares. If the company undertakes a 1 for 1 rights issue and our shareholder opts not to buy any new shares, he will end up holding 1,000 shares out of a new total of 2,000,000 company shares. His ownership and voting rights in the company will have been halved.
Subscription rights to new shares may or may not be transferable. If the rights are transferable, the holder can opt to sell these rights on the open market to a buyer who wishes to take part in the rights issue.
Different degrees of new share issue are possible. One new share for every 10 existing shares would be a less significant rights issue, requiring a modest discount to the current share price, while one new share for every four existing would be be a significant issue, involving a greater discount in the price of the new shares.
Risk Free Rate of Return
The risk free rate of return is often used when comparing the merits of different investments using discounted cash flow calculations.
The risk free rate of return is generally taken to be the return available from long-term, AAA rated, government bonds.
Government bonds are taken to be risk free because, if governments lack sufficient money to redeem bonds or to make interest payments on them, they can either raise the money through taxation or print it. Long-term bonds are chosen in preference to short-term bonds because investors in short-term bonds have to reinvest their capital more frequently and may fail to secure the same interest rate when they reinvest their money.
Whether AAA government bonds are truely risk free, with zero probability of default, is debateable. All governments are susceptible to political pressures and therefore, at some point, may deem it more expedient to default on debt rather than increase taxation or print money.
AAA government bonds do, however, represent the closest approximation there is to a risk free investment.
Time Value of Money
Money’s value changes with time.
Money tomorrow is worth less than money today because:
Inflation erodes money’s buying power. (When your great grandparents were children, the amount of money that would have bought them a fine quality restaurant meal will buy you a cut-price supermarket sandwich.)
If there is risk in the cash flow people can achive from investing their money, then the value of cash flow must be reduced to take account of the fact that it’s not 100 percent certain.
Most people prefer to enjoy what their money can buy today rather than delay enjoyment for one or more years.
The effects of time on the value of money need to be taken into account when assessing investments. Key concepts are Present Value, Future Value.
For example, consider the following situation.
An investor can achieve a guaranteed interest rate each year of 7 percent. What is worth more to this investor: $100 today to invest at 7 percent or a guaranteed payment of $200 in 6 years time?
Financial tables or calculations enable us to find the present value of $200 from 6 years in the future with a 7% interest rate environment.
PV = FV / (1 + i)n
PV = Present Value
FV = Future Value
i = interest rate
n = number of years
In our example,
PV = 200 / (1 + 0.07)6
i.e. PV = $133.27
The present value of the sum promised in six years time is higher than today’s $100 and the investor should choose this option to maximise his return.
Present value is the current worth of a future sum of money or sums of money at a specified rate of return.
When we assess the present value of a future sum, we need to choose an approprate discount (interest) rate.
In the example above, the discount rate is 7%. The higher the discount rate chosen by the investor, the lower the present value of the future money.
Using an appropriate discount rate is essential in the valuation of future cash flows and this can be as much of an art as it is a science.
Margin of Safety
Margin of safety is the difference between the intrinsic value of a stock or a company and its quoted market value.
Margin of Safety = Intrinsic Value – Market Value
If we calculate the (intrinsic) value of a stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
Warren Buffett, Chairman’s Letter To the Shareholders of Berkshire Hathaway, 1996
Book Value
A company’s book value is its total assets minus intangible assets and liabilities.
In the case of a stock, the book value per share is the same as net tangible assets per share
Unlike intrinsic value, book value is a number that may be exactly determined by examining a company’s accounts.
Discounted Cash Flow
Discounted cash flow (DCF) uses the time value of money to assess and compare investments.
There are two crucial parts of the valuation – the discount and the cash flow. Both must be estimated by the investor.
The cash flow is how much money the investment will return annually. It might, for example, be the interest paid by a bond or the earnings per share from a stock.
The discount is the percentage by which the investor believes the annual return must be reduced. For example, the interest rate from a bond could be the cash flow, and the discount rate could be the expected rate of inflation.
The discount rate need not be the rate of inflation. For example, an investor might consider investing in company shares. He might use the interest rate on government bonds as the discount rate. He would then be said to have taken the risk free rate of return as his discount rate.
