Options 101

Vertical axis – payoff
Horizontal axis – share price

WHAT ON EARTH IS THAT?!
That ladies and gentlemen, is what we call a payoff diagram. Remember it well.
In case you’re wondering what Long, Short, Call and Put means….well…..(phew, this is gonna be a long day)

Here are some useful terminologies :
Long – to buy

Short – to sell

Call – a contract whereby the buyer has the option but not the obligation to purchase the underlying asset at the contracted price (exercise price) anytime before the expiry of the contract (American Option).

Put – a contract whereby the buyer has the option but not the obligation to sell the underlying asset at the contracted price anytime before the expiry of the contract.

Expiry – maturity of the contract

Exercise price – the contracted price that is agreed between the buyer and seller.

Underlying asset - It can be anything from, company shares, to commodities, and to even the weather!

American Options & European Options – most options are categorized into these 2 forms. Basically an American Option allows the option buyer to exercise his right anytime between the initiation of the contract to the expiry of the contract. On the other hand, European Options will only allow the option buyer to exercise his rights at the option contract expiry date.


So what exactly do I mean when I say, “I just did a transaction whereby I long an American call on 1000 Rolls Royce shares at an exercise price of 6 dollars expiring in August’07”?

Any takers?

Well, it means that I just bought the right to purchase 1000 Rolls Royce shares for the price of 6 dollars anytime from now till the expiry of the contract, which is in August 2007.

Here’s another Example:

“I just short an European call on 1000 Royal Bank of Scotland shares at an exercise price of 5 dollars expiring in September ‘07”

What does all this mumbo jumbo mean?
As a seller of a call option, I am now obligated to sell to the call option buyer, 1000 Royal Bank of Scotland shares at 5 dollars at the expiry date of the contract in September’07, IF he decides to exercise his rights (note – option is only exercisable on expiry because its an European option)

Now, I’m pretty sure all this is pretty confusing especially to those new to options. So I’ll leave it here for now and allow you lot to reflect on all these new terminologies.

In my next entry, I shall be explaining the payoff diagram.

And after that, we shall explore the trading strategy which I mentioned in my first entry.

(Coming up next – Options 102)

Lets Try Something Different

The last eight months has been phenomenal for the stock market. Just by investing in the local KLCI index, an average investor would have easily made a 50% capital gain return. Now that is impressive even by Warren Buffets’ standard, who averaged 23% return p.a. over his entire career.

So while the stock market basks in celebration in the longest economic boom the world has ever experienced, I shall present to you an alternative form of investment – Options. It would seem illogical for anyone at this current point of time, to be interested in this derivative form of investment, considering the Bull Run in the stock market. So why bother introducing it? The reason, plain and simple…..an extra bit of information never hurts anyone. (or was it the other way around?)

Contrary to the belief by many that Options are limited to institutional and sophisticated investors like hedge funds, Options are actually very much accessible even to an average individual. Theoretically, no amount of capital is required to start-off your options trading (save for the margin requirements).

Now, for benefit of those who haven’t got the slightest clue what I’m talking about thus far, and to those who have heard of options, but need a refresher course, I shall go through the basics options in the first part of my blog entry. And once that is out of way, I shall share with you a trading strategy that is utilized by many, that has the ‘potential’ of generating consistent return over a long period of time.

And to make things a little bit more interesting. I shall be using actual prices from the market to show you how this strategy is carried out. And you shall be the judge on the feasibility of this trading strategy.

(Coming up next – Options 101)

when it comes to creativity...

old blog of mine.

Blogging is nothing new, nor it is something extraordinary. Yet, the impact it is making to this world is fabulous.

That leads to the talk of "globalisation".

The world hasn't changed its size, yet what we observe is that the distance between you and me, has become shorter. No matter where you are, as long as there's phone line and internet access, we are not that far apart after all.

