I’ve run across several links recently to a site called mixergy that interviews web entrepreneurs about how they got started in thier businesses, how they’re doing today and their plans for the future. Its a great resource if you’re looking for inspiration, a few war stories and the nitty gritty on what it takes to get started and run a profitable internet business. All the videos are completely free to watch and most are 10+ minutes, much more than just sound bytes. Check it out http://www.mixergy.com
I missed a speaking event with Gary Vaynerchuk in Seattle a few months back, but have been following him a bit online and his bestseller Crush It! is on its way from Amazon as we speak.
He’s pretty direct and to the point when it comes to talking about the opportunity available to entrepreneurs today in the face of online marketing and the web.
I’ve been perusing hulu.com today for some great content (don’t have cable, a trend Gary touches on in his talk) and stumbled across a great recording on Gary Vanyerchuk talking in San Franscisco in December 2009. Its free to watch and really motivational, check it out: http://www.hulu.com/watch/115722/foratv-technology-wine-library-tvs-gary-vaynerchuk-on-crush-it#s-p1-sr-i0
I was listening to NPR this morning and heard an awesome story. Local utility Puget Sound Energy has found its cheaper to offer customers rebates than to build new equipment to keep up with demand. This caught my ear due to the novelty of the idea. The idea of paying your customers to not use as much of your product as they used to seems backwards but, if your product is critical, it may offer you the ability to increase prices and improve margins and margins can make or break you as a company.
Would you rather have 100 plants that you have to build, maintain and rebuild that make a 1% profit or 10 plants that you have to build, maintain, and rebuild but you can make a 10% profit? The same overall income, but far less risk and far fewer headaches.
I can’t think of any other immediate parallels to this great concept of paying your customers to use less of your product so you can build margins, but the idea seems fantastic to me. PSE is very generous with their rebates, I’ve taken advantage of them myself when I bought my new water heater. I don’t know if they do this to increase profits down the road or just to provide a great public utility service but, the point is, it doesn’t really matter. If they can provide rebates that allow me to reduce my power consumption by 50%, I’d happily pay 2x for my energy. Its neutral to me from a money standpoint and it makes me feel better because I’m doing what I can to save the environment.
I just finished taking the BBC’s “Brain Sex” test. It took about 15 minutes, I highly recommend it. You can learn a lot about yourself, and it is a fun way to work your brain a bit. Don’t worry, its a family friendly test!
Toward the end of the test, there is an interesting question that has a bit of a personal finance twist:
Imagine you have been paired up with someone for this task. You have both been given some money to divide between you. You decide how much you want. The other person decides whether the split is acceptable.
If they say it’s OK – you get the money you demanded and they get the rest. If they say it’s not OK – both of you leave with nothing.
If you have been given £50 to split, how much would you demand for yourself?
What would your answer be? I picked $25 and, while I won’t give away the analysis behind the answer, I can tell you that $25 isn’t the norm!
Take the test at: http://www.bbc.co.uk/science/humanbody/sex/
Several years ago I picked up a copy of Robert Allen’s book Multiple Streams of Income and read it over the course of a weekend. I don’t remember it as being a terribly substantial book, but the premise has stuck with me.
To be a prudent investor, one must diversify their investments. When you think of diversification though, I’d also like you to think about it in terms of your income streams, not just your investments. It is important to diversify your income streams for many reasons.
The primary reason to develop multiple streams of income is for a reason I like to call “income redundancy”. By having multiple streams of income, if any one stream dies off for whatever reason, you have other streams to help keep things going. If you get laid off from your job, having a second stream of income may help to deal with the cash flow crunch while you find a new position. If a tenant moves out of your rental property, its nice to be able to use your stock dividends to help cover your rental expenses during the vacancy.
The second reason to work towards multiple streams of income is what I call “income home runs”. Just like with investing in several different stocks, its nice to have several streams of income operating simultaneously in case one really takes off. An example of this for me is trying to have a stream of income coming in through online advertising. While my online advertising income through Google Adsense and Commission Junction is a drop in the bucket compared to my salary, it is another ‘iron in the fire’. If any of my various websites take off, my online advertising income has a chance to greatly increase. Without having this stream in place at all, I have no ability to capitalize on any unexpected bump. The same logic goes for stock dividends in regards to raised yields or one-time special dividends or even rental income if the rental rates in your area increased dramatically due to nearby development, community improvement, etc.