Alternatively, he might say he’s not interested in investing in anything that won’t return at least 10 percent a year and set 10 percent as the discount rate.
Example
An investor usually sets a discount rate of 13%. She believes this is sufficient to cover inflation and most risks. For several years, she has been successful in choosing investments that are successful at this discount rate. (If she believes an investment carries unusually high risks, she sets a higher discount rate.)
She is offered the opportunity to buy bonds in a blue chip company. The bonds promise to pay investors a lump sum that’s double their original investment in six years’ time.
To assess whether to invest $100,000 in order to receive $200,000 in six years’ time she calculates the present value of the future cash flow using her chosen discount rate of 0.13.
PV = FV / (1 + d)n
where:
PV = Present Value
FV = Future Value
d = discount rate
n = number of years
PV = $200,000/(1 + 0.13)6
hence:
PV = $96,063
The present value of the bond is worth less to the investor than her money currently has, therefore she declines the opportunity to buy these bonds.
Return on Equity
A company’s equity is the value of its net assets.
Return on equity is a company’s after-tax profit divided by its net assets.
The higher this number, the more efficiently the company is making use of its assets.
Companies that produce a high return on equity and reinvest the proceeds grow their annual profit faster than companies with a low return on equity. Investors, however, should be careful if companies are using high debt to produce an apparently high return on equity. (See examples below.)
Investments such as real estate can also be judged by their return on equity.
Example 1
You buy a rental property for $300,000 using $100,000 of your own capital and $200,000 of commercial mortgage.
After a year, you have collected $29,000 of rent. Your running costs were $3,000, you paid $12,000 interest on your mortgage and $3,000 in taxes.
Profit after tax = $11,000
Equity = $100,000
Return on equity = 11,000/100,000 = 11%
Example 2
As per Example 1, except you use $20,000 of your own capital and $280,000 of commercial mortgage. You pay $16,800 in interest and $2,000 in taxes. (Taxes fall as your interest bill rises and profit falls.)
Profit after tax = $7,200
Equity = $20,000
Return on equity = 7,200/280,000 = 25.7%
So, for the same business activity (rental property) taking on more debt leads to a much higher return on equity. Investors, therefore, should not use return on equity alone to compare businesses. They need to ensure the returns on equity are being achieved without using a high debt to equity ratio.
Time Value
Time value has definitions both in options pricing and the time value of money.
Time Value in Option Pricing
When dealing with an option, such as a stock option, the option’s price has two conceptual components – the intrinsic value and the time value.
Time has a value. Longer dated option expiry dates attract higher prices because they allow more time for the strike price to be reached.
An option trading at its intrinsic value with no time value is said to be trading at parity and its expiration is probably imminent.
Time Value and Money
Money’s value changes with time as a result of interest earned and inflation. The effect of time on the value of money needs to be taken into account when assessing investments. Key concepts are Present Value and Future Value.
For example, consider the following situation.
An investor can achieve a guaranteed interest rate each year of 7 percent. What is worth more to this investor: $100 today to invest at 7 percent or a guaranteed payment of $200 in 6 years time?
Financial tables or calculations enable us to find the present value of $200 from 6 years in the future with a 7% interest rate environment.
PV = FV / (1 + i)n
PV = Present Value
FV = Future Value
i = interest rate
n = number of years
In our example,
PV = 200 / (1 + 0.07)6
i.e. PV = $133.27
The present value of the sum promised in six years time is higher than today’s $100 and the investor should choose this option to maximise his return.
Present value is the current worth of a future sum of money or sums of money at a specified rate of return.
When we assess the present value of a future sum, we need to choose an approprate discount (interest) rate.
In the example above, the discount rate is 7%. The higher the discount rate chosen by the investor, the lower the present value of the future money.
Using an appropriate discount rate is essential in the valuation of future cash flows and this can be as much of an art as it is a science.
Intrinsic Value
On its own the word intrinsic means basic or fundamental or inborn. So instead of talking about intrinsic value, investors could equally talk about fundamental value.
