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Presentation on theme: "AN OVERVIEW OF THE ROLE OF OPTIONS IN YOUR PORTFOLIO IBD MEETUP/ NORTHRIDGE FEBRUARY 9, 2013."— Presentation transcript:



3 LEVERAGE Financial Leverage Financial leverage is usually created by using other people’s money in an effort to maximize future profits. Mortgages are used to invest in real estate, and companies borrow money to expand operations. The benefit of the leverage comes from increased property value, or higher company revenue which raises the value of stockholders’ shares. Leverage can also be used in stock investing. To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on stocks on margin Buying on margin lets the investor use stocks as collateral to borrow money to buy more stock. Currently, investors can borrow up to half the value of the stock they wish to purchase. Your broker gladly loans you as much money as you put up, and charges you a very attractive interest rate. If the stock goes up by $1, you gain $2 since you have now have twice the number of shares. Higher risk, higher profit.

4 MARGIN VS CALL Buying on margin, however, is like a sword that cuts both ways. While its nice to know that you are earning $2 every time the share price goes up by $1, the converse is true. Every time the stock drops by a dollar, you also lose $2. Worse yet, if the stock price comes crashing down, you get the dreaded margin call and may be forced to sell the stock at the very time when you would rather be buying it instead. Alternatively, with call options, you pay a premium for a right to purchase the underlying stock at a predetermined price (strike price) for a period of time - up to 2 years with LEAPS® options. In simpler terms, buying call options is like renting the underlying stock. Each call option represents 100 optionspremiumunderlying stockstrike priceLEAPS® options Following the same example above, suppose a 3 month call option on XYZ stock with strike price of $50 is available for $3 each. To control the same amount of XYZ stock, which is 400 shares, requires the purchase of 4 call options for a total investment of only $1200. This is also the maximum amount you can lose if you are wrong about the stock. Comparatively, leveraging using margin requires a hefty $20000 and worse still, you risk a margin call! Hence, buying on margin is a dangerous way to gain leverage, especially when the underlying stock is very volatile. A better option will be to buy call options instead. In options trading, the purchase of call options is better known as a call buying or long call strategycall buying or long call strategy

5 OPTIONS VS MARGINS For the investor, however, buying options provides inherent financial leverage. Without needing to use borrowed capital, by investing in options, you can control a larger number of shares for the same initial investment, than if you purchased the shares themselves. For example, if you wish to invest $1 000 you could purchase 10 shares of IMAX stock (hypothetically) valued at $100 per share. Alternatively, the option contracts may realistically be valued at $200 for lots of 100 shares ($2.00 per option). For your investment of $1 000, you could buy five options contracts, increasing your financial leverage by allowing you to control 500 shares instead of just 10. If, during the option contract, the value of those shares rises substantially, you may wish to buy the shares that you have the right to buy, at the agreed price (strike price), which at that point is much lower than the market value. You can then resell those shares at market value, generating a profit on a much larger number of shares than the ones you would have purchased originally if you had bought the 10 shares with your $1 000. Obviously though, to execute this trade, you would need to have access to a lot more capital in order to purchase the shares that your options entitle you to buy, and be willing to take the risk of the market price suddenly dropping before you have the opportunity to resell your shares. The best source of financial leverage in this investment, however, comes from the fact that the percentage increase on the option is proportionately higher than the increase of the underlying share. This leverage also comes without the risk of investing the much greater amounts of capital in order to buy and sell the shares that your options give you the right to buy.

6 OPTIONS Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. o Some strategies are very high risk. o Others are conservative. An Option is an intangible device hence its cost is only a fraction of the underlying stock price. o This allows you to control shares of stock without assuming all the market risks. o Each option controls 100 shares, so for approximately 10% of the share cost you can create a similar profit stream. An Option has three values: o Intrinsic value – which is equal to the number of points between current strike price and current stock price. o Time value refers to all non-intrinsic value; or that portion of premium affected by the passage of time and the time remaining until expiration. o Extrinsic value is the premium value within time value caused by non-time sources, i.e price changes, stock volatility and other external causes. Each Option is characterized by four specific attributes, the terms of the option, which are o Strike Price o Expiration Date o Type of Option [Put or Call] o Underlying Stock

7 OPTIONS LEVERAGE - ILLUSTRATION How exactly does options leverage work? Stock options produces options leverage as every contract represents 100 shares of the underlying stock while costing only a fraction of the price. This allows option traders to control the profits on the same number of shares at a much lower cost. Here's an Options Leverage illustration: Assuming you have $1000 and wish to invest in shares of XYZ company. XYZ company is trading at $50 while it's $50 strike price call options are asking for $2.00. In this case, you could simply buy shares of XYZ company with all your money and own 20 shares or you can buy 5 contracts of $50 strike call options on XYZ company shares which controls 500 shares! With the same amount of money, you can control 25 times more shares of XYZ company than you normally can by buying shares. That's options leverage in option trading.

