After exercising a put option, can I still hold my option contract in order to sell it at a lower price?A:
Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to sell a stock at a specified price at a specific time. The holder of a put option expects the price of the underlying stock to decline. When the price of that stock goes down, the holder of the put option has two choices: a) sell the put option for profit, or b) exercise the option. You cannot exercise the option and then sell it at the same time; it has to be one or the other.
When a put option is in-the-money, depending on the rules of the brokerage firm you are using, instructions are submitted to your broker or it is automatically exercised. If the option is exercised, the holder buys the stock at its current price and sells the same stock at its exercise price. For example, if the put option contract for stock A specifies the exercise price at $10 at a specific date, and the actual price on that date is $8, the option holder exercises the contract by buying stock at $8 and selling it for $10 to get a $2 profit. When that option contract is exercised, it no longer exists.
To learn more, see our Options Basics Tutorial.
This question was answered by Chizoba Morah.
Are We In A Bull Market Or A Bear Market?A:
The Wall Street Journal and other media outlets often use 20% thresholds to label traditional uptrends and downtrends, stating a new bear market has begun when an index or other security falls 20% off its peak. Conversely, they announce the start of a new bull market when an index or other security rises 20% off its low. This logical approach can produce great controversy at times because a financial instrument that sells off from 20 to 1 in a bear market will enter a media-sanctioned bull market when a bounce gains 20-cents, lifting the instrument to 1.20 while marking a 20% rally off the low.
In the simplest definition, rising price signifies a bull market while falling price signifies a bear market. With this in mind, you might think it would be easy to determine what type of market we're grinding through at any point in time. However, it's not as easy as it looks because bull-bear observations depend on the time frames being examined. For example, an investor looking at a 5-year price chart will form a different opinion about the market than a trader looking at a 1-month price chart.
[There are many ways to measure bull and bear markets but quantitative methods rely on technical analysis concepts. Investopedia's Technical Analysis Course will show you how to identify technical patterns, trends, signals, and indicators that determine price behavior and how to apply them to make money in bull and bear markets.]
Let's say the stock market has been rising for the last two years, allowing an investor to argue that its engaged in a bull market. However, the market has also been pulling back for the last three months. Another investor could now argue that it's topped out and entered a new bear market. In sum, the first argument arises from looking at two years of data while the second arises from looking at three months of data. In truth, both points of view may be correct, depending on the viewer's particular interests and objectives
In reality, markets form trends in all time frames, from 1-minute to monthly and yearly views. As a result, bull and bear market definitions are relative rather than absolute, mostly dependent on the holding period for an investment or position intended to take advantage of the trend. In this scheme, day traders attempt to profit from bull markets that may last less than an hour while investors apply a more traditional approach, holding positions through bull markets that can last a decade or more.
Bottom line: there's no perfect way to label a bull or bear market and it's easier to focus on specific time frames or by considering the sequence of peaks and valleys on the price chart. Charles Dow applied this method with his classic Dow Theory, stating that higher highs and higher lows describe an uptrend (bull market) while lower highs and lower lows describe a downtrend (bear market). He took this examination one step further, advising that bull and bear markets aren't "confirmed" until major benchmarks, the Dow Industrial and Railroad Averages in his era, make new highs or new lows in tandem.
Can a stop-loss order protect a short sale?A:
The quick and simple answer to this question is yes.
The major difference between a stop-loss order used by an investor who holds a short sale and one used by an investor with a long position is the direction of the stop's execution. The individual with the long position wants the price of the asset to increase and would be negatively affected by a sharp decrease. The individual with the short sale wants the price of the asset to decrease and would be negatively affected by a sharp increase. To protect against a sharp rise in asset price, the short seller can set a buy-stop order, which turns into a marketable order when the execution price is reached. Conversely, the individual who holds the long position can set a sell order to be triggered when the asset hits the execution price.
For example, if a trader is short selling 100 shares of ABC Company at $50, he or she might set a buy-stop order at $55 to protect against a move above this price level. If the stock rallies to $55, the stop would be triggered, buying the 100 shares near the current price. A word of caution: in a fast moving market the buy-stop order could be triggered at a substantially higher price than $55.
Another way that a short seller can protect against a large price increase is to buy an out-of-the-money call option. If the underlying asset rallies, the trader can exercise his or her option to buy the shares at the strike price and deliver them to the lender of the shares used for the short sale.
(To learn more about short sales, see our Short Selling Tutorial. For more on stop-loss orders, read The Stop-Loss Order - Make Sure You Use It.)
Can an option be exercised on the expiration date?A:
The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements of stock prices. Not only can options be traded with stock as the underlying asset, they are also traded on foreign currency, interest rates and various indexes.
There are two kinds of stock options, American and European. American options can be exercised any time up to and including the expiration date of the option. However, European options can only be exercised on the date of expiration. Expiration dates follow three cycles, January, February and March. The January cycle is comprised of the first month of each quarter (January, April, July and October); the February cycle consists of the second month of each quarter (February, May, August and November); and the March cycle consists of the final month of each quarter (March, June, September and December).
Beyond the difference between American and European options, there are also more specific terms regarding expiration. Because expiration dates are usually identified just by a month, a specific date is identified within the expiration month that is used as an exact deadline. This deadline, for both types of options, is the Saturday following the third Friday of the expiration month. An investor normally has until 4:30pm Central time on the third Friday of the month to instruct his or her broker to exercise an option.
To learn more about options, see the Options Basics Tutorial, The Four Advantages Of Options and Trading A Stock Versus Stock Options Parts I and Part II.
Do I own a stock on the trade date or settlement date?A:
When buying shares, there are two key dates involved in the transaction. First is the trade date, which marks the date the buy order is executed in the market or exchange. Second is the settlement date, which marks the date and time the transfer of shares is made between buyer and seller. The settlement date, not the trade date, establishes a legal transfer of ownership from the seller to the buyer. While different rules govern various jurisdictions around the world, its commonly agreed that ownership is transferred when the funds are given in exchange for the security, which happens on the settlement date.
[Day traders must use margin accounts because settlements don't occur in time for cash accounts. But these aren't the only regulations that day traders must follow. Investopedia's Become a Day Trader Course provides an in-depth overview of day trading, with over five hours of on-demand video, exercises, and interactive content.]
However, there is little differentiation between the two dates because it is likely that ownership will be transferred without complication or conflict after the trade date. Upon execution of the buy order on the trade date, both buyer and seller incur a legal obligation to finalize the transaction. The buyer is obligated to provide the necessary funds (cash) to pay the seller and the seller is obligated to have or obtain the adequate number of shares to transfer to the owner.
Nevertheless, there are two ways in which the settlement can fail. The first is a long fail, in which the buyer lacks adequate funds to pay for the purchased shares. A short fail can also occur; which happens when the seller does not have the security on the settlement date.
The time frame between the trade date and settlement date differs from one security to another, due to varying settlement rules. For bank certificates of deposit (CDs) and commercial paper, the settlement date is the same day as the trade or transaction date. Mutual funds, options, government bonds and government bills are settled one day after the trade date, while the settlement date for foreign exchange spot transactions, U.S. equities and municipal bonds occurs two days after the trade date. This is commonly referred to as "T +2".
To read more, see The Nitty-Gritty Of Executing A Trade.
Does the seller of an option determine the details of the option contract?A:
The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between the buyer and the seller of the contract to buy or sell an underlying asset at a certain price, amount and time. These are referred to as the strike price, the contract size and the expiration date, respectively. Options are sold in two places: on option exchanges and over the counter.
Option exchanges are similar to stock exchanges in that trade happens through a regulated organization, such as the Chicago Board Option Exchange (CBOE). Exchange-traded options at the basic level are standardized; this means that each option has a set standard underlying asset, quantity per contract, price scale and expiration date. For example, when looking at a May05 MSFT 30.00 call option, the CBOE has standardized that each option contract represents 100 shares of MSFT common shares, the strike price is $30, and the contract expires on the third Friday of May. There is no customization at the basic level of option exchanges, and the terms of the contract are set out by the exchange.
Flexible exchange options (FLEX) allow for customization of the contract specifics of exchange-traded options; they are most often written by a clearing house. There are also exchange-specified rules that must be followed when creating a FLEX option; for example, the exercise date must differ from the exercise date of all other options and there may be a minimum size. This allows for some customization, which means an option contract writer can change some of the details of the contract.
Over the Counter
Options are also traded in the over-the-counter option market. Over-the-counter options are traded through a wide network of various brokers and dealers. This market allows for the complete customization of option terms, from the strike price to the expiration date. The price that is paid or received for the option is dependent on the price someone in the market is willing to sell for or pay, and this is determined by the terms of the option.
However, there is more risk in the over-the-counter market than in the exchange-traded market. In the over-the-counter market, the other party to the contract may not hold up his or her side of the agreement. This is unlike exchange-traded options, which are guaranteed by the clearing corporation to be exercisable, no matter what the other party to the option does.
For more information on options, please read the Options Tutorial.
How accurate is the forward rate in predicting interest rates?A:
Forward rates are extremely limited predictors of actual interest rates. This isn't particularly surprising, given the multitude of determinant factors for interest rates or the nature and use of forward rates. The imperfections of forward rate forecasts tend to be most glaring before the business cycle begins a boom or bust cycle.
The Determinants of Interest Rates
Generally speaking, interest rates depend on the supply and demand for interest-bearing financial instruments. There are three major influences on the supply and demand of interest rates: liquidity preference, the difference between the demand for past and future consumption, and the premium demanded for assuming market risk.
