About P/E ratio

P/E Ratio

P/E Ratio is the financial ratios most used by investor to make buy and sell decision. This is a ratio of current stock price to earnings per share for that company. This ratio appears simple but holds tons of information which investors can leverage.

P/E ratio is also called P/E multiple or just PE multiple. It is the ratio of current stock price to earning per share (EPS). All these calculations are based on per share basis.

What does P/E tell us?

P/E tells the investor the number of times a stock is trading compared to its earnings. Example P/E of 15 tells an investor that this stock is trading at 15 times its current earnings. So in essence the investors do see some future value in this company and are willing to pay 15 times its current earnings per share to buy this stock.

What P/E is good?

I have come across some folks who say that a P/E of 15 is considered average. I disagree with this. P/E will essentially tell us how much of a premium the investors are willing to pay today for the company’s stock based on their anticipated or future growth. So a higher P/E means that the share holders are optimistic of the company’s earnings, products and growth. This also means that the investors buying these stocks believe that the stock price will move up. The investors selling the stock believe that the price is too high, too optimistic and stock price will have to reduce to a lower multiple to its earnings. You have to compare P/E ratios of companies in the same business or sub sector. Say for example, in the current economy most of the investors are bullish (higher P/E) about healthcare sector while they are bearish (low P/E) on the transportation sector. So comparing P/E ratios of companies from a different sector won’t be apples to apples comparison. So to cut the long story short, you must compare P/E ratios of companies in the same sub sector. All other financial valuations considered equal (anything but reality), a company with a lower P/E is undervalued than a company from the same sub sector with a higher P/E.

Recession P/Es

Most or all the stocks have taken a beating during recession. In such a bear market which spans the entire stock market, P/E ratios of all the companies have fallen. This is the reason you must compare P/E ratios of companies in the same sector and also whenever possible companies having similar business models.

Types of P/E ratios

In calculating the P/E ratio, the P is the current share price but the E i.e. Earnings per Share (EPS) can be the most recent 12 month EPS i.e. trailing twelve months (TTM) (this is called the “Trailing P/E ratio”) or it can also be based on estimated EPS for the forward/ projected 12 month period (this is the normal P/E ratio)

Hope that helps!

Smart Option Trades

Smart Option Trades

In the previous two blogs we have gone thru option basics, terminology and some strategies. In this blog I plan to shed some light on executing smart option trades.

What should be the strike price?

Most of the folks buying options are focused on buying out of the money calls or puts. For example we will focus on call options. On 12 Jun BAC closed at $13.72. A ton of folks will speculate by buying say Nov 2009 $15 calls @ $1.79/ share. You have to realize that BAC has not yet reached $ 15 (strike price of the call). The option price of $1.79/ share is purely premium (time value). So investor will see intrinsic value in this call only after BAC stock hits $16.79 ($15 striker price + 1.79/ share spent on call option). Now let’s say that investor buys in the money option of BAC, Nov 2009 $ 9 Call @ 5.40/ share. Yes the investor does put in more money upfront to buy this call as compared to the out of the money call but the premium (time value) for a call having strike price of $9 is $0.68 vs. the premium of $1.79 paid for call having strike price of $15. The rationale for buying the in the money options similarly applies to puts too. So if the investor is confident that the stock price will move in the expected direction then putting more money in and buying in the money options makes sense. But out of the money options make sense for a speculative play where the speculator is not confident of the direction of the movement and wants more leverage.

Tracking stocks using options

In one of my previous blogs I had explained examples of how dollar cost averaging helps investors. I believe that such disciplined and planned investment strategies are helpful as they reduce the guess work. Let’s learn how we can apply similar strategy to buy options.

As of (13 Jun 2009) the stock market is coming out of recession (hopefully). We can argue all day long if the recent rally is a rally in a bear market or it’s actually a bull market. All I will say is there is lot of upside which will be realized thru a lot of fluctuations instead of a straight shot price move.

