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Collection of tutorials and a guide for using TGJU & Financial Markets
In the United States, all options contracts go through one of several options exchanges. An investor must have an account with a brokerage firm that provides options trading as part of its product offerings. As a brokerage customer, your options orders will be routed through the brokerage firm to one of the options exchanges. Depending on the broker, you may be able to “route” your order to send it to a particular exchange, or the brokerage firm will use a standardized method for selecting the exchange to carry out the order.
Before you can trade options, your broker will approve you for a specific level of options trading. You will have to fill out an options agreement form that is used to evaluate your understanding of options and trading strategies and your general investing experience. Generally, brokerages have four or five levels of approval that are based on factors such as your investing objectives, investing history and your account balance.
Your options trading level, such as “conservative” or “aggressive,” will determine the types of options strategies you will be able to trade. Since some strategies involve substantial risk, you may or may not be allowed to employ these riskier strategies, depending on your trading level. Typically, traders with more experience and more liquid assets are given higher approval levels; conversely, those with less experience and smaller accounts are given more conservative approval levels.
Once you have an account and have been approved for options trading, you can use the broker’s trading platform to scan for positions that match your market outlook or strategy and to submit orders. Alternatively, you can phone in orders by calling the broker’s trade desk.
There are other ways to trade options but they are not as common as routing orders through a broker. Over-the-counter (OTC) options are not traded via an exchange; instead, these contracts are executed between two independent parties. Since OTC options are not traded on exchanges, counter-party risk is not limited by the Options Clearing Corporation (OCC) as it is with exchange-traded options. Typically, only institutional traders or investors with large amounts of capital trade OTC options because of this increased financial risk. Well-capitalized professionals can also become members of one of the exchanges to place trades directly.
Wall Street, located in lower Manhattan, has become synonymous with the the US financial markets. Yet the history of the street goes back much further the New York Stock Exchange (NYSE).
Wall Street is a direct reference to a wall that was erected by Dutch settlers on the southern tip of Manhattan Island in the 17th century. The Dutch, located at the southernmost part of the island, erected a defensive wall to help keep out the British and pirates. Although this wall was never used for its intended purpose, years after its removal it left a legacy behind with the street being named after it.
This area didn’t become famous for being America’s financial center until 1792, when 24 of the United States’ first and most prominent brokers signed the Buttonwood agreement that outlined the common commission-based form of trading securities. Some of the first securities trades were war bonds, as well as some banking stocks such as First Bank of the United States, Bank of New York and Bank of North America.
The NYSE came later. In 1817 the Buttonwood agreement—named so because the agreement occurred under a Buttonwood tree—was revised. The organization of brokers renamed themselves the The New York Stock and Exchange Board. The the organization rented out space for trading securities, in several locations, until 1865 when they found their current location at 11 Wall Street.
The American Civil War occurred between 1861 and 1865, which actually helped the financial district get going.
In 1869, the New York Stock and Exchange Board merged with a competing firm that sprang up called The Open Board of Stock Brokers. With financial trading still getting its footing, the merger helped solidify the NYSE as one of the major places to go and trade. Membership was capped to a certain number of members, and remains capped, although increases in member have occurred over the years.
The 1929 stock market crash and the ensuing depression brought more government regulation and oversight to the US stock exchanges. Prior to this it was far less regulated, and after the crash politicians and the exchange realized more protocols had to be put in place to protect investors.
The NYSE is the largest stock exchange in the world by market capitalization. The NASDAQ Stock Exchange, at 165 Broadway, is the second largest exchange. While many still think of Wall Street as the financial center of the world, that is starting to change. While many financial firms were formerly headquartered on Wall Street, many have chosen to locate elsewhere. Many high frequency trading firms have taken up residence in New Jersey, for example. With electronic trading and technological advances in communication, it is no longer a requirement for traders to be at or near the financial district.
While the street continues to house the physical building of the NYSE, the street has much more history than just that. The name of the street dates back to a wall built in the 17th century. As the NYSE and US financial markets continue to more forward, much more will be written about this historic street in the future.
To read more about the beginnings of Wall Street, see The Stock Market: A Look Back.
As with most investment vehicles, risk to some degree is inevitable. Option contracts are notoriously risky due to their complex nature, but knowing how options work can reduce the risk somewhat. There are two types of option contracts, call options and put options, each with essentially the same degree of risk. Depending on which “side” of the contract the investor is on, risk can range from a small prepaid amount of the premium to unlimited losses. Thus, knowing how each works helps determine the risk of an option position. In order of increasing risk, take a look at how each investor is exposed.