For example, if inflation is expected to increase in the future, individual and institutional investors may demand higher rates from their financial instruments. Businesses might increase offered interest rates on issues if they need more capital than is available to spend on future expansion.
Banks may raise interest rates if they want more deposits and lower them if they want less. The opposite is true for bank lending; rates increase if banks want to discourage borrowing and decrease if they want to encourage borrowing.
In modern mixed economies, interest rates are heavily influenced by central bank policy. Rates tend to fall when the Federal Reserve pursues expansionary monetary policy and contract when it pursues contractionary monetary policy.
Limits of Forward Rates
Because there are so many complex, uncertain and interconnected influences on interest rates, it is very hard to predict where rates will land in the future.
Most forward rate calculations tell investors a lot more about how spot rate curves are set today. Even though longer-term spot rates are adjusted based on future expectations, their accuracy is limited to the forecasting ability of present market actors (and Federal Open Market Committee (FOMC) policy or other artificial manipulations).
Forward rates are intended to coordinate futures contracts so that they are competitive with other financial market transactions. There is a component of future forecasting involved, but it is ancillary rather than primary.
How can derivatives be used for risk management?A:
Derivatives could be used in risk management by hedging a position to protect against the risk of an adverse move in an asset. Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against adverse price movements.
A derivative is a financial instrument in which the price depends on the underlying asset. A derivative is a contractual agreement between two parties that indicates which party is obligated to buy or sell the underlying security and which party has the right to buy or sell the underlying security.
For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2013 for $65 a share. The investor held onto his investment for over two years and is now afraid that Tesla will be unable to meet its earnings per share (EPS) and revenue expectations.
Tesla's stock price opened at a price of $243.93 on May 15, 2015. The investor wants to lock in at least $165 of profits per share on his investment. To hedge his position against the risk of any adverse price fluctuations the company may have, the investor buys 10 put option contracts on Tesla with a strike price of $230 and an expiration date on August 7, 2015.
The put option contracts give the investor the right to sell his shares of Tesla for $230 a share. Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 * 10) shares with 10 put options.
Tesla is expected to report its earnings on August 5, 2015. If Tesla misses its earnings expectations and its stock price falls below $230, the investor could sell 1,000 shares while locking in a profit of $165 ($230 - $65) per share.
How can I calculate the delta adjusted notional value?A:
The delta adjusted notional value is used to show the value of an option. This is different from most other derivatives, which use gross notional value or, in the case of interest rate derivatives, 10-year bond equivalent value. Investors can calculate the delta adjusted notional value of a portfolio by adding the options' weighted deltas together.
The delta adjusted notional value quantifies changes to a portfolio's value if it was comprised of underlying equity positions, instead of options contracts. For example, a stock is trading at $70 and the delta of the related call option is 0.8. In this case, the value of the weighted delta for the option is $56 ($70 x 0.80).
In derivatives trading terminology, "delta" refers to the sensitivity of the derivative price to changes in the price of the underlying asset. For example, an investor purchases 20 call option contracts on a stock. If the stock goes up by 100% but the value of the contracts only increases by 75%, the delta for the options will be 0.75. Call option deltas are positive while put option deltas are negative.
Delta measures the change in option premium generated by a change in the underlying security. Delta's value ranges from -100 to 0 for puts and 0 to 100 for calls (multiplied by 100 to move the decimal). Puts generate negative delta because they have a negative relationship to the underlying security i.e. put prices fall when the underlying rises and vice versa.
On the other hand, call options generate a positive relationship to the underlying security's price. So, if the underlying goes higher so does the call premium, as long as other variables that include implied volatility and time remaining until expiration remain constant Conversely, if the underlying price falls, the call premium will also fall, as long as other variables remain constant.
An at-the-money option generates a delta of approximately 50, meaning the option premium will rise or fall by one-half point in reaction to a one-point move up or down in the underlying security. For example, an at-the-money wheat call option has a delta of 0.5 and wheat rallies 10-cents, The premium will increase by approximately 5 cents (0.5 x 10 = 5), or $250 (each cent in premium is worth $50).
Explaining Notional Value
Notional value is the total amount of an option contract's underlying asset at its spot price.. This term differentiates between the amount of money invested and the amount associated with the whole transaction. Notional value is calculated by multiplying the units in one contract by the spot price.This is easy to demonstrate with an indexed futures contract. For example, an investor or trader wants to buy one gold futures contract. The contract will cost the buyer 100 troy ounces of gold. If the gold futures contract is trading at $1,300, it then has a notional value of $130,000 (1,300 x 100).
Options have a delta-dependent sensitivity so their notional value is not as straightforward as an indexed futures contract. Instead, the option's notional value needs to be adjusted based on the sum of exposures within the portfolio. The easiest way to calculate this delta adjusted notional value is to calculate the delta for each individual option and add them together.
Notional value is useful in determining exposure levels in interest rate swaps, total return swaps, equity options, foreign currency exchange derivatives and exchange-traded funds (ETFs).
How can I identify stocks that also trade as options?A:
The trading of options has become increasingly popular among retail investors as they become aware of the different ways that options can be used to generate profits. The interesting thing about option strategies is that investors can use them in all types of market conditions; the primary question becomes which securities should be used when implementing a certain strategy.
Many beginning option traders quickly discover that not all securities have an option chain associated with them. This means there may be no options available to buy or sell on a certain security, leaving the investor no choice but to buy or sell the underlying instrument to get exposure. (To learn more about this subject, see What requirements must a company meet before exchanges will allow options on the company to be traded?)
The easiest way to find out which securities have options is to visit the websites of the exchanges where the majority of equity options are traded. The exchange listing has grown tremendously in recent years, with current primary operations at BOX Options Exchange LLC, Cboe Exchange Inc, Cboe BZX Options Exchange, Cboe C2 Exchange, Inc, Cboe EDGX Options Exchange, MIAX Options Exchange, MIAX PEARL, LLC, Nasdaq BX Options, Nasdaq GEMX, Nasdaq ISE,Nasdaq MRX, Nasdaq Options Market, Nasdaq PHLX LLC, NYSE American Options and NYSE Arca Options.
Each website has a directory of options that are available for trading on that given exchange. For example, you can click here to go to the symbol directory for options listed on the CBOE Exchange Inc..
How do currency swaps work?A:
A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.
A currency swap is similar to an interest rate swap, except that in a currency swap, there is often an exchange of principal, while in an interest rate swap, the principal does not change hands.
In currency swap, on the trade date, the counter parties exchange notional amounts in the two currencies. For example, one party receives $10 million British pounds (GBP), while the other receives $14 million U.S. dollars (USD). This implies a GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again using the same exchange rate, closing out the deal.
Since swaps can last for a long time, depending on the individual agreement, the exchange rate in the market place (not on the swap) can change dramatically over time. This is one of the reasons institutions use these currency swaps. They know exactly how much money they will receive and have to pay back in the future.
During the term of the agreement, each party pays interest periodically, in the same currency as the principal received, to the other party. There are number of ways interest can paid. It can paid at a fixed rate, floating rate, or one party may pay a floating while the other pays a fixed, or they could both pay floating or fixed rates.
On the maturity date, the parties exchange the initial principal amounts, reversing the initial exchange at the same exchange rate.
Examples of Currency Swaps
Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD).
During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR.
The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74 million pound amount.
At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and Company B receives 74 million pounds.
Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs British pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms seek each other and come to an agreement where they both get the cash they want without having to go to a bank to get loan, which would increase their debt load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as taking a loan would.
Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the agreement. While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the agreement the the USD starts to fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to receive $100 million USD for only $65 million GBP had they waited a bit longer on making an agreement, but instead they locked in at $74 million GBP.
While the notional amounts are locked in are and not subject to exchange rate risk, the parties are still subject to opportunity costs/gains in that ever changing exchange rates (or interest rates, in the case of a floating rate) could mean one party is paying or more less than they need to based on current market rates.
How Do Fully Diluted Shares Affect Earnings?A:
Basic outstanding shares and fully diluted shares measure the quantity of stock issued by a company using different methodologies. Outstanding shares are the company's stock that have been authorized and issued, representing ownership of the company by investors or institutions holding those shares. Fully diluted shares include all those equities plus additional shares if all convertible securities of a company were exercised.
What are Fully Diluted Shares?
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation, because using fully diluted shares increases the number of shares used in the calculation, reducing the dollars earned per share of common stock.
What is Earning Per Share (EPS)?
EPS is a calculation of the dollar amount of earnings a public company generates per share of common stock. Analysts consider this ratio to be a key indicator of company value, also offering an important metric for shareholders.
How Earnings Per Share Is Calculated
EPS is defined as (net income – preferred dividends) / (weighted average common shares outstanding). Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income, because the ratio applies only to common shareholders. Weighted average common shares is the (beginning period balance + ending period balance) / 2. If a business can generate more earnings per common share, the company is considered to be more valuable and the share price may increase.
Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered "basic EPS", because the total is not adjusted for dilution.
Factoring in Fully Diluted Shares
Several types of securities can be converted into common stock, including a convertible bond, convertible preferred stock, stock options, rights and warrants. Full dilution assumes every security that can be converted into common shares is converted, lowering the earnings available per share of common stock.
For example, assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert into a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock.
Full dilution assumes these 500,000 additional common stock shares are issued, which increases the shares outstanding to 1.5 million. Using the $8 million in earnings in the prior example, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.
How do I calculate a forward rate in Excel?You need to have the zero-coupon yield curve information to calculate forward rates, even in Microsoft Excel. Once the spot rates along that curve are known (or can be calculated), compute the value of the underlying investments after interest has been accrued and leave in one cell. Then link that value into a secondary forward rate formula. This produces the forward rate between two investment periods.
