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Factors influence an options price
The price of an option is made up of two components: Intrinsic Value: Is the difference between the underlying price and the strike price. Only options that are in-the-money will have intrinsic value: INTRINSIC VALUE (CALL) = UNDERLYING PRICE – STRIKE PRICE INTRINSIC VALUE (PUT) = STRIKE PRICE – UNDERLYING PRICE Time Value: Any premium that is in excess of the option’s intrinsic value is referred to as time value. 6 Factors that influence an options price 1 - Underlying Price: this is the most influential factor affecting an options price. In general, as the price of the underlying increases, the value of a call increases and the value of a put decreases. The reverse is also true; as the price of the underlying decreases, the value of a call decrease and the value of a put increases. 2 - Volatility is the degree to which a price moves, regardless of direction. It is a measure of the speed and magnitude of price changes in the underlying. There are two types of volatility that may impact option pricing: Historical Volatility: the actual price changes that have been observed over a specified time frame. Implied Volatility is a forecast of future volatility so it is an indicator of current market sentiment. Option premiums will generally be higher if the underlying exhibits higher volatility, because there is a greater chance that the underlying will move in the intended direction. 3 - Strike Rate determines the intrinsic value of an option. The premium increases as the option becomes further in-the-money (has more intrinsic value). The further an option is in-the-money the more it resembles a long or short stock position (For a Long Call and Long Put position respectively). 4 - Time to Expiry: the longer an option has until expiry, the more time the underlying has to move in its intended direction. Options are commonly referred to as wasting assets in that they lose their time value as they approach the expiry date due to the decrease in their embedded time value. In general, an option will lose one third of its time value during the first half of its life and two thirds of its value during the second half. In general, the longer the time to expiry, the higher the option price. 5 - Interest Rates and Dividends: as interest rates rise, call premiums will increase and put premiums will decrease. This is because of the potential cost associated with owning the physical stock. The purchaser of a call option is potentially deferring the purchase of the underlying to a future date. If the money to be used to buy the underlying at expiry is in a bank account waiting to purchase the underlying at expiry the interest income will be lower making it less attractive to buy the call option. 6 - Dividends: affect the underlying price because all thing being equal the underlying price should fall by the amount of any cash dividend at the ex-dividend date.
Basics Concepts for Options Trading
An Option is a contract between a buyer (taker) and a seller (writer) which gives the buyer the right, but not the obligation, to buy or sell the underlying security at a predetermined price on or before a pre-determined date. The following is a summary of the key elements you need to be aware of prior to dealing in Options to ensure you understand the basic concepts and assist you to form a view as to whether Options are right for your investment needs. COMPONENTS OF AN OPTION CONTRACT Underlying Securities (or Index); Contract Size: 1 Option contract represents 100 underlying shares; Expiry Date: All Options have an expiry date set by ASX which is typically set for the last Thursday of the relevant expiry month. Expiry dates will be either American (able to be exercised any time up to expiry) or European (can only be exercised on the set expiry date); Exercise (or Strike) Price: this is predetermined and relates to the price at which the underlying security is agreed to be bought / sold; Premium: is the price at which the option is purchased / sold. TYPES OF OPTIONS Calls – Give the Buyer (taker) the right, but not the obligation to buy the underlying securities at a predetermined price Puts – Give the Buyer (taker) the right, but not the obligation to sell the underlying securities at a predetermined price RISK PROFILE Both the Sold Call and Sold Put strategies have fixed, limited upside profit potential above the strike price of the written (sold) option, and both have downside risk below the strike price of the written option. Sold Call: The financial outcome from selling call options against your shares can be conceptualized in two ways; either the income that is generated reduces your average entry price of buying the shares or the income improves the yield on owning the shares. Sold Put: If exercised, you will be obligated to acquire the underlying shares at the pre-agreed price and more than likely at a time when the shares could be purchased more cheaply elsewhere. If the price of the underlying shares (that you have been obligated to acquire) falls by an amount greater than the combination of the premium and/or dividend income generated than a loss will be incurred that is only stopped if the share price falls to zero. However, we recommend the utilisation of Puts and stop losses to limit/mitigate downside exposure.