Lastly, having multiple streams of income can offer tax benefits. As we all know (and Ron Paul loves to comment on), the income tax system is very complex. Tax rates differ based on income type. Short term capital gains, long term capital gains, dividend income, rental income and standard hourly/salary income can all be taxed differently. Consult with a tax accountant to find out which types of income may benefit you most, but diversifying your streams of income could have a noticeable impact on tax rates. You may be able to defer some types, deduct portions of some types or have some types taxed at lower rates than the others.
Now, the fun part. There are lots of blogs, books and online communities about creating multiple streams of income. Please, leave a comment with your favorite resources online or a quick note about what you have done to acheive multiple streams of income. Do you have a hobby you capitalize on? A small business you run on the side? An effective divident portfolio that you use to supplement your standard income? Let me know! I’d love to hear about it and share it with others. To get you started, I recommend looking at the Rich Dad, Poor Dad Forums. There are a lot of entrepreneurs in the forums that are happy to help folks work through their ideas.
In recent articles (Options Basics, Options Leverage) I’ve discussed using options to boost your leverage and reduce capital requirements on making a big play. Options, while risky, can limit the amount of cash you need to put into a trade and can allow you to use your available cash to highly leverage your position without taking on debt via a margin approach.
Options aren’t only useful for increasing your potential gains though, they can also be used to mitigate your losses. Options are used by most investors as a hedge, a means to limit their risk in significant positions. There are more kinds of risk than there are investments, since every instrument carries several kinds of risk, but as an active investor, one must realize that risk isn’t inherently bad. Without risk there would be fewer opportunities for profit.
The main risk in any type of investing and especially in securities is price uncertainty. No one knows for sure whether Google’s stock price (GOOG) will be higher or lower tomorrow, let alone a week or a month from now.
Options, like futures or bonds, carry an additional risk – at some point, from a day to several months or years, they expire. On or any time before that date, the holder has to decide whether to sell the contract, exercise the option to buy, sell the underlying asset, let the option expire worthless.
Each of these options carries implications for gain or loss. Execute or sell an options contract too early and you risk losing any upward movement in the price after you sell. Execute or sell too late and you take the brunt of the time decay and put yourself at risk for negative movements in the stock price.
Complicating the price and timing risks of options is their volatility risk. It is uncertain, on any given day, how much the price will vary and how rapidly.
Ironically, options themselves are forms of risk management. Since the underlying asset has inherent risks as an investment, buying options allows holders to compensate for them.
The leverage of options is one form in which options help you, as an investor, manage risk. Leverage is the ability to control more than you own. Suppose you want to purchase a 100 shares of Google. At the current market price that’s an outlay of around $51,575 (excluding commissions). That’s a hefty sum for the average investor.
But you can control 100 shares of GOOG without owning them for about 1/50th of the cost – currently around $1050 – the price of one option. (One options contract typically is written on 100 shares.)
How is that a form of risk management? The reason is there’s another kind of risk: principal risk. I.e the risk of losing (all or part of) your investment. (Actually this is a form of price risk.)
Purchase a 100 shares of GOOG and you stand to lose $51,150 in the (very unlikely) case that Google goes bust. (Unlikely, but not impossible. Rapid shifts in technology or other factors have tanked more than one high-tech stock).
Purchase one option instead and your principal risk is limited to the $1050 cost of the option.
This is one way to hedge, but isn’t the most common usage for options in regards to risk management. Another approach to managing your risk is to hedge your existing long position in an underlying stock. Lets assume you worked for Microsoft in the 80’s and 90’s and built up a considerable position in the company’s stock. You may not want to sell your stock for one reason or another (tax implications, confidence in the company, etc), but you realize its irresponsible to leave so much of your nest egg in one company. One method that will allow you to retain your long position is to offset your risk by buying some put options. Buying a put will allow you to sell 100 shares of your underlying stock at a given price up to an including a given date. If you have 1000 shares of Microsoft stock, equating to nearly $30,000 dollars, you could currently buy January 2009 $27.50 puts for $2.75 (meaning $275.00). Basically, for $2750, you can sell all your stock in January 2009 for 27.50 a share. That equates to about $5000 less than the price you could currently get, but risk management is all about mitigating risk. Having the puts sets the ‘floor’ at which you can sell your stock. If microsoft stock is at $20 in Jan. 2009, you can still sell your stock for $27.50 per share. In this example, your $2750 investment protects you from losing $10000 if the price of microsoft’s stock declines by $10/share in the next 16 months. You may not want to put all 10 puts to protect all 1000 shares, but you get the point. You can offset some of your risk and set a floor at which you can sell your stock at a given price in the future. Interested in hedging but don’t want pay $2750 to protect it? Buy a $22.50 January 2009 call for only 1.05. Basically, for just over $1000, you’ll have the right to sell your Microsoft stock for $22.50/share anytime in the next 16 months. Think of it as insurance, its protecting against catastrophy. Will your car insurance to protect your $30,000 car cost you more than $1000 for the next 16 months? Quite possibly. Shouldn’t you have the same level of insurance on your retirement portfolio?