Compute Value of Underlying Investment
Suppose you're looking at a two-year $100 investment with a 7% annual interest rate. Its one-year interest rate is only 4%. In each case, it's easy to compute the final value in Excel.
The one-year final value for the investment should equal 100 x 1.04. This can be otherwise written as "=(100 x 1.04)" in Excel. It should produce $104.
The two-year final value involves three multiplications: the initial investment, interest rate for the first year and interest rate for the second year. Thus, the Excel formula can be shown as "=(100 x 1.07 x 1.07)." The final value should be $114.49.
Forward Rate Formula
The forward rate is the interest rate an investor would have to be guaranteed between the first investment maturity and the second maturity to be indifferent (at least in terms of returns) between picking the shorter or longer.
In other words, you need a formula that would produce a rate that makes two consecutive one-year maturities offer the same return as the two-year maturity. You know the first one-year maturity value is $104 and the two-year is $114.49.
To do this, use the formula =(114.49 / 104) -1. This should come out to 0.10086, but you can format the cell to represent the answer as a percentage. It should then show 10.09%. This information can help you determine your own investment horizon or act as an economic indicator.
How do I change my strike price once the trade has been placed already?A:
The strike price of a bought or sold option cannot be changed once that option is traded. Rather, the strike price of the option is predetermined. The only way to change the strike price for a trade is to offset that trade and then buy or sell an option at a different strike price.
The strike price is the price at which the purchaser of an option can buy or sell the underlying security when it's exercised. For a call option, the purchaser can buy the security at the strike price, while for a put option, the purchaser can sell at that strike price. In order to buy or sell the underlying security, the option must be exercised prior to its expiration date. Options are limited in their duration and expire automatically on that expiration date.
There are two different types of exercise possibilities for options. American options can be exercised at any time up until expiration. European options can only be exercised upon expiration. As a practical matter, American options are usually not exercised early. This is because options have time value associated with them.
Early exercise of an option would negate the benefit of that time value. In fact, most option traders do not exercise their options; rather they offset their trades with a profit or loss. Options trading offers significant leverage for investors by allowing investors to trade larger positions without having to put up the capital to own the underlying security. By exercising the option, the investor then has to use significant additional capital even if he is using a margin account.
Whether an option is exercised or not also depends on the extent to which the option may be in the money. The moneyness of an option refers to the price of the underlying security versus the option’s strike price. An option is in the money if the underlying security is above the strike price for a call option, and below the strike price for a put option. When an option is in the money, it has intrinsic value. The intrinsic value of an option is determined by the difference between the stock price and the option strike.
For example, if the stock of Company XYZ is trading at $50 and an investor owns a call option with a $45 strike price, the option has an intrinsic value of $5. There is a much greater likelihood that an option with intrinsic value will be exercised. In the example, the investor could exercise the option to buy 100 shares at $45 and then sell the shares in the market for a profit of $500.
An out of the money option has less intrinsic value, whereby there is much less likelihood the option will be exercised. In the example, assume that the underlying price of the stock is $40. An investor with a $45 call is not likely to exercise the option since it would not make sense to buy the stock for $45 a share when the market price is $40.
How do I set a strike price for a future?A:
Strike prices can be set for put and call options, but investors engaged in futures contracts are obligated to trade the underlying asset at the expiration date, regardless of price. Most stock futures do not make it to the expiration date – for a variety of reasons – but there is very little flexibility on futures price execution once they are agreed upon. In short, you cannot set the strike price for a future.
There can be options on futures contracts. A strike price may be placed on the future's option, not on the future itself. The option on a futures contract transfers the right to buy or sell the underlying futures contract at a given price.
Prices and Futures
Futures contracts are part hedge against risk and part gamble. In a standard futures contract, the buyer and seller agree to trade a specified amount of an asset either at an agreed upon price or, more commonly, before a given date in the future.
Futures shift the risk of future uncertainty across different parties. There are lots of ways to price this uncertainty, including the price change limit and margin amounts. There is not a strike price as with an option.
Price Change Limits
The closest futures contract function to a classic strike price is probably the price change limit. This limit determines the range between which contracts can trade daily.
For example, the price change limit on a commodity future might be $1. If the commodity's price had previously closed at $10, then the new upper price boundary would be $11 and the lower price boundary would be $9. These can be considered the strike price range where allowable contracts can be entered into at the exchange.
How do I set a strike price for an option?The strike price of an option is the price at which the contract can be exercised. The strike price of a stock and an index option is fixed in the contract. Depending on the amount of premium you want to spend, you may want to set the strike price higher or lower. Generally, if you are buying call options, a higher strike price results in a cheaper option and vice versa for put options. Setting a strike price depends on the amount of risk you want to take and how much you are willing to spend on purchasing the options.
If you buy or hold a call option, you have the right to purchase stock shares at the predetermined strike price. For example, suppose you want to purchase at the money call options of stock ABC and the stock price is currently trading at $20. Since you want to purchase at the money call options, you would set a strike price of $20. This indicates that if the stock stays above $20 before the expiration date of your call options, you could exercise your options and buy shares of ABC for $20.
On the other hand, if you buy or hold a put option, you have the right to sell stock shares at a predetermined strike price. For example, suppose you are bearish on company DEF and think that it will trade below $50 in three months. Company DEF's stock price is currently trading at $70. You could purchase put options and select a strike price between $50 to $70 depending on your risk tolerance.
How does the ISIN numbering system work?A:
The International Securities Identification Numbering system (ISIN) defines an international standard set up by the International Organization for Standardization (ISO), with ISO6166:2013 marking the latest incarnation. The system codes securities that include stocks, bonds, options and futures with unique identification numbers. ISIN identifiers are administered by a National Numbering Agency (NNA) in each country that currently uses the system and work just like serial numbers.
History of ISIN Numbering System
This complex numbering system dates back to 1981 but wasn't widely used until 1989 when the Group of 30 (G30) nations called for broad adoption. ISO joined the system a year later, using the ISO 6166 standard as the initial reference. ISIN data was distributed on disk until the start of the 21st century when transmission switched to the Internet. The European Union (EU) took an additional step in 2004, mandating the system for a large subset of its regulatory reporting needs.
Elements of the ISIN Number
An ISIN identifier code has 12 alphanumeric characters and is structured to include:
1. the country in which the issuing company is headquartered
2. the specific security identification number
3. a final character that acts as a security check to deter fraud or misuse
The first two digits are reserved for the security's country of origin or head office of the issuing company. The second grouping, which is nine characters long, is reserved for the security's unique identifying number. The final digit, known as a "check digit", assures the code's authenticity and lowers the frequency of errors or misuse.
The middle nine digits of the ISIN system number is administered by the local country's numbering agency, which is called the CUSIP Service Bureau in the United States. This office was created to improve the numbering system for securities by developing a national standard for the financial industry. The CUSIP Service Bureau was first established in 1964 and continues to enforce the numbering system through a board of trustees.
Examples of ISIN Numbers
An ISIN identifier for a fictional American company’s stock certificate may look like the following:
US-000402625-0 (dashes incorporated for simplicity)
The country code, "US", is placed at the beginning, followed by the nine-digit CUSIP number for the specific security, with the last digit acting as the check digit. On the other hand, a fictional Japanese company's stock certificate could have an ISIN identifier which appears as follows:
JP-000K0VF05-4 (dashes incorporated for simplicity)
The middle nine digits of ISIN numbers are computer-generated in a complex algorithmic formula. This numbering process is critical in helping to protect against counterfeiting, fraud and forgery. Currently, an ISIN identifier is used to number most forms of securities, including but not limited to equity shares, units, depositary receipts; debt instruments (including bonds, stripped coupons and principal amounts), T-bills, rights, warrants; derivatives; commodities and currencies.
An ISIN identifier doesn't include a specific trading venue. Another number set, usually a MIC (Market Identifier Code) or three-letter exchange code, is needed to record location information that supplements primary identification codes.
To learn more about how an ISIN number work, read Old Stock Certificates: Lost Treasure Or Wallpaper?
How is a put option exercised?A put option is a contract that gives the option holder the right, but not obligation, to sell a set amount of shares (100 shares per contract) at the strike price before the expiry date. If the option is exercised, the option writer must purchase the shares from the option holder. "Exercising" means the option buyer is taking advantage of their right to sell the shares at the strike price.
[Put and call options are the two fundamental tools for option trading. If you're new to option trading, Investopedia's Options for Beginners Course will show you the mechanics of options and how they can be used for both hedging and speculation, with over five hours of on-demand video, exercises, and interactive content.]
The opposite of a put option is a call option, which gives the holder the right to purchase a set amount of shares at the strike price prior to expiration.
There are a number of ways to close out the option trade, depending on the circumstance.
If the option expires in the money, the option will be exercised in the ways discussed below. If the option expires out of the money, nothing happens, and the premium paid for the option is lost. Exercising an option before expiry requires letting the broker know you want to exercise the option early.
If Max purchases one $11 put option on Ford Motor Co. (F), it gives him the right to sell 100 shares of Ford at $11 before the expiration date.
If Max already holds 100 shares of Ford, his broker will sell these shares at the $11 strike price. An option writer will need to purchase those shares at that price.