Sold Calls and Short Puts
Sold Calls Market Outlook Neutral/Mildly Bullish Breakeven Initial purchase price less premiums and/or dividends received Maximum Profit Strike price of sold call – purchase price of shares + call premium + dividends Maximum Loss Is only limited by how high the share price rises (less premium received) Time Decay Advantageous for strategy Margins Paid Yes, unless you own the underlying stock which can be lodged as collateral Investment Characteristics A Sold Call trade may commence with the purchase of the underlying stock and the sale of a call option(s). Once a trade has been opened, if the share price finishes above the strike price of the sold call, the call will be assigned and the shares will be sold to the Buyer at the pre-agreed price. If the share price finishes under the strike price of the sold call option, the option will expire and the Seller retains the premium they received with no further obligation. At that stage, a fresh round of calls may be sold to generate further revenue (if market conditions suit). For an investor who currently has large CGT consequences, a roll up and out strategy should be employed to avoid this event. For specific and professional tax advice, please refer to your accountant. Closing the trade early; Purchasing Put options to protect the capital invested in the position; Buying back sold Call Options if the cost is low and the time period to expiry is long; and Rolling Call to a higher strike price and longer expiry date. Short Puts Market Outlook Neutral/Mildly Bullish Breakeven Strike price less premium received Maximum Profit Premium received Maximum Loss Occurs if the share price falls to zero (less premium received) Time Decay Advantageous for strategy Margins Paid Yes, margins will be required to be paid. Investment Characteristics Each trade will commence with the sale of a put option. Once a trade has been opened, if the share price finishes above the strike price of the sold Put, the Put will expire worthless with a maximum profit being the premium received. If the share price finishes below the strike price of the sold put there are two possible outcomes: Allow the sold Put to be assigned and take delivery of the underlying shares at the pre-agreed price. Upon the purchase of the underlying shares you can: 1) Sell a Call Option to generate income to pay for the underlying stock (effectively turning the trade into a new Sold Call position); OR 2) immediately sell the underlying in to the market to generate funds to pay for the assignment; OR 3) pay for the underlying and retain the stock in your portfolio; or Buy to close the sold Put at any time prior to the expiry date (at your cost).
The Rules of Trading
There are a number of market experts who have devised a set “rules of trading” – rules that have worked out well for them. Invariably, each of these experts gives you the rules like it’s a holy grail they’ve discovered themselves. No doubt these experts have lived through a lot, and certainly experienced the ups and downs that are reflected in these rules. However, it’s also true that each of these individual lists of “trading rules” follow the same basic theme. Why’s that? Because the market is the market, humans are humans, and we all make the same mistakes when it comes to trading. Let us summarise the main rules for you below. Rule 1 - Never let your losses get out of hand This is arguably the most important trading rule. You have to learn to cut your emotions off, swallow your pride, and cut your losses (yes, there will be losses). When you can see your trade is losing, it’s best to cut it off straight away. A little loss is much better than a big loss, and very often that stock “turnaround to glory” you hope for is nothing more than a mirage. Rule 2 - Don’t put all your money on red Following on from rule one is the rule that you should never put all of your money into one trade. Taking a “basket approach” to trading ensures that you have your money spread evenly. Then, if you take a hit on one of your trades, you still have capital in your other trades. Most successful traders have suffered a massive hit at some point, usually through pride or fear. A poor trader lets this bring them down, and they quit. A good traders learns from this mistake and never lets it happen again. Rule 3 - Be patient This is one of the hardest rules for traders to follow. The need to trade on a daily basis is like a form of insanity to some traders! But it’s never wise to over-trade. Why waste money when opportunities aren’t apparent? Don’t buy a stock because you’re bored. The market’s not going to disappear – good opportunities will come along soon. Rule 4 - Follow the trend You’ve heard this before, but it’s important to follow the trend. It’s foolhardy to try to catch the bottom in a share price and time your entry to catch an impending turnaround. Chances are you will lose out as price continues to crash. Every good trader knows that when the trend is bad – and when the whole market is suffering – it’s time to be more cautious than usual, not gung-ho. If the market’s overrun by bears, it’s better to stay back until the bulls return (unless of course you are actively short selling). Rule 5 - Let profits run By the same token, when things are good, stay calm. It’s the magnitude of the profit that’s important – obtaining the most out of each positive move in price. That’s the way to win the game. Don’t close out of an uptrend too early, because they can take time to develop, and you want to make as much money as you possibly can (using a sensible plan!). Rule 6 - Don’t overreact to news or tips We hear all the time that an unknown company is set for a big future – it’s just that the market doesn’t know it yet. More often than not, this company usually fizzles and the “tip” was nothing but hot air. A lot of traders lose money by buying into these “tips”. The same goes for the advice of apparent market “honchos”. Whilst it’s not wrong to listen to solid advice, make sure it fits in with your plan or, more practically, listen to the market. Rule 7 - Just relax There’s a lot of rules in terms of the psychology of trading: take a break, don’t get overemotional, don’t get paranoid, etc. It all comes down to one thing: relax. Keep your emotions in check, and trade sensibly. If you can’t, then take time away from trading. The market will always be there when you come back.