I’ve been writing about my experience with options trading for a while now and feel like I often have to explain options-related terminology within my articles so I’ve decided to just post a quick glossary of terms that I’ll be able to refer to in future articles. This is just a basic list, but ought to cover most of the phrases I’ll use in future articles.
Options Trading Jargon:
- Bid – The highest offered price at a specified time.
- Black-Scholes Model – A theoretical method of pricing using strike price, market price, interest rates, expiration date and other factors.
- Butterfly Spread – A trading strategy consisting of the purchase of two identical options, together with the sale of one option with a higher strike price, and one option with an lower strike price. (All options are of the same type, have the same underlying asset and the same expiration date.)
- Calendar Spread – A trading strategy consisting of one long and one short option of the same type with the same exercise price, but which expire in different months.
- Call – An options contract conferring the right to buy an underlying asset, such as 100 shares of stock, at a pre-set price, by a specified date.
- Condor – A trading strategy consisting of the sale (or purchase) of two options with consecutive exercise prices, together with the sale (or purchase) of one option with a lower exercise price and one option with a higher exercise price.
- Covered Call – A trading strategy which consists of holding a long position in an asset and selling call options on that same asset.
- Delta – A ratio comparing the change in the price of an option to that of a change in the underlying asset.
- Exercise Price – Same as strike price
- Hedge – A technique of reducing risk by taking positions which tend to move in opposite directions.
- Historic Volatility – (See Volatility) Calculated by using the standard deviation of underlying asset price changes from close to close trading for the prior 21 days.
- Holder – Same as writer; the buyer of an option.
- In-the-Money – A (call/put) option is in-the-money if the strike price is (less/more) than the market price of the underlying security.
- Intrinsic Value – The difference between the underlying asset’s price and the strike price. (For both puts and calls, if the difference is negative, the value is given as zero.)
- Naked Option – An option written (sold) without a position in the underlying asset.
- Option – A contract to buy (call) or sell (put) an underlying asset at a pre-set price by a specific date (American style) or on a specific date (European style).
- Open Interest – The total number of options contracts not closed or delivered on a given day.
- Out-of-the-Money – An option whose exercise price has no intrinsic value.
- Premium – The price an option buyer pays to an option seller.
- Put – An option contract granting the right to sell an asset at a pre-set price within a specified time.
- Straddle – A trading strategy consisting of a long (short) call and a long (short) put, in which both options have the same strike price and expiration date.
- Strangle – A trading strategy consisting of a long (short) call and a long (short) put in which both options have the same expiration date, but different strike prices.
- Strike Price – The price at which an underlying asset must be bought (call) or sold (put), if an option is exercised.
- Time Value – The amount by which the current market price of a option exceeds its intrinsic value.
- Volatility – A measurement of degree of change in price over a specified period of time.
- Writer – The seller of either a call or put option.
Why do options offer any advantage over trading stocks? They’re riskier, since they expire within a certain amount of time and their values are more complicated to assess.
Because they expire on a given date, the investor has to make a choice within a relatively short time frame.Â In my earlier post, I think this expiration can be viewedÂ in a positive light as it forces one to get out of tradesÂ without relying on their emotions but, for the sake of this article, lets consider it a disadvantage as itÂ forces you to make accurate price predictions over a given time and, we all know, that is difficult and sometimes impossible.Â All options expire and even the longest term options, calledÂ LEAPsÂ (Long Term Equity AnticiPation Securities) generally expire withinÂ two years.
Because options, as derivatives,Â have no inherent worth, Â they can move in sharply different directions from the underlying asset. One can short a stock or purchase a long position but, once bought, the value of the shares is known. Even after you purchase options, their value is often solely ‘time value’, they’re worth money only because some event may occur in the future, such as a rise in the price of the asset.