Intrinsic Value of Stocks
The influential value investor, Benjamin Graham, believed the intrinsic value of a stock was a rather subtle concept and different from its market valuation as measured by the price quoted on a stock exchange.
Investors originally believed intrinsic value was arrived at by subtracting a company’s liabilities from its assets. This idea, however, ignored a company’s return on equity, profits, and future return and profit expectations. Clearly these are necessary components in determining the intrinsic value of a company.
Given that future expectations can only be estimated, the intrinsic value of a company or stock can also only be estimated. Investors should estimate a reasonable range within which a company’s true intrinsic value is likely to lie.
Most investors now measure a company’s intrinsic value by calculating the present value of all future expected net cash flows. The present value is calculated using a discounted cash flow.
For situations in which a company’s current stock market valuation is lower than its intrinsic value, Benjamin Graham coined the phrase margin of safety.
Warren Buffett explained intrinsic value to Berkshire Hathaway shareholders using an analogy with the cost of a college education.
He told his shareholders to consider the total cost of education as its book value. This cost would contain the actual cost of the years spent studying plus the earnings lost as a result of not working.
Then estimate the excess earnings resulting from the college education. That is subtract the earnings expected without the education from the earnings expected with the education.
That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day.
The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
Warren Buffet, Berkshire Hathaway Owner’s Manual
Intrinsic Value of Options
When dealing with an option, such as a stock option, the option’s price has two conceptual components – the intrinsic value and the time value.
Only in-the-money options have intrinsic value. The value exists because the option is priced favourably compared with the underlying asset.
For example, if ABC stock is trading at $114, while a call option on ABC stock has a strike price of $100, the intrinsic value of the call option is $14.
Investment Strategy
An investment strategy represents the overall plan of action by which an investor seeks to profit from his or her financial assets.
The driving force of Warren Buffett’s investment strategy is the rational allocation of capital… determining how to allocate one’s savings is the most important decision an investor will make. Rationality – displaying rational thinking when making that choice – is the quality Buffett most admires. Despite its underlying vagaries, there is a line of reason that permeates the financial markets. Buffett’s success is a result of locating that line of reason and never deviating from its path.
(His) success is as much a result of eliminating those things you can get wrong… as it is about getting things right, which are few and simple (valuing a business and paying a price for the business that is below its intrinsic value).
Robert G. Hagstrom, The Essential Buffett
The global macro approach to investing attempts to generate outsized positive returns by making leveraged bets on price movements in equity, currency, interest rate, and commodity markets. The macro part of the name derives from manager’s attempts to use macroeconomic principles to identify dislocations in asset prices, while the global part suggests that such dislocations are sought anywhere in the world.
Joseph G. Nicholas, Inside the House of Money, edited by Steven Drobny.
The reason CAN SLIM continues to work cycle after cycle is that it’s based solely on the reality of how the stock market actually works rather than on our personal opinion or anyone else’s, including Wall Street’s. Furthermore, human nature at work in the market simply doesn’t change. So CAN SLIM does not get outmoded as fads, fashions and economic cycles come and go.
William J. O’Neil, How to Make Money in Stocks
Straddle Option
A straddle option is one of the simplest combination strategies in options trading.
If an investor believes there could be a big price movement in some asset, such as a stock or commodity, but he is unsure whether the move will be upwards or downwards he could adopt a straddle trading strategy. Such a situation could arise if a company was defending a lawsuit. A guilty verdict would send the stock plummeting while a not guilty verdict would cause the stock price to soar.
The investor could buy a call option and a put option with the same strike price and the same exercise date. This is termed a long straddle. In theory, “not guilty” results in the call option producing a profit, while the put option is profitable in the event of “guilty”.
If other traders have the same idea as our investor the prices of both calls and puts will rise reducing the potential profit from the straddle – perhaps to the point where making any profit is difficult.
Writing straddle options – short straddles – is, like selling naked calls, a very dangerous strategy.
The writer of a short straddle takes the opposite view to the long straddle. The short straddle writer hopes to profit from relative stability in the price of the underlying asset. In 1995 options trader Nick Leeson took short straddle positions on the Nikkei 225 stock index. Leeson bet the Nikkei would not stray far from 19,000. His bet failed and his losses of $1.4bn caused the collapse of his employer, Barings Bank. Barings had been trading for 233 years.