Max realizes a gain on the option if the price of Ford is below the $11 strike price. If, after Max purchases the put option, the share price falls to $8, he would be able to sell 100 shares at $11 instead of the current $8 market price. By buying the option, Max saves himself $300 (less the cost of the option), as he can sell 100 shares at $11, and make $1,100, instead of having to sell the shares at $8 for $800. Max could have also sold his stock at $11, and not bought a put option. This is also reasonable, yet possibly he thought the stock price could rise so he didn't want to sell the stock, but he did want protection incase the stocked dropped and so he was willing to pay the option premium for that protection.
Now let's assume that Max does not have shares of Ford, but has bought the $11 put and the stock currently trades at $8. Just prior to expiration (or when he wants to exercise) he could purchase shares of Ford at $8 and then have the broker exercise the option at $11. This would net Max $300, less the cost of the option premium,fees, and commissions.
If Max doesn't own shares, the option can be exercised to initiate a short position in the stock. Since max doesn't own any shares to sell, the put option will initiate a short position at $11. He can then cover the short position at the current market price of $8, or continue to hold the short position. Initiating a short position requires a margin account, and capital within the account to cover the margin on the short trade.
The other alternative to exercising an option is to simply sell the option back to the market. This is the simplest approach, and is how most option trades are closed. There is no exchange of shares, rather the trader simply makes money off the change in the option price. For example, the $11 put may have cost $0.65 x 100 shares, or $65 (plus commissions). Two months later the option is about to expire and the stock is trading at $8. Most of the time value of the option will be eroded, but it still has intrinsic value ($3), so the option may be priced at $3.10. Max bought his option for $65 and can now sell it for $310. In the scenarios above, you add in the cost of the option ($65, in this case) to see the net advantage from exercising the option.
Option premiums are in constant flux, and purchasing put options that are deep in the money or far out of the money drastically affect the option premium and the possibility of being able to exercise (if desired).
Closing out a put trade by simply selling the put is popular because most brokers charge higher fees for exercising an option compared to the commission for selling an option. Before exercising an option, see how much your broker charges to do so. This could have a material impact on profits, especially on smaller trades.
To learn more, see Options Basics.
How is the price of a derivative determined?A:
Many different types of derivatives have different pricing mechanisms. The most common derivative types are futures contracts, forward contracts, options and swaps. More exotic derivatives can be based on factors such as weather or carbon emissions. A derivative is a financial contract with a value based on an underlying asset.
Futures contracts are financial contracts to buy or sell an underlying commodity at a certain price in the future. Therefore, the futures contract's value is based on the commodity's cash price. For example, consider a corn futures contract that represents 5,000 bushels of corn. If a bushel of corn is trading at $5 per bushel, the value of the contract is $25,000. Futures contracts are standardized to include a certain amount and quality of the underlying commodity, so they can be traded on a centralized exchange. The futures price moves in relation to the spot price for the commodity based on supply and demand for that commodity.
Options on stocks and exchange-traded funds are also common derivative contracts. Options give the buyer the right, as opposed to the obligation, to buy or sell 100 shares of a stock at a strike price for a predetermined amount of time. The best-known pricing model for options is the Black-Scholes method. This method considers the underlying stock price, option strike price, time until the option expires, underlying stock volatility and risk-free interest rate to provide a value for the option.
I own options on a stock, and it's just announced a split. What happens to my options?A:
An options contract undergoes an adjustment called "being made whole" when the underlying stock splits.
"Being made whole" means the options contact is modified so that the holder is neither negatively nor positively affected by the corporate action. While a stock split adjusts the price of an option's underlying security, the contract is adjusted so that any changes in price due to the split do not affect the value of the option. If your option is purchased post-split (i.e. after the split is announced), it will not be adjusted because it already reflects the post-split price of the underlying security. The Options Clearing Corporation will automatically make these adjustments, for the sake of orderly and smoothly functioning markets.
The "being made whole" calculation is relatively straightforward. Each option contract typically controls 100 shares of an underlying security at a predetermined strike price. The new share ownership is generated by taking the split ratio and multiplying by 100. while the new strike price is generated by taking the old strike price and dividing by the split ratio.
For example, you buy a call option that controls 100 shares of XYZ with a strike price of $75. if XYZ announces a 2: 1 stock split, the contract would now control 200 shares with a strike price of $37.50. On the other hand, if the stock split 3 for 2, the option would control 150 shares with a strike price of $50.
A reverse split also reverses the adjustment process. For example, you buy a call option that controls 100 shares of XYZ with a strike price of $5. if XYZ announces a 1: 5 stock split, the contract would now control 20 shares with a strike price of $25.
I own some stock warrants. How do I exercise them?A:
Most stock warrants are similar to call options in that they provide the holder the right, but not the obligation, to buy shares of a company at a specified price (strike price) before the warrant expires. Unlike an option, a warrant is issued by the company instead of an option writer. Here's how to sell or exercise a warrant.
A warrant holder may choose to exercise the warrant if the current stock price is above the strike price of the warrant. Alternatively, the warrant holder could sell their warrants, as warrants can be traded similar to options.
If the current stock price is below the strike price, it makes little sense to exercise the option, since it is cheaper to buy the stock on the stock market. For example, if the strike of the warrant is $40, and the stock is currently trading at $30, it is not prudent to exercise the right to buy the stock at $40 when it can be purchased at $30.
On the other hand, if the stock is trading at $50, and strike of the warrant is $40, it is beneficial to exercise the warrant. That said, just because the current stock price is above the strike price doesn't mean the warrant has to be exercised. If there is still lots of time until the warrant expires, holding onto the warrants may prove even more profitable. For example, if over the next year the stock rises to $80, the warrant has become more valuable. The stock is trading at $80 and the warrant holder has the right to buy at $40 (and could immediately sell those shares for $80).
The easiest way to exercise a warrant is through your broker. They will handle much of the paperwork and correspondence with the company that issued the warrant to you. Warrants show up in your trading account just like a stock or option. Contact the broker and let them you would like to exercise the warrants in your account. Stipulate how many, out of the total number you hold, you would like to exercise. Once the broker has contacted the issuing company, the exercised warrants will disappear from the account and the stock will appear. Your broker will likely charge a fee for this service.
Exercising warrants is dilutive to existing shareholders. When a warrant is exercised the company issues new shares, increasing the total number of shares outstanding.
Warrants are not necessarily one warrant for one share.
The warrant could be based on any ratio chosen by the company. It may require five warrants for one share, or 10, or 20. When selling or exercising an option, make sure you are aware of all the stipulations of the warrant so you end with the number of shares (and exercise the number of warrants) you want.
Another alternative a warrant holder has is to sell the warrants. Warrants can be bought and sold up until expiry. If a stock is trading at $50, and the strike of the warrant is $40, the warrant should trade for at least $10 (assuming one warrant equals one share). This is because someone could buy the stock at $40 with the warrant and sell it immediately for $50...a $10 profit per share. Likely, though, the warrant will trade for more than $10. This is because there is also time value added into the cost of the warrant. If there is a year left before expiration, the person selling the warrant will want to sell it for more than $10, since there is a chance the stock price could move up within that time, making the warrant worth more. Therefore, the warrant could actually be sold for potentially $12, instead of $10, as an example.
Even if the current stock price is below the strike price, the warrant may still have some time value, and can therefore be sold for something.
If the trader opts to sell the option instead of exercising it, sell the warrant within your trading account how you would any other stock or option. Set the price to sell it at, the quantity, along with any other order parameters you want.
If everyone is selling in a bear market, does your broker have to buy your shares from you?A:
A broker won't lose money when a stock goes down in a bear market because the broker is usually nothing more than an agent acting on sellers' behalf in finding somebody else who wants to buy the shares. A broker is not required to buy from you if you want to sell shares and there is no one willing to buy.
Other traders and investors are on the opposite side of a transaction, not usually the broker. To say "everyone is selling" is usually an erroneous statement, because in order for transactions to occur there needs to be buyers and sellers transacting to create trades, even though those trades may occur at lower and lower prices. If literally everyone were to sell, there is no market in that stock (or other asset) anymore until sellers and buyers find a price they are willing to transact at.
When a stock is falling it does not mean there are no buyers. The stock market works on the economic concepts of supply and demand. If there is more demand, buyers will bid more than the current price and, as a result, the price of the stock will rise. If there is more supply, sellers are forced to ask less than the current price, causing the price of the stock to fall.
For every transaction there must be a buyer and a seller. If the last price keeps dropping, transactions are going through which means someone sold and someone else bought at that price. The person buying was not likely the broker, though. It could be anyone, like another trader or investor who thinks the price offers an opportunity to make a profit, whether in the short-term or long-term.
That said, it is possible for a stock to have no buyers. Typically, this happens in thinly traded stocks on the pink sheets or over-the-counter bulletin board (OTCBB), not stocks on a major exchange like the New York Stock Exchange (NYSE). When there are no buyers, you can't sell your shares, and you'll be stuck with them until there is some buying interest from other investors. A buyer could pop in a few seconds, or it could take minutes or even days or weeks in the case of a very thinly traded stocks. Usually someone is willing to buy somewhere, it just may not be at the price anyone else to sell at. This happens regardless of the broker. The broker only places your order in the market place, so it can transact with other orders. The broker itself does not typically try to solicit trade in a stock, which means your decision to buy and sell are up to you, and the broker just facilitates those decisions.
If an institution acts as the principal to a certain amount of stock, a rapidly declining stock price will affect them. This is because, unlike an agent, the dealer is an owner of the stock. Examples of this include market makers.
Brokers and Market Makers
As discussed above, many brokers are just trade facilitators. They don't take a position opposite to your orders.
Markets makers do take the opposite side of a trade, and may act as a buyer if you are a seller, or vice versa.