Rising floor method of buying options

Example: As of 12 Jun 2009, BAC is at $13.72/ share. An investor believes in the upside and buys in the money (say in the money by about $5) call options. The investor buys 10 Calls Aug 09 strike price $9 for 5.00/ share. Initial investment for 10 calls is $5000. Now if the stock price increases to $18 (price increased by $4.28) in early August, price of these calls will now be about $8.70. This future estimated value of the call is based on the call price close to strike price of $4.72 (original strike price $9- $4.28 (stock price increased by). Let me tabulate these transactions to show you how to execute the rising floor method.

After selling the 10 Aug 09 calls, in the rising floor method the investor should again invest the profits (same number of calls) or the sales proceeds (more number of calls) with strike price of 13 (about 5 dollars in the money compared to then current price of $18). A conservative investor can remove the initial investment ($5000 in the above case) and only invest the profits. Using this method an investor can take advantage of the uptrend in the stock price till the point where the investor feels that the stock price has reached its peak and is showing some signs of reversal. It’s recommended to use options about 2 to 3 months or more out in the future to avoid any near term stock fluctuations. Similar method can be applied while buying put options which can be called as falling floor method. The calculations shown above do not include brokerage commissions which will also influence your profit or losses.

I personally believe that such planned investments will produce more repeatable and reproducible results than just speculation. You can get lucky once or twice but bringing in results most of the times requires a strategy.

Play safe!

Option Strategies

In the previous blog we have covered the option basics. Here are a few investing strategies using options.

We discussed buying and selling options (both puts and calls) which can we worded as buying the right (but not an obligation) to buy or sell (calls or puts respectively). Similarly an investor can also initiate an options contract by writing it (called writing as the investor initiated the contract). So this investor will be selling the right to buy or sell the underlying shares to the investor buying such a right. If the investor buying such a right decides to exercise it the investor who has written the contract has to oblige. So broker of an investor writing an option generally will not let them right the option unless this investor shows the ability to meet the obligation. When the investor writing an option demonstrates the ability to cover/ meet that obligation the option he/she sells are called covered option.

Investor writing a covered call (person buying this call may decide to exercise the right and buy the underlying shares at strike price) should demonstrate the availability of these shares till the call option they wrote expires.

Investor writing a covered put (person buying this put may decide to exercise the right and sell the underlying shares at strike price) should demonstrate the availability of cash to buy these underlying shares till the put option they wrote. This availability of cash can be done by having cash, generating cash by short selling (cannot close the position till option expires)

Investors writing call or put options cannot use stop losses but have to wait till the option expires or gets exercised.

Spreads

There are ways to reduce risks associated with writing these covered options. Easy way to offset this risk is to buy and sell (write) the same type of option at a different strike price and/ or different expiry. Here is a current example. Price of BAC on 7th June 2009 is $11.86

Sell Jan 2010 Call of BAC for $0.53/ share at strike price of $20 (Profitable below 20)
Buy Jan 2010 Call of BAC for $1.42/ share at a strike price of $15 (Profitable above 15)

So investor gains $0.53 per share of liquidity by selling such a call of 100 shares and pays out $ 1.42 to buy the call. The investor here believes that the stock price will be between 15 and 20 by the option expiry date.

Lets look at selling these calls with and without using spreads. An investor is hoping that that his sell or writing an option makes money.

Case 1: Stock price above $20 (say $25)
i.e. this investor sold the right to other investor to buy BAC at $20. This call got exercised so the selling investor will now exercise the $15 call option and sell the shares to the other investor at $20.

Selling Investor’s balance sheet/ share

With Spread
+0.53 (sale of call)-1.42 (buy of call)-15 (exercise call)+ $20 (proceeds from the option which got exercised)= profit of $4.11/ share

Without spread:
+0.53(sale of call)-25 (buy at market price)+ 20 (proceeds from the option which got exercised)= loss of -4.47/ share

Case 2: Stock price below $20 (say $13)
So the sold call won’t get exercised and the investor won’t exercise the call they bought either and let his bought call expired.