Patience and Impatience
Impatience is one of the biggest demons traders have to fight throughout their trading careers and one of the biggest factors which can hurt new traders. There is no doubt that embarking on a trading career is exciting. The promise and possibility far outweighs the potential pitfalls when you’re standing on the precipice. So many times new and even experienced traders get frustrated with the market and pull the trigger on a trade that goes wrong, only to have the ideal setup form not long thereafter. There are no guarantees in the stock market but unless you are the strictest of strict traders you will experience this feeling. And it really is a feeling of dread and remorse because you know that if you had have been slightly more patient you would have been rewarded. Subconsciously, we as traders worry that we will miss out on an opportunity. There is absolutely no rush, no schedule when it comes to trading. You can rest assured that you can take your time and that if you miss one opportunity there will definitely be other opportunities at a later point in time. So, be patient and continue to keep an eye on this aspect of your psyche and your trading as it is something that can return without you even realising it. Impatience will likely rear its ugly head just after a losing trade or a string of losing trades, as you search frantically for that next winner to make back your losses. After a string of losses is the most appropriate time to take a step back, consider your recent trades, and wait for a quality setup to present itself, rather than being impatient and forcing the action.
Consistency and Discipline
For any trader, consistency and discipline are two closely related character traits that are essential if you are to be successful. Trading is about analysing data and making decisions. Each time you buy or sell a financial instrument you are making a decision, informed or otherwise, about the prospects for that particular financial instrument. As trading revolves around decision making, it follows that you need to be decisive if you are to be successful. In my opinion, the only way you can be decisive is by applying a disciplined and consistent approach each and every time you engage with the market, and the easiest way to do this is by having a detailed and robust trading plan. A detailed trading plan essentially lays out what you will do in certain situations that the market presents. It is a detailed set of instructions that will help you deal with each and every situation that might arise. The reason why a disciplined and consistent approach is necessary for success is because most of us mere mortals get caught up in the emotion of trading, i.e. fear and greed plague our decision making. We may be able to avoid the consequences of these largely uncontrollable emotions for some time but they eventually they catch up with us and destroy our resolve and, worse still, our capital. The common examples of fear and greed by new traders are; Holding onto losing positions for too long and/or, Taking profits on winning positions too early When new traders find themselves in losing positions a whole host of fear elements kick in; fear of losing money, fear of being wrong, etc. All novice traders have, at one stage or another, deluded themselves by saying, ‘I haven’t lost anything yet because I haven’t yet closed my position’. New traders must learn to accept losses and take them on the chin, and the only way to do this is to have a clearly defined set of rules for exiting losing trades and having the discipline to apply those rules consistently. Just as big an issue is not letting profits run and closing out of winning positions too early. So many new traders come to the market unprepared as to what they are going to do should they find themselves in a winning position. As a result, when they see a trade in profit they begin to worry about giving back those profits. They get greedy, thinking about what they are going to do with winnings and close their trade as a result. Often times this ends up costing them a lot of money by not allowing for the trade to make even more profit. Once again, the only way to overcome this issue is by having a clearly defined set of rules for managing winning trades and having the discipline to apply those rules consistently.