Some firms that offer brokerage service are also market makers. Market makers are there to help facilitate trade so there are buyers and sellers in stocks listed on the major exchanges. They doesn't mean they will always give a good price, they are just providing some liquidity. In some cases lots of liquidity, or in same cases very little. After a market maker has taken on a trade, they will then attempt to move those shares along (buy or sell) to another party, attempting to make a profit along the way.
There are also times when the market maker may decide to purchase a stock from you and add the position to the firm's inventory...or sell you shares from their current inventory. The inventory is a compilation of securities out of which the firm may trade in the near term or hold for the long haul.
On most trades, brokers act as conduits. They simply post your trade in the market place so others can choose to transact with it. This means anyone may interact with your order, including other traders and investors, or market makers. There are times when a market marker will take the opposite side of your trade. They are providing liquidity, but will also try to turn a profit for providing that service...as any other trader or investor is hoping to do.
Most market makers, and other traders, will not buy something if they don't think they can make a profit on it, which means prices will as far as they have to entice buyers back in.
Is it more advantageous to purchase a call or put option?A:
Before purchasing a call or put option, it is important to understand the basics of options, as they can expose an investor to potentially unlimited risk. Once a basic understanding is established, investors can start to formulate a strategy and discover the advantages of puts and calls. Neither is particularly better than the other; it simply depends on the investment objective and risk tolerance for the investor. Much of the risk ultimately resides in the fluctuation in market price of the underlying asset.
Advantages of Call Options
A call option gives the buyer the right to purchase the underlying asset at the strike price at any time before the expiry date. Thus, the seller is obligated to deliver the underlying asset at the strike price, once assigned. This can be advantageous for either the buyer or the seller, or both simultaneously, depending on each investor's position. For example, if Investor A buys a $20 call and the asset price increases to $30, he profits a $10 share price difference, minus the premium he paid to purchase the call. Investor B, who sold a covered call to Investor A, pockets the premium and sold his shares with a cost of $15 for a profit too.
Advantages of Put Options
A put option gives the buyer the right to sell the underlying asset at the strike price. With this option the seller is obligated to purchase the shares from the holder. Again, depending on the investor's goals, this could be advantageous for each of them. Suppose Investor A buys a put at $20 against a stock he paid $20 per share for as a hedge. If the price falls below $20 and he exercises his option, he reduces his losses. Meanwhile, the seller, Investor B, can profit from this assignment of shares if he foresees the price returning higher.
What are the differences between AMEX and Nasdaq?A:
While similar in purpose, the American Stock Exchange (AMEX) and the National Association of Securities Dealers Automated Quotations (Nasdaq) are also unique from one another. The AMEX is the third-largest stock exchange by trading volume in the United States. In 2008, AMEX was acquired by NYSE Euronext. The Nasdaq is another American stock exchange, also located in New York City. Nasdaq holds a higher trading volume per day than any other stock exchange in the world. Both the Nasdaq and the AMEX provide a platform for exchange where buyers and sellers meet. However, there are several differences between these two exchanges.
The Nasdaq is significantly larger than the AMEX, as noted previously. Another key difference is the method of exchange: The AMEX is auction-based, which means that the specialists are physically present at the exchange and the buying and selling of stocks is done verbally. The Nasdaq, on the other hand, is a market-maker based exchange and is completely electronic meaning specialists are not required to match trades. The two exchanges also differ in their focus. The AMEX includes innovative trades, boasting the second-largest options trading market and it helped pioneer the inclusion of exchange-traded funds. The Nasdaq focuses primarily on technology deals and corporate exchanges. (To read more about specialists and their role on the AMEX read our related article Electronic Trading: The Role of a Specialists.)
What do all of the letters in a stock option ticker symbol mean?A:
The option ticker explains four main things about the option: the underlying stock, whether it is a call or a put option, the expiration month and the strike price. An option ticker is quoted by a series of letters. This is a lot of information crammed into one ticker, but we can help you decode option ticker symbols.
Option Ticker Structure
An option ticker can be broken down into three parts. The first part of the option ticker is the option symbol, which can vary in letter length. Typically, this symbol will be found on all the options of the company and will be identical to the stock symbol. However, this is not an absolute. For example, Microsoft's ticker is MSFT, while its option symbol is quoted as both MSQ and MFQ. The second part of the option ticker is the expiration date and the call or put classification of the option, and it consists of a single letter. There are 12 possible expiration periods for options - one per month. Options classified from A to L are call options and M to X are put options. The third part to the option ticker is the strike price of the option, and this is also a single letter. Because there is a wide range of potential strike prices and a limited number of letters, each letter represents more than one strike price. This creates the need for a bit of guesswork, but nothing overly complex.
Here is a visual breakdown of an Oct. 05 35.00 Merck Option:
To help you decode any option ticker, we are providing you with a code sheet:
Now that you have your option ticker code breaker, let's try an example:
GMIU - The last two letters provide information pertaining to the terms of the contract. This leaves the other two letters as the option symbol (GM). Again, the second part of the ticker (I) explains the month of expiry and whether it is a call or a put. Looking at the above chart, we see that this is a call option that expires in September. The third part (U) is a bit trickier: if we know that this is a General Motors option and the current stock price is $31.50, we can easily find that the strike price of this option is $37.50. By looking at the option ticker, we now know that it is a Sept. 37.50 GM call option.
When it comes to the strike price, it is important to remember that strike prices for most options do not vary a great deal from the current stock price. For example, it is rare that you would be able to purchase an option with a strike price of $500 that has a stock price of only $15.
Be warned that in the event of stock restructurings, like five for seven stock splits or mergers, there may be no way to use the codes above to find out information about the option. If such a restructuring occurs, the exchange on which the option is traded will change the option ticker symbol accordingly.
For further reading, see our Option Basics Tutorial.
What do the SP-500, Dow and Nasdaq futures contracts represent?A:
A futures contract represents a legally binding agreement between a party and counterparty to pay or receive the difference between the price when entering into the contract and the price when the contract expires. Contracts carry a multiplier that inflates the value of the contract, adding leverage to the position, and can be traded on the long side or short side without restrictions or uptick rules. An index futures contract mirrors the underlying cash index and acts as a precursor for price action on the stock exchange where the index is used.
Index futures contracts trade continuously throughout the market week, except for a 30-minute settlement period in the late afternoon US central time, after stock markets close. SP-500, Dow and Nasdaq index futures contracts trade on the CME Globex system, a 24-hour electronic marketplace, and are called "e-mini contracts". SP-500 also trades a larger-sized contract on CME's open outcry system but it attracts little volume compared to the electronic markets. Contracts are updated four times per year, with expiration taking place during the third month of each quarter.
E-mini futures contracts trade from Sunday evening (US time) through Friday afternoon, offering traders nearly continuous market access during the business week. Liquidity tends to dry up between the US equity market close and opening of the European stock exchanges in the early morning hours (US time). Spreads and volatility can widen during these periods, adds significant transaction costs to new positions.
If the e-mini SP-500 futures contract is trading higher before the opening of US stock markets, it means the SP-500 cash index will trade higher following the opening bell. Contracts track US index direction closely during regular stock market trading hours but will be priced higher or lower because they represent expected future prices rather than current prices. Contracts denote approximate valuations for the next trading day when US markets are closed, based on perceptions about overnight events and economic data, as well as movements in correlated or inversely-correlated financial instruments that include the forex markets, which also trades nearly 24 hours per day.
The contract multiplier calculates the value of each point of price movement. The e-mini Dow multiplier is 5, meaning each Dow point is worth $5 per contract. The e-mini Nasdaq multiplier is 20, worth $20 per point, while the e-mini SP-500 carries a 50 multiplier that's worth $50 per point.. For example, if an e-mini Dow futures contract is valued at $10,000 and a buyer picks up one contract, it will be worth $50,000. If the Dow then falls 100 points, the buyer will lose $500 while a short seller will gain $500.
Index futures contracts are marked to market, meaning the change in value to the contract buyer is shown in the brokerage account at the end of each daily settlement until expiration. For example, if the e-mini Dow contract drops 100 points in a single trading day, $500 will be taken out of the contract buyer's account and placed into the short seller's account at settlement.
What does "guns and butter" refer to?A:
Guns and butter explains the relationship between two goods that are important for a nation's long-term economic growth and stability. This classic example of the production possibility frontier (PPF) defines the relationship and conflict between a nation's investment in the military, defense and civilian goods.
Countries need to choose between two options when spending finite resources, either buying goods that benefit local citizenry or applying those resources to territorial expansion and security, allocating capital to military forces and equipment. These opposing priorities characterize a nation's choices and identity in first world societies.
Politicians use "guns or butter" arguments to state positions about national priorities, deeply impacting gross domestic product (GDP) and economic policy. All nations need to determine the ratio of guns vs. butter to meet external and internal demands. influenced by local economic conditions and the military stance of potential opponents.
To learn more, read Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and Trade.
What is a debt/equity swap?A:
When a company wants to restructure its debt and equity mix to better position itself for long-term success, it may consider issuing a debt/equity or equity/debt swap.
In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt in the same company. Bonds are usually the type of debt that is offered.
A debt/equity swap works the opposite way. Debt is exchanged for a predetermined amount of stock.
After the swap takes place, part or all of the one asset class will be phased out and everyone who participated in the swap will now participate in the new or growing asset class being phased in.
Reasons for Swaps
There are many possible reasons why management may restructure a company's finances.