With Spread
+0.53 (sale of call)-1.42 (buy of call)= loss of $0.89/ share

Without spread
+0.53 (sale of call)= profit of $0.53/ share

Case 3: Stock Price between $20 and $15 (say $ 18)

So the sold call won’t get exercised and the investor will be able to exercise the call they purchased

With Spread
+0.53 (sale of call)-1.42 (buy of call)-$15 (exercise call)+$18 (sell at market)=
Profit of $ 2.11/ share.

Without Spread
+0.53(sale of call)= Profit of $0.53/share

Straddle:

For a stock in news with high expected fluctuations, an investor can buy both a call and a put on the same underlying security at same strike price. So the investor makes large profit in one direction and small loss in the other direction. Generally Straddle will have a strike price close to the market price of the stock when the straddles are bought.

Example
Here is a current example. Price of BAC on 7th June 2009 is $11.86. Now we are talking about a certain event which may occur in the near future so lets consider options expiring in June 2009. We will consider buying call and put close to current market value of $11.86

Buy Jun 2009 Call of BAC for $0.55/ share at strike price of $12 (Profitable above $12)
Buy Jun 2009 Put of BAC for $0.62/ share at a strike price of $12 (Profitable below $12)

Positive news

So say there is positive news for BAC and stock jumps 15% to 13.63 (so call is in the money). We assume that this investor will sell these options after the news is released. Also we assume that the value of option not in the money will reduce by three times as much%.(ie.45% reduction that original value)

Investors balance sheet will look like
-.55(price paid for call)-0.62 (price paid for put)+1.63 (intrinsic value of call)+0.341(reduced value of put)=0.801/ share profit

Negative news

So say there is negative news for BAC and stock slides 15% to 10.08 (so put is in the money)
-.55(price paid for call)-0.62 (price paid for put)+1.92 (intrinsic value of put)+0.302 (reduced value of call)= 1.052/ share profit

So a Straddle will produce a profit in case of big price fluctuations.

What are Options?

What are Options?

As promised in my previous blog I am posting some option basics in this post.

Options are derivatives (refer to previous blog for derivative basics). Options derive their value form the underlying value of the stock or index they follow. Let just stick to the options for the stocks for ease of understanding.

An option is a contract which is a right to buy (called call option) or right to sell (called put option) a predetermined number of shares of a certain company at a pre-determined price on or before the specified expiry date. The owner of call or put option has the right (but not an obligation) to buy or sell that quantity of shares at the pre-determined strike price no matter what the market price of that stock is. The buyer does pay a certain price per share to have this option of buying/ selling the stock at that strike price.

Writing an Option

Investor writes an option when they sell or give someone the right to buy or sell (you sell a call or put) and while they take up the obligation. So the buyer of an option who buys this right (option) from you pays you in exchange for that right. This price depends on the then current market value.

American Options

In American exchanges, options are generally contracts representing 100 shares. So 5 option contracts will include 500 shares. There may be options for odd number of shares and an investor has to be vigilant about that. Also the options in American exchanges expire on the Saturday following the third Friday. So they must be traded/ exercised by that Friday.

Types of Options

Call Options

Call Option is the right but not an obligation to buy the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date. So to buy an option which is traded in the market you have to pay the current trading price for that option.

Example:

The Call Option buyer paid $1.5/ share (i.e. 150 for a lot of 100 shares) for the right to buy 100 shares of XYZ company at a strike price of $10 with expiry of July 2009 (17 JUL 2009). So the buyer has spent $ 150 already for such a right. If the market price of a share of XYZ company is less $ 10 then it doesn’t make sense for option owner to exercise the option and buy shares at strike price of $10. But say that the current share price is $20 then it makes sense for the call option owner to buy the shares at a strike price of $10. To have such a right the option buyer has paid $1.50 per share which is called premium. Looking at the math behind the deal. So the intrinsic value of this call option will be current price ($20)- strike price($10) i.e. $10/ share. But the call buyer has already paid $1.50/ share so the call option buyer will net $8.50 using this trade.

We know that the option described above should trade at atleast $10/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is more than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $10.5 per share then $ 10 is the intrinsic value (current share price-strike price) and $0.5 per share is the time value.

Put Option

Put Option is the right but no obligation to sell the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date.