Out-of-the-Money
Out-of-the-money is a term from options trading.
A call option (the right to buy a stock at a set price) is out-of-the-money when the stock price is lower than the option strike price.
A put option (the right to sell a stock at a set price) is out-of-the-money when the stock price is higher than the option strike price.
An out-of-the-money option has no intrinsic value, only time value. The option has time value until it reaches its expiry date.
Jim Leitner uses an option-based strategy whenever possible to manage his fund and is not afraid to sit on long-dated out-of-the-money options and just wait until they eventually pay off.
“When I started trading currencies, options didn’t even exist. Today you can get options on anything and the bid/offer spreads are peanuts.”
Jim Leitner speaking to Steven Drobny, Inside the House of Money
Options can also be at-the-money or in-the-money.
At-The-Money
At-the-money is a term from options trading.
The option is said to be at-the-money when the underlying asset is trading at the same price as the option.
For example, if a stock is trading at $50 and the option strike price is $50, the option is at-the-money.
An at-the-money option has no intrinsic value, only time value. The option has time value until it reaches its expiry date.
As a rough approximation, the price of an at-the-money option increases with the square root of its time to maturity.
John C. Hull in The Harriman Book of Investing Rules, edited by Philip Jenks and Stephen Eckett.
Options can also be in-the-money or out-of-the-money.
Underlying Asset
Underlying asset is a term from derivatives trading. For example, in the case of a Microsoft stock option, the underlying asset is Microsoft stock. In the case of gold options, the underlying asset is gold. Price movements of options are derived from price movements of the underlying assets – hence the term derivatives.
It is possible to have underlying assets which are themselves derivatives; for example, options on gold futures. In this case the gold future is the underlying asset, while the gold future is also a derivative of gold.
Option Pricing
The principle considerations in option pricing are the value of the underlying asset, the options expiry date, expectations for volatility, and, in the case of a stock option, for example, expectations for interest rates and dividends.
Time has a value. Longer options expiry dates attract higher prices because they allow more time for the strike price to be reached.
Higher price volatility in the underlying asset also increases the price of an option. Many options writers use mathematical models to price options, the most popular of which is the Black-Scholes model.
Option pricing models such as Black-Scholes… should be used with caution by investors.
Professional traders price options as follows. Each day they observe the prices of a number of actively traded options in the market. They use Black-Scholes to calculate implied volatilities for these options. They then interpolate between the implied volatilities to get a table showing the implied volatility as a function of strike price and time to maturity. This table is used to price other options during the day.
John C. Hull in The Harriman Book of Investing Rules, edited by Philip Jenks and Stephen Eckett.
In-The-Money
In-the-money is a term from options trading.
A call option (the right to buy a stock at a set price) is in-the-money when the stock price rises enabling the option holder to buy shares for less than their current market price.
A put option (the right to sell a stock at a set price) is in-the-money when the stock price falls enabling the option holder to sell shares for more than their current price.
An in-the-money option has intrinsic value as well as time value. The option has time value until it reaches its expiry date.
Options can also be at-the-money or out-of-the-money.
Covered Calls
A call option gives its buyer the right but not the obligation to buy an asset at an agreed price (the strike price) within a fixed timeframe. The asset might be a stock, commodity or bond, for example.
The person who writes the option is legally obliged to sell the underlying asset (for example shares, if the option is a stock option) to the option buyer.
Call options are profitable for the buyer when the underlying asset’s price rises to reach or exceed the strike price.
Buyers of call options can lose no more than the price they pay for the option. Their gains are potentially very high.
Call options are sold (written) by people who believe the price of the underlying asset is unlikely to rise.
The writer sells the call for a sum of money called the premium.
The call option is said to be covered if the writer of the option owns the stock on which he has sold the call option. He will never be forced to go into the market to buy shares at a higher price than he has to deliver them to the option holder for.
The call option is uncovered or naked when the option writer does not own the stock he sells options for. Potential losses for people who write naked call options can be very large.