Investor A purchases a call on a stock, giving him the right to buy it at the strike price before the expiry date. He only risks losing the premium he paid if he never exercises the option.
Investor B, who wrote a covered call to Investor A, takes on the risk of being “called out” of his long position in the stock, potentially losing out on upside gains.
Investor A purchases a put on a stock he currently has a long position in; potentially, he could lose the premium he paid to purchase the put if the option expires. He could also lose out on upside gains if he exercises and sells the stock.
Investor B, who wrote a cash-secured put to Investor A, risks the loss of his premium collected if Investor A exercises and risks the full cash deposit if the stock is “put to him.”
Suppose Investor B instead sold Investor A naked put. Then, he might have to buy the stock, if assigned, at a price much higher than market value.
Suppose Investor B sold Investor A call option without an existing long position. This is the riskiest position for Investor B because if assigned, he must purchase the stock at market price to make delivery on the call. Since market price, theoretically, is infinite in the upward direction, Investor B’s risk is unlimited.
Forward contracts are buy/sell agreements that specify the exchange of a specific asset and on a specific future date but on a price that is agreed upon today. They do not require early payment or down payment unlike some other future commitment derivative instruments. Since no money changes hands at the initial agreement, no value can be attributed to it. In other words, the forward price is equal to the delivery price.
Derivative valuation is not an exact science, and it is a subject of serious philosophical and methodological deviation between financial economists, security engineers and market mathematicians. The most common treatment of forward contracts begins with the assumed observation that forward contracts can be stored at zero cost. If a security can be stored at zero cost, then the forward price for delivery of the security is equal to the spot price divided by the discount factor.
You may see this expressed as: F = S / d(0,T), where (F) is equal to the forward price, (S) is the current spot price of the underlying asset, and d(0,T) is the discount factor for the time variable between the initial date and the delivery date.
This might seem complicated and technical, which it is; the discount factor depends on the length of the forward contract. Mathematically, this is demonstrated as an equilibrium price because any forward price above or below this value represents an arbitrage opportunity.
At a date where (T) is equal to zero, the value of the forward contract is also zero. This creates two different but important values for the forward contract: forward price and forward value. Forward price always refers to the dollar price of assets as specified in the contract. This figure is fixed for every time period between the initial signing and the delivery date. The forward value begins at storage cost and tends toward the forward price as the contract approaches maturity.
What is the initial value of a $300,000 mortgage contract that requires a 15% down payment? Simple economic logic suggests the initial contract value is $45,000, or 0.15 x $300,000. That is how much money the lender demands to establish the contract. The borrower also agrees to part with $45,000 to receive the initial contract.
Carry this logic to forward contracts. The vast majority of forward contracts carry no down payment. If both parties are willing to exchange their commitment to the contract for $0.00, then it follows that the initial value of the contract is zero.
These explanations are incomplete, because they ignore many of the factors associated with mortgage and forward contracts, namely the underlying assets. However, in a strict economic sense, these arguments are valid as far as they go.
| Why Should I Invest?A: |
There are only two ways to make money in our modern world: by working, for yourself or someone else, and/or by having your assets work for you. If you keep your life savings in your back pocket or under a mattress, instead of investing, the money doesn’t work for you and you’ll never have more than what you save or receive through inheritance. Conversely, investors generate money by earning interest on what they set aside or by buying assets that increase in value.
It doesn’t matter how you do it. Whether you invest in stocks, bonds, mutual funds, options, futures, precious metals, real estate, a small business or a combination of assets, the objective is the same: to make investments that generate additional cash. As the old expression goes, “Money isn’t everything but happiness alone can’t keep out the rain.” So, whether your goal is to send your kids to college or to retire on a yacht in the Mediterranean, investing is essential in getting where you want to go in life.
Investment goals diverge, depending on age, income and outlook. You can further sub-divide age into three categories, young and starting out, middle aged and family building, old and self-directed. These segments often miss their marks at the appropriate age, with middle-aged folks considering investments for the first time or the elderly forced to budget, employing the discipline they lacked as young adults.
Income provides as the natural starting point for investment planning because you can’t invest what you don’t have. The first career job issues a wake-up call for many young adults, forcing decisions about IRA contributions, savings or money market accounts, and the sacrifices needed to balance growing affluence with the desire for gratification. Don’t worry too much about setbacks during this period, like getting overwhelmed by student loans and car payments, or forgetting that your parents no longer pay the monthly credit card bill.
Outlook defines the playing field on which we operate during our lifetimes and the choices that impact wealth management. Family planning sits at the top of this list for many individuals, with couples figuring out how many kids they want, where they want to live, and how much money is needed to accomplish those goals. Career expectations often complicate these calculations, with the highly-educated enjoying increased earning power while those stuck in low level jobs are forced to cut back to make ends meet.