"globalisation" makes things easier, it also leads to the disruption of the natural law of economics. there used to be an era when things got expensive, demands will fall and thus price will fall. Yet, in today's context, this seems to be abit obsolete. The emergence of the oriental dragon and the south asian mammoth have created a world with new economic rules. What suppose to be going up continue to stay low, and what suppose to be coming down, continue to be up and rising. What has gone wrong?

This should be exciting because this is a brand new era that we're observing. 200 years down the road, our great great grand children will be referring to this era as the "globalizing era" or perhaps some other more fascinating terms. This is similar to the time when the europeans learnt about sailing and start doing world trades. Now, we're doing world manufacturing, world marketing and of course, a global trades.

so, what happen when it comes to creativity? In today's context, it's hard to survive if we still follow the traditional way in doing things. Why would you be writing articles for local newspaper by paying 30cents postage fees while you can choose to post a blog on line / write an article for online magazine for zero costs and with unlimited exposure? now even you and i can be a columnist on line, even you and i can do business with merely zero cost by starting a e-business. Therefore with abit of creativity, we can spot the next opportunity in this ever-changing world and make a fortune out of it.

we're observing the globalizing trend in the world that we're living in today, yet the fortunate thing is that it has just begun and might take a century or more to complete the progress. The utopia of globalization is when we're only using one currency in trading, where the oriental dragon is the only one manufacturing, the south asian mammoth is answering all your phone enquiries, the pisa leaning tower and eiffels are making the food for the world & etc etc. so before everything converges, there are opportunities for us to exploit this arbitrage. This mean that you can do something with lower price, and sell it to other continents at a higher price, thus, reap the margins and help globalizing.

when it comes to creativity, it is time for us to spot what our competitive edge is, and be able to fully utilise it, before the G-Day arrived.

Happy reading and will be back for more.

Change of Perception

Remembering not too long ago, the financial market was pricing in a possible "rate cut" by the U.S. Fed. Well, growth seems to be slowing down, inflation remain benign, housing sector woes were developing into a 'crisis' etc etc. Thus, equity and bond markets were both rallying and guess alot people out there have made some handsome profits for the last few months.

But is growth really slowing down? i am not too sure, neither does the global investing community, mainly because the "confirming numbers" are not out yet.

Nonetheless, the markets were "moving ahead of themselves" where we see huge foreign inflows flooding Asian markets, pricing in a rate cut anytime soon by the Fed. As a result, KLCI went up 23% year-to-date, while Malaysia's bond yields have dipped below its overnight rate. Crazy indeed.

The market trades on expectation. So the market priced in (i.e. BET) that the US growth was going to slow down, inflation will be kept low, housing market will go bust etc etc... However, after few months and nothing has materialised yet!

and out of a sudden, (not really that dramatic, but what da heck) US growth number published was rather resilient and employment data was still ok. Analysts out there were shouting for a possible spike up in the inflation numbers, and in turn, both market went into a technical correction last week. It is a "technical correction" because the markets were just correcting to the level that goes in line with the "revised expectation". A change of perception.

Due to the flushed liquidity in the system, coupled with the positive few good factors on global front, both bond and equity markets were positively correlated for the last few months. Both move up and down together, which is not what the financial text book has taught us.

The inversion of US yield curve (usually signify a recession) few months ago was deemed as "not telling the true story" as the "conundrum story" of excess global savings is the main culprit causing the inversion, but not the slowing economy.

Yet, at our own backyard, Malaysia's bond yield curve has been inverted for quite some time, and i believe that this time around, it is trying to tell us something...

Ex Ante – Ex Post

Last Thursday was a public holiday in Malaysia. 26th of April 2007 marked the day of the installation of our latest Agung – the king of kings in Malaysia. Anyway, looking at an ex-ante basis, I guess everyone was glad that there was a holiday after such a long dreadful working month…

But then on an ex post basis, some investors might not feel the same…

“Basket, I can’t believe this. U.S. stock market has to hit all time high on that day, and you know what, regional markets were flying on Thursday as well! And where were we? MARKET CLOSED!” said a friend of mine when we resumed work on Friday.