Example

The Put option buyer paid $1.5 per share (i.e. 150 for a lot of 100 shares) for the right ot sell 100 shares of XYZ company at a strike price of $10 with expiry of July 2009. So the buyer of this put option paid $1.50 for such a right. If the market price of one share of XYZ company is more than $10 the it doesn’t make sense for the option owner to exercise the option and sell the shares at the strike price of $10. But say that the current share price for this company is $ 5 the it makes sense for the put option owner to sell the shares at the strike price of $10. To have such a right the option seller has paid $1.50 per share which is called premium.

We know that the option described above should trade at atleast $5/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is different than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $5.5 per share then $ 5 is the intrinsic value (strike price-current stock price) and $0.5 per share is the time value.

In/ Out of the Money

An option is “In the Money” when the trading price of the underlying stock crosses the strike price in a favorable direction (stock trading above the strike price for call options and stock trading below the strike price for put options). So the call in the above example will be in the money when the share price is above $10 (strike price) and put will be in the money when the share price is below $5 (strike price)


An option is “Out of the Money” when the trading price of the underlying stock has not crossed the strike price in a favorable direction (stock trading below the strike price for call options and stock trading above the strike price for put options). So the call in the above example will be out of the money when the share price is below $10 (strike price) and Put will be out of the money when the share price is above 5 (strike price)

Warning

Before trading options an investor has to realize that options are far more volatile than the underlying stock. So an investor should not expect option’s trading price to fluctuate proportional to its underlying stock. Also extreme caution is advised during writing an option as the option writer has to oblige when the investor buying that option decides to exercise the option. More on option strategies later!

About Structured Products...

What are structured products?

Structured products are an investment instrument formed with a combination of a multiple financial instruments with one or more derivatives.

So in order to understand structured product we need to understand what derivatives are.

Derivatives like the name suggest, derive their value from the underlying asset. So an equity derivative will derive its value partly from one or more of the underlying equities it represents. So some of the examples of derivatives are as follows. So derivatives can derive their value from an asset like stocks, bonds, real estate (commercial & residential), mortgages, loans and commodities. Derivatives can also be based on an index like any of the stock indices, interest rates, or currency exchange rates. Investors and institutions use derivatives to mitigate risk (hedging) of economic loss arising from fluctuations in the underlying asset value. So investors will use these derivatives either to increase profit or protect against loss. Some of the commonly used derivatives are options, futures and swaps. Generally the price the derivative is less than that of the actual asset which makes it and ideal instrument for speculation. So investors can take advantage of asset’s price fluctuations using less amount of money on the board. In a nutshell structured product can be called hybrid securities which can be used to hedge and speculate

Here are how some of the widely talked about derivatives.

Options:
Options derive their value form the underlying stocks/ index or asset. An options gives the option owner a right (but not an obligation) to buy or sell the asset at strike price and before a specified expiry. A buy option is called Call option while a sell option is called a Put option. If option is not exercised before its expiry date then its value dies down to zero. In the coming days I will devote and entire post just for these options.

Swaps
As reflected by its name, swaps are contracts which exchange cash flows on or before a specified future date. So swaps can have an underlying asset in the form of currencies/ exchange rages, interest rates. Swaps are important as the parties selling and buying these swaps does not exchange the asset’s principal amount but profit can be derived from the asset’s price fluctuations.

Futures/ Forwards:
Futures and Forwards are contracts to either buy or sell an underlying asset on or before the future date. Unlike forwards, futures are created by the exchange on which the futures are sold.

Now coming back to the structured products

So structured products are an investment instrument based on derivatives. These are contracts issued by an investment bank promise to pay a specific payments in specified circumstances described in the contract. So the investment bank in this case will replace the usual periodic interest/ final principal payment to an investor with a non traditional payment offered to an investor based on the performance of the underlying asset. This non traditional pay off may be based on the contingency that the underlying asset returns a specified return as per the contract. Structured products are popular with investors because they can be customized for exposure in various asset classes which may not be otherwise available to the investors.