It’s never too late to become an investor. You may be well into middle age before realizing that life is moving quickly, requiring a plan to deal with old age and retirement. Fear can take control if waiting too long to set investment goals but that should go away once you set the plan into motion. Remember that all investments start with the first dollar, whatever your age, income or outlook. That said, those investing for decades have the advantage, with growing wealth allowing them to enjoy the lifestyle that others cannot afford.
Articles that will help you on your way: Basic Investment Objectives, Ten Tips For The Successful Long-Term Investor and Ten Books Every Investor Should Read.
Return on equity (ROE) and return on capital (ROC) measure very similar concepts, but with a slight difference in the underlying formulas. Both measures are used to decipher the profitability of a company based on the money it had to work with.
Return on equity measures a company’s profit as a percentage of the combined total worth of all ownership interests in the company. For example, if a company’s profit equals $10 million for a period, and the total value of the shareholders’ equity interests in the company equals $100 million, the return on equity would equal 10% ($10 million divided by $100 million).
There are number different figures from the income statement and balance sheet that a person could use to get a slightly different ROE. A common method is to take net income from the income statement and divide it by total shareholders equity on the balance sheet. If a company had a net income of $50,000 on the income statement in a given year, and recorded total shareholders equity of $100,000 on the balance sheet in that same year, then the ROE is 50%. Some top companies routinely have an ROE north of 30%.
Return on capital, in addition to using the value of ownership interests in a company, also includes the total value of debts owed by the company in the form of loans and bonds.
For example, if a company’s profit equals $10 million for a period, and the total value of the shareholders’ equity interests in the company equals $100 million, and debts equal $100 million, the return on capital equals 5% ($10 million divided by $200 million).
As with ROE, and investor could use various figures from the balance sheet and income statement to get slightly different variations of ROC. Ultimately what matters is that the investor uses the same calculation over time, as this will reveal wether the company is improve, staying the same, or declining in performance over time.
A common method for calculating ROC is to take long-term debt from the balance sheet and add it to total shareholders equity. Divide net income by this total debt+equity figure. If a company had a net income of 50,000 on the income statement in a given year, recorded total shareholders equity of 100,000 on the balance sheet in that same year, and had total debts of 65,000, then the ROC is 30% (50,000 / 165,000). This is a very quick way to calculate ROC, but only for very simple companies. If a company has lease obligations this too needs to factored in. If a company has one time gains which aren’t useful for comparing the ratio year-to-year, then these would need to be deducted. For additional ways of calculating ROC, see Return on Invested Capital.
ROC and ROE are well-known and trusted benchmarks used by investors and institutions to decide between competing investment options. All other things being equal, most seasoned investors would choose to invest in a company with a higher ROE and ROC when compared to a company with lower ratios.
Return on sales (ROS) is another ratio that often comes up when discussing ROE and ROC.
Businesses and accountants measure ROS to gauge how efficiently profit is generated against sales.
Return on sales reflects operating performance. ROS is commonly referred to as “net profit margin” or “operating profit margin.” The formula used to generate ROS varies, but the standard equation is net income before interest and taxes divided by the total sales revenue.
On its own, ROS doesn’t provide a ton of information because i…
The volatility skew refers to the shape of implied volatilities for options graphed across the range of strike prices for options with the same expiration date. The resulting shape often shows a skew or smile where the implied volatility values for options further out of the money are higher than for those at the strike price closer to the price of the underlying instrument.
Implied volatility is the estimated volatility of an asset underlying an option. It is derived from an option’s price, and is one of the inputs of many option pricing models such as the Black-Scholes method. However, implied volatility cannot be directly observed. Rather, it is the one element of the options pricing model that must be backed out of the formula. Higher implied volatilities result in higher option prices.
Implied volatility essentially shows the market’s belief as to the future volatility of the underlying contract, both up and down. It does not provide a prediction of direction. However, implied volatility values go up as the price of the underlying asset goes down. Bearish markets are believed to entail greater risk than upward trending ones.
Traders generally want to sell high volatility while buying cheap volatility. Certain option strategies are pure volatility plays and seek to profit on changes in volatility as opposed to the direction of an asset. In fact, there are even financial contracts which track implied volatility. The Volatility Index (VIX) is a futures contract on the Chicago Board of Options Exchange (CBOE) that shows expectations for the 30-day volatility. The VIX is calculated using the implied volatility values of options on the S&P 500 index. It is often referred to as the fear index. VIX goes up during downturns in the market and represents higher volatility in the marketplace.