Interest Rates and the Sharemarket
The Reserve Bank of Australia has been cutting interest rates for years, and there may still be further to go. Interest rates effect the economy, businesses and the sharemarket. Once, twice, three times an interest rate effect There are basically three ways in which changes in interest rates can impact the sharemarket. Firstly, it needs to be remembered that a significant proportion of a company’s costs are made up of interest payments. When interest rates fall, companies’ cost of doing business falls, most obviously in relation to their cost of funding – servicing their debt becomes cheaper, in much the same way as a household’s monthly mortgage cost falls when interest rates come down. This reduction in business costs results in an increase in profits (all else being equal), which leads to an increase in demand for shares, thereby pushing them higher. On the other hand, when interest rates rise, company profits are hurt due to increased funding costs. As a result, this diminishes demand for shares, negatively affecting share prices. Another way in which interest rates can impact the sharemarket is in relation to investors who borrow to fund their investments. The most obvious case is where an investor operates a margined account, effectively putting up a small amount of the total investment – the margin – and borrowing the rest, at current interest rates. As interest rates fall, the cost of borrowing to fund investments falls too, making sharemarket investments more attractive. This leads to an increase in the demand for shares, thereby pushing their values higher. As interest rates rise, you guessed it, the opposite happens. Investing in the sharemarket with borrowed funds becomes more expensive, and thus less attractive, leading to a decrease in the demand for shares, which negatively impacts share prices. The third way in which interest rates affect the sharemarket is in relation to investors who invest in stocks to receive dividends. These investors assess the attractiveness of their proposed share investments in relation to interest rates. When interest rates are low, certain, specific types of stocks - of which we will speak below - become more attractive to this type of investor. This is because the dividends these shares pay are higher than the interest that would be received from an interest-bearing bank account, when interest rates are low. The increased demand for these sorts of shares, when interest rates are low, has a positive impact on their values - that is, these shares go up. We will refer to these types of shares as ‘interest rate sensitives’. When interest rates are high, interest rate sensitive stocks become less attractive to dividend-focussed investors, as they are able to receive more in interest from an interest-bearing account, than they would in dividends from a dividend-paying stock. Interest rate sensitives Every so often you’ll hear the term “interest rate sensitives” used in relation to various sections of the market. But what does it mean? Interest rate sensitive stocks are the companies that are most affected by changes in interest rates. Fairly obvious, really, isn’t it? The sectors most generally recognised as interest rate sensitive are financials, property trusts and utilities. What is interesting is the manner in which these stocks are affected by changes in interest rates. A choice of yields? Property trusts and utilities are particularly sensitive to changes in bond yields because investors will usually make decisions to invest in these sectors according to the yield they expect to receive. As bond yields and term-deposit rates rise, the yields offered by these stocks become less attractive, on what is known as a “relative yield” basis. This will usually cause investors to sell interest rate sensitive stocks – at least until the point where their yields are closer to bond yields. As the price of these securities falls, and their dividends are kept constant, these stocks’ yield will increase. Of course, property trusts and utilities are usually also very highly geared (have high levels of borrowings), so higher interest rates can really hurt their profitability. So, any expectation of higher interest rates will usually result in falling share prices for property trusts and utilities. But banks offer more Financial institutions like banks are also affected, but banks are hurt not just because of change in the relative yield, but also because higher interest rates directly impact the prices they charge for their financial services (such as loans). This is balanced to some extent by the fact that investors will usually expect some level of capital growth, as well as yield, from banks or insurers, so the relative yield impact is less than that seen for property trusts and utilities. All of these sectors are seen as defensive because a slowing economy will usually result in lower interest rates, which in turn benefits these stocks by making them more attractive on a relative yield basis. Interest rates hurt consumers, too While financials, property trusts and utilities are the most affected by changes in interest rates, most other parts of the market will also be hit by moves in interest rates. Importantly, any changes in interest rates will particularly hurt consumer and business sentiment, so sectors that rely on consumer or business spending are particularly sensitive to changes in monetary policy. In simple terms, all the market is impacted by changes in interest rates, but some sectors are affected more than others. These are the interest rate sensitives.
