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!