There are different types of volatility skews. The two most common types of skews are forward and reverse skews.
For options with reverse skews, the implied volatility is higher on lower option strikes than on higher option strikes. This type of skew is often present on index options, such as those on the S&P 500 index. The main reason for this skew is that the market prices in the possibility of a large price decline in the market, even if it is a remote possibility. This might not be otherwise priced into the options further out of the money.
For options with a forward skew, implied volatility values go up at higher points along the strike price chain. At lower option strikes, the implied volatility is lower, while it is higher at higher strike prices. This is often common for commodity markets where there is a greater likelihood of a large price increase due to some type of decrease in supply. For example, the supply of certain commodities can be dramatically impacted by weather issues. Adverse weather conditions can cause rapid increases in prices. The market prices this possibility in, which is reflected in the implied volatility levels.
A contingent claim is another term for a derivative with a payout that is dependent on the realization of some uncertain future event. Common types of contingent claim derivatives include options and modified versions of swaps, forward contracts and futures contracts. Any derivative instrument that isn’t a contingent claim is called a forward commitment.
Vanilla swaps, forward and futures are all considered forward commitments. These are relatively rare, making options the most common form of contingent claim derivative.
In a contingent claim, one party to the contract receives the right – not the obligation – to buy or sell an underlying asset from another party. The purchase price is fixed over a specific period of time and will eventually expire.
By creating a right and not an obligation, the contingent claim acts as a form of insurance against counterparty risk.
The payoff for all financial options is contingent on the underlying asset or security reaching a target price or satisfying other conditions. The most common contingent claim transaction is an option traded on an option exchange. In these cases, the contingent claim is standardized to facilitate speed of trade.
For example, suppose a stock is trading at $25. Two traders, John and Smith, agree to a contract whereby John sells a contingent claim that stipulates he will pay Smith if, after one year, the stock is trading at $35 or above. If the stock is trading at less that $35, Smith receives nothing.
Smith’s claim is obviously contingent on the $35 strike price on the option. Because the financial contract is being agreed to today (and not a year from now), Smith has to pay John for the right to that claim.
In essence, Smith is betting that the price will be higher than $35 in a year, and John is betting that the price will be less than $35 in a year.
Selling naked calls creates unlimited liability. Therefore, these types of option strategies are considered appropriate for sophisticated traders with proper risk management and discipline due to the limitless losses.
Selling calls is typically done against existing stock holdings in an attempt to create income from the position by capturing premium. For example, assume that a trader owns 1,000 shares of Apple Inc., which is trading at $125. The trader sells 10 calls at a strike price of $150 for $2. Each option contract represents 100 shares, so the sale nets the trader $2,000.
Essentially, if Apple climbs above $150, the trader must sell his position or buy back the options. If Apple does not climb above that level by the option’s expiration date, he can hold onto his shares and pocket the premium. Owning the shares takes the risk away from this strategy.
In the case of naked selling of call options, the risk is theoretically unlimited. Suppose a trader sells calls on a company that is trading for $10. He believes the upside is limited for the company and sells 100 calls at a strike price of $15 for $1. From this sale, he collects $10,000.
It turns out that the trader’s judgement is incorrect, and a competitor buys out the stock for $50. All of a sudden, the call options that the trader is short climbs to $35, even though he sold them for $1. His $10,000 profit would turn into a $350,000 loss. This example illustrates the dangers of naked selling call options.
Naked selling of put options can be quite dangerous in the event of a steep fall in the price of a stock. The option seller is forced to buy the stock at a certain price. However, the lowest the stock can drop to is zero, so there is a floor to the losses. In the case of call options, there is no limit to how high a stock can climb, meaning that potential losses are limitless.
An option contract is a financial derivative that represents a holder who buys a contract sold by a writer. The moneyness of an option describes a situation that relates the strike price of a derivative to the price of the derivative’s underlying security. A put option can be either out of the money, at the money or in the money.
A put option buyer has the right – but not the obligation – to sell a specified quantity of the underlying security at a predetermined strike price on or before its expiration date. On the other hand, the seller, or writer, of a put option is obligated to buy the underlying security at a predetermined strike price if the corresponding put option is exercised. A put option should only be exercised if the underlying security is in the money.
A put option is in the money when the current market price of the underlying security is below the strike price of the put option. The put option is in the money because the put option holder has the right to sell the underlying above its current market price. When there is a right to sell the underlying security above its current market price, then the right to sell has value equal to at least the amount of the sale price less the current market price. The amount that a put option’s strike price is greater than the current underlying security’s price is known as intrinsic value because the put option is worth at least that amount.