So to go into a bit more detail, a structured product will a note part and a derivative part with it. The note pays the investor an interest at a specific time interval and the derivative as discussed previously can be based on stock, bond, index etc. There is also a level of principal protection i.e. risk (full, partial or no principal protection) which brings along with it returns (less than, equal to, multiple of the underlying assets return)

One type of structured product is principal-protected notes (PPN). These are considered one of the safest structured products. So because this investment protects the principal, the investor buying such a note gives up the dividend yield. So normally the initial investment is invested in federally insured CDs and the rest is invested in securities which track the market indexes. So the principal get shielded and investors benefit as markets rise/ rebound.


Other example of a structured product is reverse convertible notes which are linked to a stock or a basket of stocks. These notes offer some % of downside protection but also have a cap on the upside. So if the stock doubles i.e. goes up 100%, the note may only return about 15% while if the stock tanks, these structured products offer a buffer. These are the most risky structured products. But these were the very instruments which burned investors in the current recession. Investors got burned as the underlying asset tanked and as per the contract, the investors received the tainted shares instead of getting their money back. When the stocks below a certain value (below the buffer) also known as the knock-in level, the investors will be given the lower value shares instead of the principal. So the investors now becomes an unwilling owner of those low valued stocks.

For Pros only!

Risk, return, acronyms associated with structured products can be very confusing for any naive investor. There are good reasons why a lot of investors are apprehensive about putting there money in structured products: loss of dividends, low trading volume, taxing inefficiencies and complex fee, cost and returns disclosure. Investors putting their money into structured products require a broad understanding of the actual assets, their derivatives, rate of return, risks and fees.

Did you buy low and sell high?

Did you buy low and sell high?

If you ask me this question or for that matter any other investor, they would say that all I try to do is buy low and sell high. It’s was necessary for some folks to sell securities at whatever rate they can get coz it was an emergency but blog is for all the other folks who sold their securities out of fear.

Looking back at 2007 highs

Buy Low and Sell High has not always what we do. Especially during the 2007’s earnings season when companies were reporting out of the roof positive earning surprises and at the same time you must have overheard folks discussing their stock market paper profits at lunch, gym and during other water cooler conversations. Such conversation was dreadful especially if you had not invested money other than your 410K into the stocks or mutual funds. I bet you went online to check your bank balance and also had a chat with your honey about that money which needs to be moved to the brokerage account. Yes, we have all done that some point in time. We did it due to the human tendency of fear of being left on the sidelines while people board the train. Looking at the stock market after a few months or years (if you were long on those positions), your investment doesn’t look that rosy does it? The reason for the super rally in the stock market was surely an “irrational exuberance” or super optimism but the recession/ depression we are in right now may well be coined as irrational pessimism. We as humans will do any certain act only to avoid pain or gain pleasure. So most of us buy stocks at high prices or during a rally coz we don’t want to be left behind when others/market makes progress. On similar lines we sell stock when newspapers, TV channels and other media are portraying super pessimism about the stock market. This is when we decide enough is enough and we refuse can’t take any more potential losses. We just went through a naïve investor’s mindset of buying high and selling low even when we know that the right thing to do is buy low and sell high.

Have you adjusted your 401k contributions lately?

I know some many people who changed their 401k allocations from high in stocks to low in stocks during Nov 2008 to April 2009 window. Guys..let me remind you that stocks market is cyclic with the only difference in each of the recession and the following rise being the cycle time. If stocks in your 401k fall by a huge percentage and you end up changing the allocation to something less risky then necessarily you have booked those losses and delayed the recovery of your 401k by several years (read my DCA blog) I can say this confidently because risk and return go hand in hand. There is no way in the world that you can recover the paper loses you took in your riskier allocation and come back up in green using the allocation which is less risky than the one you were previous in. Moreover if you changed your allocation at or close to the bottom of the stock market means that you took the biggest possible loses and having done that you have surrendered to the fact that your 401k’s recovery won’t be at a dramatic rate as its decline. My heart goes out to the older folks close to retirement who lost tremendous amount of money in their retirement account. I am confident that recovery is imminent, but chances that these older folks would be able to make full use of the recovery are slim. I hope some of these folks would have changed there allocations to bonds or other fixed income sources when market was at the peak.