The Importance of Your Mindset
Trading psychology is, by far and away, the MOST important aspect of trading. Yet surprisingly it is an area of trading that most people dedicate the least amount of time and energy to. For example, most new traders are concerned with how they are going to select their trades or the latest trading method ‘guaranteed’ to be successful, rather than how their own thought processes and biases might affect how they trade. The most common example of this is when a new trader does not appropriately consider how much risk they are willing to take on board. In their planning stage (if in fact they even consider it) they affirm that they are prepared to accept a certain amount of risk and the subsequent consequences of that risk. When they come face to face with the consequences of that risk in the real-world however, they cannot handle it. For example, many trading strategies have an expected drawdown, i.e. an amount that a trading account may fall below the original balance. Given that not every trade taken will provide a positive result, it stands to reason that a trading account can and will fall below the original amount if a series of losing trades are experienced. Many new traders might say that they are prepared to experience a 30% drawdown (i.e. their starting balance of $10,000 is reduced to $7,000), only to find that when their account is down 10%, they bail out because they are scared of losing any more money. This can have broader implications. If their trading methodology is sound, they may just have experienced a tough period and the next 10 trades they take could be winners, sending their account soaring back into positive territory. However, because they were not able to cope with the drawdown they have taken themselves out of the game and removed any possibility that they will recover the money and become profitable. If the new trader had been able to better assess his own risk tolerance, he would have been able to reduce the risk profile of his trading strategy accordingly. We would all agree that when it comes down to it, your psychology is what ultimately will determine your success or failure in any pursuit in life. Those who have a positive attitude towards life and their goals will undoubtedly achieve better outcomes than those who have a negative attitude. This principle is perhaps even more pronounced when it comes to trading because of the subject matter. Just about everyone is concerned with their financial security and independence, placing a high level of importance on the achievement of this end. As such, it naturally becomes a highly emotive topic, stirring feelings that other, more trivial matters, simply do not. Having acknowledged this, one can begin to understand just how important a person’s psychology is when it comes to trading.
The Different Ways of Valuing Companies
The term “value” can often mean different things to different investors. It’s not just perception of value that changes – actual valuations are also calculated differently according the circumstances of both those using the valuation and the company that’s being valued. This can initially be frustrating for many new investors. How can you decide whether to invest in Gold Miner Corp or Media Giant Limited if they are valued in different ways? Moreover, should you place more confidence in one valuation method over the other? The simple answer is that valuations are a matter of ‘horses for courses’. Valuation methods should change according to the circumstances. In the first instance, the purpose of the valuation needs to be understood. The valuation method needs to correspond to the company you are valuing. As a brief summary, these are the methods most often used in the Australian market: Discounted cash flow is the most complex of valuation methods. This method is best used for companies in which earnings are expected to fluctuate or grow, start-ups, and companies with limited life spans. DCFs require considerable information and the analyst must have confidence in this information because even a small change in one of the variables can have a massive impact on the end result. This method is especially useful for mining companies, but it can be used for any company that is experiencing growth (or is expected to experience growth). This is the most commonly used valuation method (and the method we most often use). Earnings before interest and tax (EBIT) is often used in the instance of a potential takeover because the new owner will be able to make changes to the target’s gearing structure. An analyst would never use this EBIT for a financial institution or any company that makes substantial earnings from interest income. Earnings before interest, tax, depreciation and amortisation (EBITDA) should be used when most comparable companies are based overseas. For example, analysts rating telecommunications companies will often use this method. This method strips out much of the financing and taxation effects from a company’s performance and leaves you with an indication of a company’s earnings power. Price-to-earnings ratio is one of the most commonly used valuation methods. P/E ratios are used when companies have relatively stable earnings and there are a number of comparable companies in the local market. Banks are most often valued according to P/E ratios. Net realisable value is used when things get gloomy. An analyst will value a company according to the amount the company’s assets are worth (rather than the earning these assets generate) when the company is making sustained losses or is close to liquidation. Investors should realise that one size rarely fits all in the financial markets. Careful analysis of a company’s attributes will help you determine which valuation method best fits any potential investment.