One reason is that the company may need to meet certain contractual obligations, such as a maintaining a target debt/equity ratio. The contractual obligations could be a result of financing requirements imposed by a lending institution, or may be self-imposed by the company as detailed in the prospectus. The company may want to keep the debt/equity ratio in a target range so they can get good terms on credit/debt if they need it, or will be able raise cash through a share offering if needed. If the ratio is too lopsided, it may limit what they can do in the future to raise cash.
A company may swap stock for debt to avoid making coupon and face value payments on the debt in the future. Instead of having to pay out a large amount of cash for debt payments, they company offers debt holders stock instead.
Both equity/debt and debt/equity swaps are typically valued at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap.
For example, assume there is an investor who owns a total of $1,500 in ZXC Corp stock. ZXC has offered all shareholders the option to swap their stock for debt at a rate of 1:1, or dollar for dollar. In this example, the investor would get $1,500 worth of debt if he or she elected to take the swap. If the company really wanted investors to trade shares for bonds, it can sweeten the deal by offering a swap ratio of 1:1.5. Since investors would receive $2,250 (1.5 * $1,500) worth of debt, they essentially gained $750 for just switching asset classes. However, it is worth mentioning that the investor would lose all respective rights as a shareholder, such as voting rights, if they swapped their equity for debt.
Debt/Equity Swap Implications
When more stock is issued, this dilutes current shareholders. This typically has a dampening effect on share price because what the company earns is now spread out among more shareholders.
While in theory a company could issue stock to avoid debt payments, if the company is in financial trouble, the move would likely hurt the share price even more. Not only does the swap dilute shareholders, but it shows how cash-strapped the company is. On the flip side, with less debt and now more cash on hand the company may be in a better position.
Issuing more debt means larger interest expenses. Since debt can be relatively cheap, this may be a viable option instead of diluting shareholders. A certain amount of debt is good, as it acts as internal leverage for shareholders. Too much debt is a problem though, as escalating interest payments could hurt the company if revenues starts to slip.
With there being pros and cons to issuing both debt and equity in different situations, swaps are sometimes necessary to keep the company in balance so they can hopefully achieve long-term success. For additional reading, see Fundamental Analysis Tutorial.
What is stock dilution?A:
Stock dilution occurs when company actions reduce the ownership percentage of current shareholders. Dilutive stock is any security that generates this reduction..The reason why dilutive stock has negative connotations is quite simple: a company's shareholders are its owners and anything that decreases an investor's level of ownership also decreases the value of the investor's holdings.
Ownership can be diluted in a number of ways:
1. Secondary Offerings: For example, if a company had a total of 100 shares on the market and its management issues another 100 shares, the owners of the first 100 shares would face a 50% dilution factor. In a real life example, consider the secondary offering made by Lamar Advertising in 2018. The company decided to issue more than 6 million shares of common stock, diluting then-current holdings of 84-million shares.
2. Convertible Debt/Convertible Equity: When a company issues convertible debt, it means that debt holders who choose to convert their securities into shares will dilute current shareholders' ownership. In many cases, convertible debt converts to common stock at some sort of preferential conversion ratio. For example, each $1,000 of convertible debt may convert to 100 shares of common stock, thus decreasing current stockholders' total ownership.
Convertible equity is often called convertible preferred stock. These kinds of shares usually convert to common stock on some kind of preferential ratio - for example, each convertible preferred stock may convert to 10 shares of common stock, thus also diluting ownership percentages of the common stockholders.
3. Warrants, Rights, Options and other claims on security: When exercised, these derivatives are exchanged for shares of common stock that are issued by the company to its holders. Information about dilutive stock, options, warrants, rights and convertible debt and equity can be found in a company's annual filings.
For more information on shareholder dilution and its costs, check out Accounting And Valuing ESOs.
What is the CBOE Volatility Index? (VIX)A:
The Chicago Board Options Exchange (CBOE) calculates a real-time index to show the expected level of price fluctuation in the S&P 500 Index option over the next 12 months. Officially called the CBOE Volatility Index and listed under the ticker symbol VIX, investors and analysts sometimes refer to it by its unofficial nickname: the fear index.
Technically speaking, the CBOE Volatility Index does not measure the same kind of volatility as most other indicators. Volatility is the level of price fluctuations that can be observed by looking at past data. Instead, the VIX looks at expectations of future volatility, also known as implied volatility. Times of greater uncertainty (more expected future volatility) result in higher VIX values, while less anxious times correspond with lower values.
The initial VIX was released by the CBOE in 1993. At the time, the index only took into consideration the implied volatility of eight separate S&P 100 put and call options. Following 2002, the CBOE made the decision to expand the VIX to the S&P 500 in order to better capture market sentiment. VIX futures were added in 2004 and VIX options followed in 2006.
VIX values are quoted in percentage points and are supposed to predict the stock price movement in the S&P 500 over the following 30 days. This value is then annualized to cover the upcoming 12-month period. The VIX formula is calculated as the square root of the par variance swap rate over those first 30 days, also known as the risk-neutral expectation. This formula was developed by Vanderbilt University Professor Robert Whaley in 1992.
Investors, analysts and portfolio managers look to the CBOE Volatility Index as a way to measure market stress before they make decisions. When VIX returns are higher, market participants are more likely to pursue investment strategies with lower risk.
What is the difference between "right" and "obligation" on a call option?A:
An option is a financial instrument whose value is derived from an underlying asset. A call option is an agreement that gives the buyer, or holder, the right to buy the underlying asset, or stock, at a predetermined strike price on or by a predetermined expiration date. The buyer of an option is not obligated to buy the stock at the strike price; he just has a right to do so if he chooses.
For example, an investor buys one XYZ call option with a strike price of $10, expiring next week for $1. If the stock trades at $10.05 the day after he buys it, he has the right to buy the stock for $10, but he is not forced to buy the stock.
On the other hand, a writer, or seller, of a call option is obligated to sell the underlying asset at a predetermined price, known as the strike price, if the call option the investor sold is exercised. The writer of a call option is paid to take on the risk that is associated with being obligated to deliver shares; the payment is known as the premium, or price of the option.
For example, an investor sells one TUV call option with a strike price of $15, expiring next week, for $1, and the stock is trading at $13. The writer collects a premium of $100 because an equity option contains 100 options per contract.
The investor is bearish on the stock and thinks the price of the stock will decrease. He hopes that the call will expire worthless.
The day before the option expires, company TUV publishes news that it's going to buy another company, and the stock price increases to $20. Many holders of the call options exercise their options to buy. The seller of the call option, then, is obligated to deliver 100 shares of TUV at $15.
What is the difference between a covered call and a regular call?A:
A call option is a contract that gives the buyer, or holder, a right to buy an asset at a predetermined price by or on a predetermined date. A call option is used to create multiple strategies, such as a covered call and a naked call.
A covered call is an options strategy that consists of selling a call option that is covered by a long position in the asset. This strategy provides downside protection on the stock while generating income for the investor. On the other hand, a regular short call option, or a naked call, is an options strategy where an investor sells a call option. Unlike a covered call strategy, a naked call strategy's upside is just the premium received. An investor in a naked call position believes that the underlying asset will be neutral to bearish in the short term.
For example, suppose an investor is long 500 shares of stock DEF at $8. The stock is trading at $10, and the investor is worried about a potential fall in price within six months. The investor can sell five call options against his long stock position. Suppose he sells five DEF call options with a strike price of $15 and a expiration date in six months. If the stock price stays below the strike price, he would keep all the premium on the call options because they would be worthless. He would still profit if the shares rise above $15 because he is long from $8. Since the investor is short call options, he is obligated to deliver shares at the strike price on or by the expiration date, if the buyer of the call exercises his right.
On the other hand, suppose another investor sells a call option on DEF with a strike price of $15, expiring next week. She is in a naked call position; theoretically, she has unlimited downside potential. Her reward for taking on this risk is just the premium she received.
What is the difference between a currency and interest rate swap?A:
Swaps are derivative contracts between two parties that involve the exchange of cash flows. Interest rate swaps involve exchanging interest payments, while currency swaps involve exchanging an amount of cash in one currency for the same amount in another.
An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest rate cash flows. The interest rate swap generally involves exchanges between predetermined notional amounts with fixed and floating rates.
For example, assume bank ABC owns a $10 million investment, which pays the London Interbank Offered Rate, or LIBOR, plus 3% every month. Therefore, this is considered a floating payment because as the LIBOR fluctuates, so does the cash flow. On the other hand, assume bank DEF owns a $10 million investment, which pays a fixed rate of 5% every month. Bank ABC decides it would rather receive a constant monthly payment. However, bank DEF decides to take a chance on receiving higher payments. Therefore, the two banks agree to enter into an interest rate swap contract. Bank ABC agrees to pay bank DEF the LIBOR plus 3% per month on the notional amount of $10 million. Bank DEF agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of $10 million.
Conversely, currency swaps are a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.
For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in Russia and deals only with rubles. Suppose bank QRS has investments in the United States worth $5 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank DEF the LIBOR plus 1% per month on the notional amount of $5 million. Bank QRS agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of 253,697,500 Russian rubles, assuming $1 is equal to 50.74 rubles.
What is the difference between a short position and a short sale?A:
A short position and a short sale are very similar concepts; for this reason, they are often collectively referred to as "shorting," and the two terms are quite commonly used interchangeably. The difference between the two lies in the subject of the transaction. While short selling and short positioning generally refer to the same thing both in common parlance and technical jargon, there are some instances where short positioning is not the same as short selling. A transaction undertaken by means of a derivative contract is a short position, but it is technically not a short sale because no asset is actually delivered to the buyer. Therefore, when the transactions involve futures, options and swaps, it is short positioning and not short selling.