Naked Calls
A naked option (for example a naked stock option) is written by someone who does not own the underlying asset.
In the case of stock options, the naked call option writer offers to sell shares at a specified price in the future without actually owning any of these shares.
Writers of naked call options (also known as uncovered call options) expect the underlying asset price will not rise. Should they be wrong, they face potentially unlimited losses because there is almost no limit to how high a stock price might rise. The option writer is legally obliged to provide shares to the option holder at the strike price, which can be much lower than the current share price. Losses are enhanced by the leveraged nature of options – a single option usually controls 100 shares.
Naked call writing is one of the riskiest market transactions possible.
When one sells a call option without owning the underlying stock or any equivalent security (convertible stock or bond or another call option), one is considered to have written an uncovered call option. This strategy has limited profit potential and theorically unlimited loss… This fact is not particularly attractive, but since there is no actual cash investment required to write a naked call… the strategy can be operated as an adjunct to many other investment strategies.
Lawrence G. McMillan, Options as a Strategic Investment
Naked Puts
A naked put (or an uncovered put) is a put option issued by an option writer who does not hold the underlying asset.
Naked puts are used in the stock markets by investors seeking to build up their holdings in the underlying stock – but only if the stock’s price falls to the price they are willing to pay.
If the stock price does not fall sufficiently, the investor does not buy any shares, but makes a profit by holding on to the option premium – the price the buyers of the put options paid for the options.
In 1993 Warren Buffett used a naked put strategy to purchase shares in Coca-Cola. He determined that he was willing to pay $35 per share for the stock, which was trading at about $39. His method involved writing 5 million put options at a strike price of $35.
Warren Buffett’s Naked Put Option Strategy to Invest in Coca-Cola
If Coke stock fell below $35, the option takers would “put” their shares to him, Buffett would be forced to buy at $35. This was perfectly fine for Buffett because he wanted to buy at that price anyway. If Coke rose instead Buffett would be happy enough, he collected a $1.50 option premium ($7.5 million) even if the stock never fell to his target. Being a strict value investor he would not have been interested in buying Coke at more than $35 so therefore the fact that it went up without him buying it was perfectly fine by him.
Exercise Price
The exercise price, or strike price, is stated in all option contracts between two parties, for example in a stock option contract.
It is the price at which the owner of a call option can purchase (or the owner of a put option can sell) the underlying asset to the writer of the option. For example:
If you have a Microsoft August $70 call, you have the right but not the obligation to purchase 100 shares of Microsoft for a price of $70 – that is the (exercise) price… (Exercise prices) are usually available in $5 increments and in $2.50 increments for stocks under $25.
Bill Johnson with James DiGeorgia and David Nichols, An Investor’s Guide to Understanding and Mastering Options Trading
In the case of stock options, a call option is in-the-money if the market price of the stock is higher than the exercise price. A put option is in-the-money if the market price of the stock is lower than the exercise price.
Put Option
A put option gives its buyer the right but not the obligation to sell an asset at an agreed price (the strike price) within a fixed timeframe. The asset might be a stock, commodity or bond, for example.
The person who writes the option is legally obliged to buy the underlying asset (for example shares, if the option is a stock option) from the option buyer.
An auto insurance policy can behave like a put option:
You buy a policy for a premium and collect the insurance value if you wreck your car. If you do not wreck your car, you are out the amount only of the premium. Likewise, you can buy a put option for a premium and turn it back to the insurer (the put seller) if your stock should crash (fall below the strike price). If the stock stays above the strike, you would let the “insurance” expire and lose only the premium you paid.
Bill Johnson with James DiGeorgia and David Nichols, An Investor’s Guide to Understanding and Mastering Options Trading
Put options are profitable for the buyer when the underlying asset’s price falls to the strike price or below.
When the price of the underlying asset is lower than strike price, the option is in-the-money.
Buyers of options can lose no more than the price they pay for the option. Their gains are potentially very high.
If the asset’s price falls, but not sufficiently far to reach the strike price, the option holder might still be able to sell it on profitably to another trader, provided that trader sees a potential profit in the time remaining before the option expires.