In reality, trading ranges are simply key support and resistance areas in the market. This allows the astute trader to manage a trade professionally, as the "market risk" is always defined by the boundaries of the trading range. The process of “fading” key levels in a trading range is quite a simple strategy, but requires a little more thought than the typical textbook approach might usually suggest. Nonetheless, the method is easily constructed on a chart, and provides a solid strategy for short-term CFD traders. Firstly, we need to ascertain what a trading range is... Some variations exist to the typical definition of a trading range, which generally considered to be a periodic and consistent swing in prices between two price levels. But, in practice, for the majority of cases a trading range is almost indefinable because each case is so unique. It’s a catch-22, because most trading ranges used as examples in trading literature are “past events” and always appear to be correct in hindsight (aren't we all?). A trading range does not need to be perfect, nor does it need to have a perfect parallel top and bottom horizontal channel as most believe. Whilst we concede that no concrete definition on how to define a trading range exists, we strongly urge traders to use the chart examples provided in this lesson as a basis to aid their own pattern recognition. Trading ranges, or “trading brackets” as they are called by the professional trading community, are identified on a chart using "key swing turning points". Prices are known to be in a trading range once we have a flattening of the short term trend and the chart begins to display congested price action within an obvious range. From here, only three points need to be available for reference. The first two immediate highs and lows become the initial reference levels and the trader will then attempt to speculate on the third and subsequent swing turning points. The trading range will remain until those initial swing points or “risk levels” are breached. [Image] Once an immediate high is formed at point “x”, we await a new swing down to an immediate low at swing point “y”. Upon a retest of point “x”, we speculate on shorts, and upon a retest of point “y” we speculate on longs. It really is quite simple. Let’s assume a stock is generally down trending overall, but has a habit of stalling for several weeks and congesting in wide ranges. We can easily deduce the trading ranges by looking at a daily chart and applying the above analysis. [Image] Capital protection – the holy grail of a contrarian approach. The next part of this strategy is risk protection, and how one implements a stop loss and exit plan to avoid losses. There are two ways we manage risk when trading key levels within trading ranges. Typically, when trading a range the trader “fades” or enters as a contrarian, trading against short-term momentum. The idea is that by acting at or near the upper or lower extremes of the trading range we have some natural protection against further price movement against our contrarian position. Therefore, it’s logical to assume a stop loss is placed outside the extremes of the trading range. Stops are generally placed 2% below (for longs), or above (for shorts) the extremes of the trading range. Regardless of the stop level, any prices outside the trading range extremes are considered to be “risk levels” for traders in contrarian trades. Remember, we are trying to go against the short term trend by trading a range, so there is always a chance that the range is breached permanently resulting in a “breakout”. Here comes the variation of traditional use of stop losses which most are aware of. As traders, we notice particularly in the Australian stock market, given the small size of the market, prices can be manipulated easily. For this reason, all too often, a potentially reliable trading range setup can be “ambushed” by larger players who attempt to push the price out of the trading range boundaries to “run stops”. A break outside of the trading range is a momentum breakout, and any subsequent overnight move could be largely against your position if you choose to hold. Knowing this, we generally don’t want to be holding a position overnight if the stock closes outside of the trade boundaries, and therefore at risky levels for our contrarian trade. Even if your stop is not hit, logic suggest that it’s safer to exit a contrarian trade if there are signs of a breakout at the close of the trading day. The rules are simple: if your stop is not hit, and the market is pushing but does not close outside the extreme of the trading range, we stay in the trade. If you stop is not hit, and the market pushes and closes outside the extreme of the trading range, we should exit without hesitation at the close of market. [Image] When it comes to these sorts of trade setups, profit targets are hard to gauge, but most might look for the entire width of the range as the target. Others prefer to use 50% of the current swing range to gauge an area to cover positions, and some a 61.8% Fibonacci retracement of the range. 50% of the range is generally considered the gravitation point. The Twist Most major breakouts occur from trading ranges, and it’s viable to consider going with a move or “stopping and reversing” on a break down or break out of the trend. If the trading range fails, it’s usually because of a resumption of the primary trend. Note this, and pay attention to the previous direction the price action was moving in before the trading range appeared. Future movements in price will favour this direction.
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