In both cases, the aim of the trader is to sell the items at a high price and then to purchase them back at a lower one. The profit accrued from these techniques is the difference between the price at which the trader sold and the price at which they were purchased back. As shorting refers to borrowed commodities, they must be eventually returned to their rightful owner, so buying them back is a necessity. For this reason, it is a very risky strategy and should only be undertaken by experienced traders who know when to short a stock.. This can be done at any time before the time the securities are supposed to be returned. Purchasing the sold goods back is referred to as both "covering the short" or "covering the position."
What is the difference between an option-adjusted spread and a Z-spread in reference to mortgage-backed securities (MBS)?A:
Unlike the Z-spread calculation, the option-adjusted spread takes into account how the embedded option in a bond can change the future cash flows and overall value of the bond. Mortgage-backed securities often have embedded options due to the prepayment risk associated with mortgages. As such, the embedded option can have a significant impact on the future cash flows and present value of the mortgage-backed securities. The embedded option's cost is calculated as the difference between the option-adjusted spread at the expected interest rate and the Z-spread. The base calculations for both spreads are similar, while the option-adjusted spread discounts the bond's value since the option is callable.
The nominal spread is the most basic spread concept and measures the difference in the basis points between a risk-free Treasury debt instrument and a non-Treasury instrument. This spread difference is measured in basis points. The nominal spread only provides the measure at one point along the Treasury yield curve, which is a significant limitation.
The Z-spread provides the difference in basis points along the entire Treasury yield curve. The Z-spread is the constant spread that will make the bond's price equal to the present value of its cash flows along each point of maturity for the Treasury curve. Therefore, the cash flow is discounted at the Treasury spot rate, plus the Z-spread. However, the Z-spread does not include the value of embedded options in its calculation. Embedded options can impact the present value of bonds.
The option-adjusted spread adjusts the Z-spread to include the embedded option's value. The option-adjusted spread is therefore a dynamic pricing model that is highly dependent on the model being used. The option-adjusted spread considers the variability of interest rates and of prepayment rates. These factors' calculations are complex, since they attempt to model future changes in interest rates and prepayment behavior of mortgage borrowers. More advanced statistical modeling methods such as Monte Carlo analysis are often used to predict prepayment probabilities.
Mortgage-backed securities often include embedded options, since there is a significant risk of prepayment. Mortgage borrowers are more likely to refinance their mortgages if interest rates go down. The embedded option means the future cash flows are alterable by the issuer since the bond can be called. The embedded option may be used by the issuer if interest rates drop. The embedded call allows the issuer to call the outstanding debt, pay it off and reissue it at a lower interest rate. By being able to reissue the debt at a lower interest rate, the issuer can reduce the cost of capital.
Investors in bonds with embedded options therefore take on more risk. If the bond is called, the investor will likely be forced to reinvest in other bonds with lower interest rates. Bonds with embedded call options often pay a yield premium over bonds with similar terms. Thus, the option-adjusted spread is helpful to understand the present value of debt securities with embedded call options.
What is the difference between derivatives and options?A:
A derivative is a financial contract that gets its value, risk and basic term structure from an underlying asset. Options comprise one category of derivatives while other types include futures contracts, swaps and forward contracts. Derivatives have been used to hedge risk and increase returns for generations, especially in the agricultural industry, where one party agrees to sell crops or livestock to a counter-party who agrees to buy those crops or livestock for a specific price on a specific date. These bilateral contracts were revolutionary when first introduced, replacing oral agreements and the simple handshake.
An equity option is a derivative that obtains its value from an underlying stock.. An equity option represents the right, but not the obligation, to buy or sell a stock at a certain price, known as the strike price, on or before an expiration date. If the option is exercised by the holder, the seller of the option must deliver 100 shares of the underlying stock per contract to the buyer. Equity options are traded on exchanges and settled through centralized clearing houses, providing transparency and liquidity, two critical factors when traders or investors take derivatives exposure.
American-style options can be exercised at any point up until the expiration date while European-style options can only be exercised on the day it is set to expire. Most equity and exchange traded funds (ETFs) options on exchanges are American options while just a few broad-based.indices, including the SP-100 Large Cap Index, have American-style options. Major benchmarks, including the SP-500, have actively traded European-style options.
Other Types of Derivatives
Futures contracts are derivatives that obtain their value from an underlying cash commodity or index. A standard corn futures contract represents 5,000 bushels of corn, while a standard crude oil futures contract represents 1,000 barrels of oil. There are futures contracts on assets as diverse as currencies and the weather.
A swap is a financial agreement among parties to exchange a sequence of cash flows for a defined amount of time. Interest rate swaps and currency swaps are common types of swap agreements. Swaps are generally traded over the counter but are slowly moving to centralized exchanges. The financial crisis of 2008 led to new financial regulations such as the Dodd-Frank Act, which created new swaps exchanges to encourage centralized trading.
There are multiple reasons why investors and corporations trade swap derivatives. The most common include:
- A change in investment objectives or repayment scenarios.
- A perceived financial benefit in switching to newly available or alternative cash flows.
- The need to hedge or reduce risk generated by a floating rate loan repayment.
A forward contract is an agreement to trade an asset, often currencies, at a future time and date for a specified price. Forward contracts are traded over the counter since they are custom agreements between two parties. Due to the over the counter transactions, there is a higher risk of counterparty default. As a result, forward contracts are not as easily available to retail traders and investors as futures contracts.
- A change in investment objectives or repayment scenarios.
What is the difference between derivatives and swaps?A:
A derivative denotes a contract between two parties, with its value generally determined by an underlying asset's price. Common derivatives include futures contracts, options, forward contracts and swaps. Swaps comprise one type of the broad derivatives universe but its value isn't derived from an underlying security or asset.
The Difference Between Derivatives and Swaps
The value of derivatives are generally derived from the performance of an asset, index, interest rate, commodity or currency. For example, an equity option, which is a derivative, derives its value from the underlying stock price. In other words, the value of the equity option fluctuates as the price of the underlying stock fluctuates.
Swaps are agreements between two parties, where each party agrees to exchange future cash flows, such as interest rate payments. Contrary to other derivatives, swaps do not derive their value from an underlying security or asset.
Explaining Interest Rate Swap
The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties agree to exchange interest payments. For example, assume Bank A agrees to make payments to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A based on a floating interest rate.
Assume Bank A owns a $10 million investment that pays the London Interbank Offered Rate (LIBOR) plus 1% each month. Therefore, as LIBOR fluctuates, the payment the bank receives will fluctuate. Now assume Bank B owns a $10 million investment that pays a fixed rate of 2.5% each month.
Assume Bank A would rather lock in a constant payment while Bank B decides it would rather take a chance on receiving higher payments. To accomplish their goals, the banks enter into an interest rate swap agreement. In this swap, the banks simply exchange payments and the value of the swap is not derived from any underlying asset.
Interest rate risk is significant because interest rates do not always move as expected. Both parties have interest rate risk. The holder of the fixed rate risks the floating interest rate going higher, thereby losing interest that it would have otherwise received. The holder of the floating rate risks interest rates going lower, which results in a loss of cash flow since the fixed rate holder still has to make streams of payments to the counterparty.
The other main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the floating rate is unable to make payments under the swap agreement, the holder of the fixed rate has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed rate was seeking to avoid.
Legislation passed after the 2008 economic crisis requires most swaps to trade through swap execution facilities as opposed to over the counter, and also requires public dissemination of information. This market structure is intended to prevent a ripple effect impacting the larger economy in case of a counterparty default.
What is the difference between in the money and out of the money?A:
In options trading, the difference between "in the money" (ITM) and "out of the money" (OTM) is a matter of the strike price's position relative to the market value of the underlying stock, called its moneyness.
An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option is one that has a strike price that the underlying security has yet to reach, meaning the option has no intrinsic value.
A call option gives the option buyer the right to buy shares at the strike price, if it is beneficial to do so. An in the money call option, therefore, is one that has a strike price lower than the current stock price. A call option with a strike price of $132.50, for example, would be considered ITM if the underlying stock is valued at $135 per share because the strike price has already been exceeded. A call option with a strike price above $135 would be considered OTM because the stock has not yet reached this level.
In the case of the stock trading at $135, and the option strike of $132.50, the option would have $2.50 worth of intrinsic value, but the option may cost $5 to buy. It costs $5 because there is $2.50 of intrinsic value and the rest of option cost, called the premium, is composed of time value. You pay more for time value the further the option is from expiry, because the underlying stock price will move before expiry which provides opportunity to the option buyer and risk to the option writer which they need to be compensated for.
Put options are purchased by traders who believe the stock price will go down. ITM put options, therefore, are those that have strike prices above the current stock price. A put option with a strike price of $75 is considered in the money if the underlying stock is valued at $72 because the stock price has already moved below the strike. That same put option would be out of the money if the underlying stock is trading at $80.
In the money options carry a higher premium than out of the money options, because of the time value issue discussed above.
Comparing the ITM and OTM
In the money or out of the money options both have their pros and cons. One is not better than the other. Rather, the various strike prices in an options chain accommodate all types of traders and option strategies.
When it comes to buying options that are ITM or OTM, the choice depends on your outlook for the underlying security, financial situation, and what you are trying to achieve.
OTM options are less expensive than ITM options, which in turn makes them more desirable to traders with little capital. Although, trading on a shoe-string budget is not advised. Some of the uses for OTM options include buying the options if you expect a big move in the stock. Since OTM options have a lower up front cost (no intrinsic value) than ITM options, buying an OTM option is a reasonable choice. If a stock currently trades at $100, you can buy a OTM call option with a strike of $102.50 if they think the stock will reasonably rise well above $102.50.