Put options are sold (written) by people who believe the price of the underlying asset is unlikely to fall.
The writer sells the put for a sum of money called the premium.
Warren Buffett’s Naked Put Option Strategy to Invest in Coca-Cola
In April 1993, with Coca Cola stock hovering around $39 per share (before splits), Buffett valued the company and determined that he would be interested in buying some more shares if the price fell below $35.
He wrote 5 million put options with a $35 strike price.
If Coke stock fell below $35, the option takers would “put” their shares to him, Buffett would be forced to buy at $35. This was perfectly fine for Buffett because he wanted to buy at that price anyway. If Coke rose instead Buffett would be happy enough, he collected a $1.50 option premium ($7.5 million) even if the stock never fell to his target. Being a strict value investor he would not have been interested in buying Coke at more than $35 so therefore the fact that it went up without him buying it was perfectly fine by him.
Call Option
A call option gives its buyer the right but not the obligation to buy an asset at an agreed price (the strike price) within a fixed timeframe. The asset might be a stock, commodity or bond, for example.
The person who writes the option is legally obliged to sell the underlying asset (for example shares, if the option is a stock option) to the option buyer.
Coupons from shops often behave like call options:
Your local pizza place may have a coupon good for the next thirty days that allows you to buy a large pizza for $10. That is similar to a call option. It is like a contract that locks in the purchase price over a fixed time period. After that time period, the option to buy at that price expires… The big difference between a coupon and a call option is that you must pay for the option, while coupons are generally handed out free of charge.
Bill Johnson with James DiGeorgia and David Nichols, An Investor’s Guide to Understanding and Mastering Options Trading
Call options are profitable for the buyer when the underlying asset’s price rises to reach or exceed the strike price.
When the price of the underlying asset is higher than strike price, the option is in-the-money.
Buyers of options can lose no more than the price they pay for the option. Their gains are potentially very high.
If the asset’s price rises, but does not reach the strike price, the option holder might still be able to sell it on profitably to another trader, provided that trader sees a potential profit in the time remaining before the option expires.
Call options are sold (written) by people who believe the price of the underlying asset is unlikely to rise.
The writer sells the call for a sum of money called the premium.
Potential losses for people who write naked options can be very large.
Naked Options
An option is said to be naked if the person who writes the option (the option writer) does not own any of the underlying asset(s).
For example, someone might write a stock option offering to sell 100 IBM shares at price of $80 per share in three month’s time. The option is said to be naked if the writer does not own the shares he or she is offering to sell.
The writer of the call option above enters a legally binding contract to supply the person who buys the option with the underlying shares. (The writer of a put option enters a legally binding contract to purchase the underlying asset from the option buyer.)
The writer of a naked call option therefore enters a legally binding contract to supply the buyer with an asset the writer (seller) does not actually own. If the price of the underlying asset rises strongly, this can prove very expensive – perhaps catastrophically so – for the option writer.
Naked options can be classed as Naked Calls (the riskiest naked option to write) and Naked Puts.
Option Writer
The option writer’s purpose is to earn the premium paid by the option buyer.
The buyer pays a premium hoping that in the time before the option expires, the price of the underlying asset will move in the direction he has bet on.
The option writer has to take account of several factors in pricing the option including: the current price of the underlying asset, the historical volatility of the underlying asset and the value of time.
Time has a value – longer time frames are priced higher because it gives the underlying asset longer to reach the strike price, the price at which the buyer will be in-the-money.
Higher price volatility in the underlying asset also increases the premium the option writer will demand for an option. Assets prone to large price swings are more likely to move the buyer to an in-the-money position. Many options writers use the Black-Scholes model to price volatility, but the model is not universally loved.
The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes…
If the formula is applied to extended time periods, however, it can produce absurd results… Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism.
Warren Buffett, Berkshire Hathaway Shareholder Letter, 2008.
The option writer’s objective is option pricing that’s both sufficiently attractive for investors to buy and sufficiently far from the strike price that the writer will make a profit because the option will expire without reaching the strike price.
For any option that expires without being exercised, the writer keeps the full premium paid for the option by the buyer.