Nevertheless, options are actively traded in large volumes. What do options traders know that many investors have yet to learn? One thing they know is the value of leverage.
Imagine a teeter totter on aÂ playground.Â A small child can lift an adult into the air, provided the pivotÂ point is placed appropriately. ThatÂ multiplying effect has an analogy in financial markets.
For generally around 5% of the price of the underlying asset an investor can control – even though they do not own – 100% of a quantity of stock.
Suppose MSFT (Microsoft) is trading at $28 on a given day. A trader who anticipates that the price will rise can purchase one options call contract which allows the right to buy 100 shares of the underlying stock.
That call option,Â lets say with an expiration date in three months time with a strike price of $30, will cost somewhere around $3. (The ‘strike price’ is the pre-set price at which the shares have to be bought if the option is exercised.)
If the shares were purchased outright, even at the lower $28 price, the investment would cost $28 x 100 shares = $2,800 (plus ~$10 commission). Buying a call instead costs $3 x 100 shares = $300 (plus ~ $10 commission). That ratio, $2800/$300 = 9.33 is the effect known as leverage.
In another scenario, you could invest the same $2,800 dollars by simply buying more contracts to control more shares. That’s another form of leverage. Controlling more shares for the same money is equivalent to controlling the same shares for less money.
“Okay, I understand what you’re saying, but what isÂ your point?” you say.Â
How is this leverage an advantage?
The answer is that, though the investor takes on the risk of losing the premium (the cost of the contract), that multiplier effect operates on profits as it does on costs. Since the investor controls more shares, profits are exponentially higher.
Suppose MSFT rises above the strike price ($30) to $35. If you purchased the shares directly at $28 per share, with $300 to invest, you could only purchaseÂ 10 shares.
The stock’s price increased by $7 and yourÂ profit on the trade would be 10 xÂ $7 = $70. If instead you had purchased an option on 100 shares, your profit would be (($35 – $30) – $3) x 100) = $200.Â Remember, the option had a strike price of $30, so you only captured $5 of the gain, not the full $7 as you would have if you had bought the underlying stock.Â The point is to look at the percentages of your return.Â Making $70 on your $300 is, an impressive, 23% return, but making $200 on your $300 options purchase would have netted you a 67% return.
You had to pay more per share, and the premium reduced your profits, but you controlled many more shares. The net is still considerably higher.
Keep in mind, though, that it works on losses the same way. If MSFT had fallen in price, but you were obligated to a strike price of $30, exercising the option would cost you by that same factor. Under those circumstances, traders simply let the option expire worthless, limiting the loss to the amount of the premium.Â You put your $300 completely on the line with options with a very real possibility of losing it all, but if you want to make a big play on a given stock and believe it will move dramatically in a given time period, options allow you to skyrocket your returns by giving you leverage.Â
Trading on margin lets you leverage as well, but margin requires borrowing money which requires you to pay back the borrowed portion whether the stock went up or not (leading to the dreaded ‘margin call’), but with options, the amount you put in is the maximum amount you can lose.Â If Microsoft went to zero, you’d still lose only your $300, but if Microsoft went to $40, you’d stand to gain $1000 on the $300 investment, more than tripling your investment.
Leverage can be your best ally in skyrocketing your returns, but it requires accuracy in predicting stock movements over a fixed time table and a much higher tolerance for risk (unless you use options for hedging techniques which I’ll address in a future article).Â Definitely do your research before getting involved in options trading, but I encourage you to investigate as they can be an exciting and rewarding way to boost your returns.
I’ve been experimenting with options as a way to turbo charge my portfolio for the past year or so. Overall, I’d say my trades so far have been a wash, but I still think it is a very valuable strategy to heavily leverage your portfolio and limit your risk. In discussing options trades with friends, I’ve realized most people I talk to know nothing about options. They may have some stock options though work, but buying and selling options in a regular brokerage account is a whole different ball game. For the next few weeks, I’ll be posting a series of articles designed to give the average person an introduction to options trading, and I’ll try to sprinkle in some of my own experiences along the way.
The first topic will be a basic introduction to options. What they are, how they are useful to you, what the risks are and what the potential rewards are. Check back every few days for new postings to get you acquainted with options trading and learn about how options trading strategies can be a good way to complement your existing portfolio.