OTM options often experience larger percent gains/losses than ITM options Since the OTM options have a lower price, a small change in their price can translate into large percent returns and volatility. For example, it is not uncommon to see the price of an OTM call option bounce from $0.10 to $0.15 during a single trading day, which is equivalent to a 50% price change. The flip side is that these options can move against you very quickly as well, though risk is limited to the amount paid for the option (assuming you are the option buyer and not the option writer).
ITM options also have their uses. For example, a trader may want to hedge or partially hedge their position. They may also want to buy an option that has some intrinsic value, and not just time value. Because ITM options have intrinsic value, and are priced higher than OTM options in the same chain, the price moves (%) are relatively smaller. That is not to say ITM option won't have large price moves, they can and do, but compared to OTM options the percentage moves are smaller.
Certain strategies call for ITM options, while others call for OTM options, and sometimes both. One is not better than another, it just comes down to what works for the best for the strategy in question. For further reading, check out the Options Basics Tutorial.
What is the difference between open interest and volume?A:
Two measurements describe the liquidity and activity of contracts In the options and futures markets:
1. Volume refers to the quantity of contracts traded in a given period
2. Open interest denotes the number of active contracts.
[Open interest and volume are two important concepts to understand when trading options. If you're new to trading options, Investopedia's Options for Beginners Course provides a comprehensive overview of options, covering everything from risk management to advanced strategies like spreads, strangles, and straddles.]
Trading volume measures the number of options or futures contracts being exchanged between buyers and sellers, identifying the level of activity for that contract. For example, assume the volume in call option ABC with a strike price of $55 and an expiration date in three weeks did not trade any contracts on a specified day. Therefore, the trading volume is 0. In the next session, an investor buys 15 call option contracts while a market maker sells 15 call option contracts, lifting trading volume for that session to 15.
Open interest indicates the number of options or futures contracts that are held by traders and investors in active positions. These positions have not been closed out, expired or exercised. Open interest decreases when holders and writers of options (or buyers and sellers of futures) close out their positions. To close out positions, they must take offsetting positions or exercise their options. Open interest increases once again when investors and traders open new long positions or writers/sellers take on new short positions. Open interest also increases when new options or futures contracts are created,
For example, assume the open interest of call option ABC is 0. The next day an investor buys 10 option contracts and another investor sells 10 option contracts. The open interest for this particular call option is now 10.
Options or futures contract trading volume can only increase while open interest can either increase or decrease. While trading volume indicates the number of contracts that have been bought or sold, open interest identifies the number of contracts that are currenltly held.
Price Vs. Open Interest
1. Rising prices in an uptrend while open interest is on the rise indicates that new money is coming into the market (reflecting new buyers). This is considered bullish.
2. Rising prices in an uptrend while open interest is on the decline indicates that short sellers are covering positions. Money is leaving the marketplace; which is a bearish sign.
3. Falling prices in a downtrend while open interest is on the rise indicates that new money is coming into the market on the short side. This scenario is consistent with downtrend continuation and is bearish.
4. Falling prices in a downtrend while open interest is on the decline indicates disgruntled holders forced to liquidate positions and is a bearish sign. However, it can also indicate that a selling climax is near.
5. High open interest while price drops sharply at a potential market top indicates a bearish scenario because holders who bought near the top are now losing money, raising the potential for panic selling.
What is the difference between options and futures?A:
The fundamental difference between options and futures lies in the obligations they put on their buyers and sellers. An option gives the buyer the right, but not the obligation, to buy (or sell) a certain asset at a specific price at any time during the life of the contract. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration.
[Futures may be great for index and commodities trading, but options are the preferred securities for equities. Investopedia's Options for Beginners Course provides a great introduction to options and how they can be used for hedging or speculation.]
Aside from commissions, an investor can enter into a futures contract with no upfront cost, whereas buying an options position does require the payment of a premium. Compared to the absence of upfront costs of futures, the option premium can be seen as the fee paid for the privilege of not being obligated to buy the underlying in the event of an adverse shift in prices. The premium is the maximum a purchaser of an option can lose.
Another key difference between options and futures is the size of the underlying position. Generally, the underlying position is much larger for futures contracts, and the obligation to buy or sell this certain amount at a given price makes futures more risky for the inexperienced investor.
How Gains Are Received
The final major difference between these two financial instruments is the way the gains are received by the parties. The gain on an option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price. In contrast, gains on futures positions are automatically marked to market daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day, but a futures contract holder can realize gains also by going to the market and taking the opposite position.
Options and Futures Example
Let's look at an options and futures contract for gold. One options contract for gold on the Chicago Mercantile Exchange (CME) has the underlying asset as one COMEX gold futures contract, not gold itself. An investor looking to buy an option may purchase a call option for $2.60 per contract with a strike price of $1600 expiring in Feb 2019.
The holder of this call has a bullish view on gold and has the right to assume the underlying gold futures position until the option expires after market close on Feb 22, 2019. If the price of gold rises above the strike price of $1,600, the investor would exercise his right to obtain the futures contract, otherwise, he may let the options contract expire. The maximum loss of the call options holder is the $2.60 premium he paid for the contract.
The investor may instead decide to obtain a futures contract on gold. One futures contract has its underlying asset as 100 troy ounces of gold. The buyer is obligated to accept 100 troy ounces of gold from the seller on the delivery date specified in the futures contract. If the trader has no interest in the physical commodity, he can sell the contract before delivery date or roll over to a new futures contract. If the price of gold goes up (or down), the amount of gain (or loss) is marked to market (i.e. credited or debited) in the investor's account at the end of each trading day. If the price of gold in the market falls below the contract price the buyer agreed to, he is still obligated to pay the seller the higher contract price on delivery date.
(To learn more about options see: Options Basics. To learn more about futures see: Futures Fundamentals.)
What is the difference between return on equity and return on capital?A:
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.
Calculating Return on Equity
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%.
Calculating Return on Capital
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
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 it is a relative value. Knowing the value is 10% or 30% doesn't explain much as to whether a business is good or not, as ROS will vary across different industries.
To see if an ROS is strong or weak, it needs to be compared across time or between competitors. The most efficient companies tend to have the highest ROS values within their industry.
What is the relationship between implied volatility and the volatility skew?A:
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.
Types of Skews
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.
What kinds of derivatives are types of contingent claims?A:
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.
Rights and Obligations
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.
What types of options positions create unlimited liability?A:
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.
What's the difference between a credit spread and a debt spread?A:
When trading or investing in options, there are two main option spread strategies, credit spreads and debit spreads. Credit spreads are options strategies that involve receipts of premiums, whereas debit spreads involve payments of premiums.
A credit spread involves selling, or writing, a high premium option and simultaneously buying a lower premium option. The premium received from the written option of the spread is greater than the premium paid for the long option, resulting in a premium being credited into the trader or investor's account when the position is opened. When traders or investors use a credit spread strategy, the maximum profit they can receive is the net premium.
For example, an investor implements a credit spread strategy by writing one March call option with a strike price of $30 for $3 and simultaneously buying one March call option at $40 for $1. Since the usual multiplier on an equity option is 100, the net premium received is $200 for the trade, and he will profit if the spread strategy narrows.
Conversely, a debit spread involves buying an option with a higher premium and selling an option with a lower premium, where the premium paid for the long option of the spread is more than the premium received from the written option. Unlike a credit spread, a debit spread results in a premium being debited, or paid, from the trader's or investor's account when the position is opened.
For example, a trader buys one May put option with a strike price of $20 for $5 and simultaneously sells one May put option with a strike price of $10 for $1. Therefore, he paid $4, or $400 for the trade. If the trade is out of the money, his max loss is reduced to $400, as opposed to $500 if he only bought the put option.
When is a put option considered to be "in the money"?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.
When was the first swap agreement and why were swaps created?A:
Swap agreements originated from agreements created in Great Britain in the 1970s to circumvent foreign exchange controls adopted by the British government. The first swaps were variations on currency swaps. The British government had a policy of taxing foreign exchange transactions that involved the British pound. This made it more difficult for capital to leave the country, thereby increasing domestic investment.
Swaps were originally conceived as back-to-back loans. Two companies located in different countries would mutually swap loans in the currency of their respective countries. This arrangement allowed each company to have access to the foreign exchange of the other country and avoid paying any foreign currency taxes.
IBM and the World Bank entered into the first formalized swap agreement in 1981. The World Bank needed to borrow German marks and Swiss francs to finance its operations, but the governments of those countries prohibited it from borrowing activities. IBM, on the other hand, had already borrowed large amounts of those currencies, but needed U.S. dollars when interest rates were high for corporate borrowers. Salomon Brothers came up with the idea for the two parties to swap their debts. IBM swapped its borrowed francs and marks for the World Bank’s dollars. IBM further managed its currency exposure with the mark and franc. This swaps market has since grown exponentially to trillions of dollars a year in size.
The history of swaps wrote another chapter during the 2008 financial crisis when credit default swaps on mortgage backed securities (MBS) were cited as one of the contributing factors to the massive economic downturn. Credit default swaps were supposed to provide protection for the non-payment of mortgages, but when the market started to crumble, parties to those agreements defaulted and were unable to make payments. This has led to substantial financial reforms of how swaps are traded and how information on swap trading is disseminated. Swaps were historically traded over the counter, but they are now moving to trading on centralized exchanges.
Where can I purchase options?A:
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.
Where does the name "Wall Street" come from?A:
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.
Why are call and put options considered risky?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.
Long Call Option
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.