“But you must admit that you did have a nice holiday celebrating the installation of our new King right?”

“Yeah, but I rather go into the market and make a few thousands bucks more…”

Well, it’s always easy when we do things on an ex post basis, i.e., we only look at it once it’s over. But on an ex ante basis, do you think you will be as gung ho as my friend?

That’s why people say Fund Manager should add more value in terms of judging the market correctly, consistently on an ex ante basis, performing better than the normal investors like you and me. But of course, sh*t happens. It’s always easy to say, ex post, that I should have, I could have buy or sell this and that.

Oh well.

The finance text books in town which touch on the subject of hedging always bring out an important point. Before a trade is being done, you are always concern about the potential downside risks of your investment, thus, you wish to hedge away your downside risk. However, in the end, it might be better off if you don’t hedge. On an ex post basis, it shows that hedging is a waste of time.

But is it so? By performing the pre trade hedge, although at a cost, it does remove all your worries and give you a certain outcome. A sense of security and comfort, and that’s most important of all.

Back to the market, if you pull out any chart, everyone will start sighing…. “ I should have bought in November, sell them off in February, then when the market corrected in end Feb, I should have more balls, going in to the market and grab as much as I could…I should have…”

Usually my response is, “so what are you going to do next?”

“I don’t know, what do you think?”
I think, based on an ex ante basis, I would suggest this:

I am still a firm believer of Come-May-Sell-All-Go-for-Summer-Holiday theory. Thus, will the market correct come May? I don’t know for sure. But I rather miss out the next rally than losing and cursing everyday!

The market is overvalued, if, and only if you believe comparing to historical level is useful. What goes up must come down. I guess that’s the law of nature…

Despite the talk of huge liquidity and the hunger for yield enhancement are dominating the market. But I do strongly believe that our market is quite vulnerable when there’s a change in risk appetite globally. We might not suffer as bad as Indonesia or Thailand, but who knows? Ask the more senior investors, they can tell you a few ringgit drops in a day in Maybank is not something impossible…

So, if you fear of regret, I suggest you should park some money in those stocks that you are familiar with, and if you have some buffer of profit, hold on to it until the correction comes, then you sell all.

But if your cost of entry is very near to its current price, I would suggest you to sell it now, and stay out of the market, until there are cheaper entry prices…

On an Ex Ante basis, what do you say?

1st April 2007 - a better april fool for us

is it a sign that election is coming soon in Malaysia? who knows? but today...

Bank Negara (Central Bank of Malaysia) has announced further liberalisation of our foreign exchange administration. Previously, as an individual, we only can invest up to RM 100k abroad per annum...now, RM 1 million! bravo! but seems like it has nothing to do with me...

Limits for Corporation for overseas investment has increased to RM50million p.a. from RM10million p.a. before... good stuff, shall we expect to see more growth in earnings in coming years or more volatility in their earnings? well, in the end of day, it's fundamental that counts. Company with good management team will always outperform the rest...

Onshore funds like Unit Trust, Fund Management and Insurance companies can now invest up to 50% of their Net Asset Value (NAV) in foreign currency assets from 30% previously. This is good news for investors as you will expect fund houses and insurance company will continue to roll out more innovative product for us to invest in overseas, thus better diversification i would say.

there are more details to it, but bottom line is, we're on our way back to the open market that we used to be in before the Asian Crisis 1997. Most importantly, foreign investors will regain their confidence in our market again!

but then, there was an argument saying that it might not be such a good idea as investment flow might flow out faster that usual as previous "liquidity trap" in the market has loosened up abit... oh well... what ever it is, if you believe in economic theory, an economy with no government intervention or any form of capital control is the best form of market, as dead weight loss will be minimize, more efficient allocation of assets.... etc etc

This relaxation will officially be effective on....1st April 2007.

if you think this piece of news is not good enough. wait, we have more!

The government has announced several incentives to boost the property market, but most exciting of all, is this.