What did I do?

I will admit that I was devastated by more than 50 % loses on some of my holdings and took loses last year as I Sold Low the securities I had bought High previously. But I invested (speculated) the same money back in some of the securities which had lost about 80 to 90% of their value as compared to their 52 week high. That is surely risky because their prices were beat up for a reason but you have to realize that these are the very securities which will and have bounced back up from their 52 week lows. So I moved my money to more risky positions with an anticipation of recovery. I take pride in the fact that I am back in green (marginally) after considerable amount of effort, research and gut checking. I am confident that it’s going to be a huge upside form here on forward.

The logic is simple here…even JT (Justin Timberlake) knows it … “That's okay baby 'cause in time you will find...What goes around, goes around Comes all the way back around”

Here is a link to an interesting article on similar lines at…

http://www.filife.com/stories/investors-lament-buy-high-sell-low

Common Stock Preferred Stock Arbitrage

Hey Folks. Happy Friday! After reading today’s blog you guys are going to do some homework for sure. Brain food is here!

What is Stock Arbitrage?

Stock Arbitrage started as a means of cashing in on the difference between the prices of same stock listed on different exchanges. So an investor wanting to take advantage of this discrepancies, buys stock from an exchange where it is at a lower value and hopes that the stock price will eventually catch up to the higher stock price in the other exchange. This is arbitrage trade and such a discrepancy in the prices of same security is short lived and only the most active traders will be able to take advantage of such an arbitrage trade.

On similar lines, an investor can take advantage of difference in stock price of Preferred Stock and Common stock. Such a trade has many advantages over the earlier arbitrage trade I have described

Let me introduce to Common Stock and Preferred Stock before we jump into this arbitrage.

A company issues common and preferred stock. Dividends for common stocks vary based on the company’s financial health and performance whereas generally all the preferred shares have a fixed dividend payment. Unlike to preferred stock, common stock has voting rights. In case of bankruptcy, preferred stocks holders are paid after common stock holders, bondholders and creditors.

Now getting back to the Common-Preferred Stock Arbitrage trade and its advantages.

Preferred stock generally trades at a lower volume than common stock. Although the same news generally applies to preferred and common stock, common stock tends to be very volatile and trades in greater volume. Take a look at the stock’s Beta (volatility compared to S&P 500) to know the difference between the volatility of preferred and common stock.

It is the common stock price which fluctuates quite a bit with positive or negative news. So in normal circumstances, the movement in the stock value of the preferred shares lags behind the movement observed in common shares. This lag in a few cases is not in seconds, minutes but also can be days or even weeks. So using this finite lag an investor who doesn’t keep a pulse on the market will get a chance to identify this discrepancy easily.

Any news about the company does apply to both preferred and common stock. So this brings us to another major advantage. An investor can predict the movement of preferred stock because it always follows the common stock which instantaneously tracks investor sentiment based on current news. Having said that, an investor must be really careful not to place such an arbitrage trade close to earnings, court ruling, board elections or any other news expected by that investor. Always remember that it is not the news but the way the market perceives the news that moves stock price. Such a trade placed by a vigilant investor will ensure that the common stock maintains the direction of its movement which the investor was tracking till the trade has been placed.

I am sure what the discussion above will open you eyes to a whole new area of investment strategy. Hold on now…before you place a bunch of money in preferred stock which lags commons stock be sure to try this strategy out with small or no money by tracking such shares.

Case Study 1

The above column is focused on an arbitrage where we are assuming that the price of preferred stock will converge with the price of common stock.

But in the following case study, investors are betting that there is too large of a spread between the common and preferred stock. The article suggests not only to buy preferred stock but to sell common stock as the author believes that the stock prices will converge some where in between the current spread.

http://www.bloomberg.com/apps/news?pid=20601086&sid=aAdZKSyBdqjs

Case Study 2

All the above strategies I have mentioned are good for a healthy company. But in case you want to analyze how certain news about a distressed company can lead to different arbitrage trade, please read the following article.

http://www.marketwatch.com/story/investors-buy-citi-preferred-sell-common

Until then…its Suaz signing off…