If the option buyer exercises the option, the writer pays the difference between the exercise price and the market value. Options are generally only be exercised when they are in-the-money sufficiently to make a profit for the buyer after all costs have been taken into account. This is the case with American options. If the option writer writes European options, these can only be exercised at their expiry date. (The American/European terminology is purely historical and is not related to where these options can actually be traded.)
Strike Price
The strike price, or exercise price, is stated in all option contracts between two parties, for example in a stock option contract.
It is the price at which the owner of a call option can purchase (or the owner of a put option can sell) the underlying asset to the writer of the option. For example:
If you have a Microsoft August $70 call, you have the right but not the obligation to purchase 100 shares of Microsoft for a price of $70 – that is the strike price… Strikes are usually available in $5 increments and in $2.50 increments for stocks under $25.
Bill Johnson with James DiGeorgia and David Nichols, An Investor’s Guide to Understanding and Mastering Options Trading
In the case of stock options, a call option is in-the-money if the market price of the stock is higher than the strike price. A put option is in-the-money if the market price of the stock is lower than the strike price.
Stock Option
A stock option is a legal contract between two parties who agree to trade a fixed number of shares with each other at a fixed price within a fixed timeframe. Like shares, options are traded on stock exchanges and are available through online stock brokers.
The obligations of the option buyer and seller are different.
The option buyer has the right to buy or sell shares at the specified price, within the specified time frame, but he or she need not exercise this right.
The option seller – often called the option writer – is legally obliged to fulfill the contract if the buyer chooses to exercise the option, which they will do if the contract is in profit.
The most basic attraction of options is leverage. The percentage movement in an option price is much higher than the percentage movement in the underlying share price.
Options are a type of financial derivative. This means their price is based on the price of an underlying asset. In the case of stock options, the underlying asset is shares. Options differ from their underlying assets in that they have an expiry date. The expiry date also helps determine the price of an option. The longer the time to the expiry date, the higher the price of an option – the buyer pays extra for additional time in which the underlying asset can reach a price that makes him or her a profit – or in traders’ jargon, until the option is in-the-money.
Option buyers’ potential profits are unlimited but, since they do not need to exercise the option, their loss is limited to the initial cost of the option. Option sellers must be more cautious. Writing naked options carries considerable risks.
There are two types of option – call options and put options.
A call option gives its buyer the right to buy shares at the strike price. The person who writes the option is legally obliged to sell stock to the option buyer if he or she requests it.
A put option gives its buyer the right to sell shares at the strike price. The person who writes the option is legally obliged to buy stock from the option buyer if he or she requests it.
In fact, shares do not need to change hands. If the option buyer is in-the-money when the option expires, they are generally paid their winnings in cash rather than via a delivery of shares.
A Stock Option Example
Suppose that shares of stock XYZ trade for $10, and a trader with $1,000 believes that in six months the stock price will double to $20.
He could buy 100 XYZ shares with his $1,000, and sell them in six months for $2,000, yielding a $1,000 profit.
Alternatively, an option to buy an XYZ share for $10 in six months time costs $2. Our trader could buy 500 XYZ options with his $1,000.
In six months time, if the trade turns out as he hopes, his options will give him the right to buy 500 shares for $10 when their price has risen to $20.
He could therefore sell 500 XYZ shares for $20 each, receiving $10,000. His profit (disregarding fees) would be $9,000 (the sale price of the shares minus the premium paid for the options) compared with a profit of $1,000 if he had traded the underlying shares.
If he were wrong and XYZ stock fell to $7, his options would expire with zero value and he would have lost the entire $1,000 premium he paid for the options compared with a loss of $300 if he had traded the underlying shares.
Costly common mistakes investors make – Speculating too heavily in options or futures because you see them as a way to get rich quick… Some investors also focus mainly on shorter-term, lower-priced options that involve greater volatililty and risk. The limited time period works against holders of short-term options.
William J. O’Niel, How to Make Money in Stocks
Macro trading is all about timing. We all know stuff is going to move, but we’re not exactly sure when. Options are the easiest way of controlling risk while affording a good return.
Interview with Currency Fund Manager, Steven Drobny, Inside the House of Money