The Abolishment of nationwide REAL PROPERTY GAINS tax with effect from...1st April 2007!

what does this mean?

it means that if you have recently bought a house, you can straight away sell it off, with no property gain tax! (of course, provided you make a gain...) or, if you think this property can make money, but you have not enough capital, plus you don't want to stay there...you can borrow from bank, buy the property, and "flip" it within months, sell it at a gain, and hey ! no property gain tax!

by no mean, for foreigners and those who leaving the countries for good, this sounds like a good way to make more profit on the way out...

but would this induce to a mini-version of US Housing crisis? when there's too much flipping in the property market wouldn't it leads us to the same collapse that happened in Hong Kong's property market as well?

well, oh well, it's a good news, so at the mean time, we should embrace it happily. Who knows what lies in the future?

hopefully, this is a good April fool gift.

Behavioural Finance - the answers...

In my previous entry, i've posted a question developed by Kahneman & Tversky. Here's the question again:-

#Choose 1 from (a) (b) and 1 from (c) (d) the following

(a) A sure chance of getting $2,400, or
(b) A 25% chance of getting $10,000 and a 75% chance of getting nothing.

(c) A sure chance of losing $7,500, or
(d) A 25% chance of losing nothing and a 75% chance of losing $10,000 #

Ok, generally, normal people, like you and me will choose (a) and (d). Why?

The efficient market theory assumes that all investors are Rational, i.e. we will always allocate our assets according to Expected Return and Risks. A rational investor will always go for the asset with the highest expected return, at a given level or risk, or invest in the asset with the lowest level of risk, at a given level of expected return. That's the theory.

In reality, we're no where near that. We are rather emotional. Ok, back to the question. Why choose (a) over (b)?

We will generally choose (a) because (a) gives you a 100% chance of receiving $2,400 bucks! A windfall! Whereas in (b), you have to gamble for it. So your mind has already been anchored that you can get $2,400 for sure, why gamble for it? But, in terms of finance, the way we generally look at it is through the calculation of Expected Return.

In (a), the expected return is $2,400.
In (b), the expected return is [0.25 x $10,000] + [0.75 x $0] = $2,500

Since (b) has the higher expected return comparing to (a), (b) should be chosen instead!

Ok, how about (c) and (d)?

Most people, including myself, Hate Losing. Let it be sports, card games, in relationship & investing, we dislike losing. Most people will choose (d) over (c), why?

Basically, (c) tells you, “You are a confirm loser. Pay me $7,500 now!” This is painful. (Both emotionally and financially)
So you say, “Hey, I am not a loser, I will choose (d) and I am not going down without fighting!”

Some academics say investors always believe too much in his/herself, i.e. Over-confidence. Oh well, we will eventually be humbled by the market…

Anyway, so you chose (d). Let’s do some calculation.

In (c), the expected return is -$7,500
In (d), the expected return is [0.25 x $0] + [0.75 x -$10,000] = -$7,500

Well, in this case, a rational investor should be indifferent between (c) and (d), but of course in reality, most of us hate losing and always over-confident that we might be lucky this time, (d) will be the favourite for sure.

So, if I combine all four of them together, which two is the best combination?

Let’s start with combination (a) & (d), the top picks by most people. The total expected return is

E(R) = [1 x $2,400] + [0.25 x $0] + [0.75 x -$10,000] = a loss of $5,100. Ouch!

According to Kahneman & Tversky, the optimal combination is (b) & (c) [or (d)]!

Here’s the expected return

E(R) = [0.25 x $10,000] + [0.75 x $0] + [-$7,500] = a loss of $5,000, effectively $100 better off than the (a) & (d) combination.

So what does this tell us?

Most people, like you and me, have mind-framing in our decision making process. We always differentiate the decision making process of “realizing gains” & “realizing loss”. In terms of gain, we always want the safest bet, unless, you have some buffer to gamble. Whereas, for loss, we prefer to gamble, and who knows, we might be lucky and can get away with lesser losses?

We rarely combine those two decisions together, although we should.

That’s the mentality of general investors ;)