Options Trading – The basics
Trading shares of stock has become as common as surfing the Internet. But, like any financial investment, trading stock is risky. The price can fall unexpectedly and stay down for lengthy periods. Many investors have a hard time liquidating a losing position, constantly waiting for the stock price to rebound. There is no forced exit point and no clean break from your underwater position. To force an exit point to losing positions and to heavily leverage your investment in a given security options are… well, an option.
An option is a contract giving the investor the right to buy or sell a security at a given price on or before a stated date. The last portion is crucial… on or before a stated date. European options are similar to American options, except American options let you sell any time leading up to the expiration date which, I view, is a huge and critical advantage.
Options contracts are written on all sorts of underlying assets: real estate, stocks, bonds, etc.
The basic idea is simple. Invest a fairly small sum today to control something worth a often much larger amount. Depending on your strategy, you can bet that the price will move up, down or within a range before a certain date, then you can sell (or close) your position and pocket the difference.
For example, suppose Google shares are selling at $500 per share, but buying 1,000 shares of GOOG at $500 each would cost $500,000. I don’t know about you, but I don’t have half a million to invest in one company, thats putting a few too many eggs in one basket and is far beyond the means of the average speculator.
You could buy on margin, but you’d still likely have to put up half of that money in cash and would be liable for the other half should the stock go down (not something I’d be looking forward to). The other option in this scenario gives you the option to control that 1000 shares of Google stock without having to come up with all the money up front. Simply buy an option at, say, $30 per share (the ‘premium’). Now your investment is $30,000 – hefty, but within reach. That’s called ‘leverage’, and it can be your best friend when you are trying to turbo charge your portfolio.
Each option has an expiration date – the date at which the investor must “exercise his option”, i.e. make a decision to buy/sell the underlying security or lose his invested money. Depending on the underlying asset, and other factors, the date can be anywhere from a day to several months in the future. LEAPs even allow you to buy options on a given security for years in the future.
Options also have a strike price – the price at which the underlying instrument has to be bought or sold when exercising the option.
Continuing the example, suppose the option for GOOG expires in 30 days and has a strike price of $510. The break-even price would be $510 + $30 = $540 per share. At this point, you are ‘under water’ by $40 per share x 1,000 shares = $40,000. You put $30,000 into the transaction and the stock needs to go up by $40 just for you to break even Doesn’t sound so exciting so far does it?
But, lets assume three weeks pass and Google announces some good news about earnings. The price per share rises to $540. Now you can exercise your option by “closing out your position” and selling your contract to buy the underlying stock.
The options contract price has increased as well, to $35. Your profit is: ($35-$30) x 1,000 = $5,000. (Ignoring likely $25 in brokage fees.) Not bad. Five thousand dollars on a $30,000 investment is about a That’s a 16% profit on a $30,000 investment. If the price of Google had fallen over the same period, your $30,000 investment would be completely at risk, thats where risk and hedging strategies come in which I’ll talk about in a future post.
Buying and risking $30,000 on a single security is still more risk than I’m willing to take, so most of my options positions are in the $800-$1500 range. Commissions eat up more of the profits as a percentage, but the way options move, typically $25 in brokerage fees becomes fairly insignificant by the time I’ve executed my options trade.
Options aren’t for everyone. They’re more complicated (though not too much), riskier, and generally involve shorter term trades and the requirement to watch the market more closely.
But note that purchasing the options contract did NOT involve investing 6% ($30/$500 x 100%) and borrowing the other 94%. Options contracts are a straight investment of funds, not a broker loan.
If the price goes in the predicted direction before expiration, you make money. If the price goes the other way, you lose (some or all of) your investment. The contained risk is an aspect I appreciate and the forced exit is also a benefit. If you buy an option 60 days in the future, whether the stock goes up or down, you will exit that position in at least the next 60 days, guaranteed. You may be up, you may be down, but you’ll be out. That forced execution is better in risk planning, liquidity strategies, and a general training tool to force yourself to be disciplined in your other investment decisions. I know I’m not the only one who has bought a long stock position that declined below my purchase price, then I held onto it through future declines in a hope that it would increase over time to recover my investment. Options force you to close things out in a predetermined time period. Your ability and skill at predicting short term price movements becomes more critical, but you’ll never be caught holding a dog for years, tying up your investment capital and eating away at your confidence every time you look at your list of open positions.
As with any investment, do your homework. Make sure you understand how options work and what the relative risks are. In particular, study the market for that type of underlying instrument. Throwing darts blindly is the least successful options trading strategy.