8 Options Leverage - Calculation The problem with the former illustration of options leverage is that even though 5 contracts of the $50 strike price call options represents 500 shares of XYZ company, it does not move in exactly the same magnitude as the shares of XYZ company. Stock Options move only a fraction of the price move on its underlying stock, governed by its delta value. An At The Money Option, typically has a delta value of 0.5. This means that each contract of $50 strike call options moves only $0.50 for every $1 move in the underlying stock. Options Leverage Calculation Example Assuming XYZ company rallies to $55 the very next day, the $50 strike call options will rise from $2 to $4.50, up $2.50 ($5 x 0.5 = $2.50). Therefore, the actual options leverage of an option position can be arrived at using the following formula : Options Leverage = (delta equivalent stock price - option price) / option price Following up from our above example: XYZ shares is trading at $50 and its $50 strike price call options has a delta value of 0.5: Options Leverage = ([$50 x 0.5] - $2) / $2 = 11.5 times The above options leverage calculation reveals that the $50 strike call options of XYZ company carries an options leverage of 11.5 times, which means that it allows you to make 11.5 times the profit on the same amount of money, which also means that it allows you to control 11.5 times the number of share equivalent with the same amount of money. In layman terms, 11.5 times options leverage balloons your money by 11.5 times, allowing your $1000 to be worth $11,500 in share control power.


10 HOW DO I CALCULATE THE GREEKS You can calculate Delta by noting the change in option price compared to the change in stock price, i.e option price changes $.60 per $1.00 change in stock price. This is a Delta of.6; or Many Options Brokerages will provide this information in their trading platforms, i.e. ‘Think or Swim’; or You can go to – click on ‘TOOLS’ then click ‘OPTIONS CALCULATOR’ in the pull

11 SOME TERMS TO KNOW Long — When you’re talking about options and stocks, “long” implies a position of ownership. After you have purchased an option or a stock, you are considered "long" that security in your account. Short --- If you’ve sold an option or a stock without actually owning it, you are then considered to be “short” that security in your account. Strike Price — The pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some people refer to the strike price as the “exercise price”. – In-The-Money (ITM) — For call options, this means the stock price is above the strike price. So if a call has a strike price of $50 and the stock is trading at $55, that option is in-the-money. For put options, it means the stock price is below the strike price. So if a put has a strike price of $50 and the stock is trading at $45, that option is in-the-money. – Out-of-The-Money (OTM) — For call options, this means the stock price is below the strike price. For put options, this means the stock price is above the strike price. The price of out-of-the-money options consists entirely of “time value.” – At-The-Money (ATM) — An option is “at-the-money” when the stock price is equal to the strike price. (Since the two values are rarely exactly equal, when purchasing options the strike price closest to the stock price is typically called the “ATM strike.”)

12 SOME TERMS TO KNOW Intrinsic Value — The amount an option is in-the-money. Obviously, only in-the-money options have intrinsic value. Time Value — The part of an option price that is based on its time to expiration. If you subtract the amount of intrinsic value from an option price, you’re left with the time value. If an option has no intrinsic value (i.e., it’s out-of-the-money) its entire worth is based on time value. Exercise — This occurs when the owner of an option invokes the right embedded in the option contract. In layman’s terms, it means the option owner buys or sells the underlying stock at the strike price, and requires the option seller to take the other side of the trade. Assignment — When an option owner exercises the option, an option seller (or “writer”) is assigned and must make good on his or her obligation. That means he or she is required to buy or sell the underlying stock at the strike price.

13 SELECTING OPTIONS There are many sophisticated techniques for evaluating options: – These are based upon the intrinsic nature of an option contract and how the option performs versus its underlying stock. – However a good rule of thumb for a beginning investor is to analyze the option as if it were the underlying stock. – In other words never buy an option unless you would have purchased the underlying stock. – Now you simply have to analyze the underlying stock.

14 ANALYZING A STOCK You use Fundamental Analysis to build your watch list. You use Technical Analysis to select your entry and exit points. – Setting up your charts so that you can get confirming signals from 2-3 indicators is essential – We will review some key indicators and then have a live demo of a TC2000 chart.


16 STOCHASTICS The “Stochastics” indicator is a popular member of the “Oscillator” family of technical indicators. George Lane created the Stochastics oscillator when he observed that, as markets reach a peak, the closing prices tend to approach the daily highs, and vice-versa. The Stochastics indicator is said to be “leading” since it generates signals before they appear in pricing behavior. Traders use the indicator to determine overbought and oversold conditions and the beginnings and endings of cycles. The Stochastics indicator is classified as an “oscillator” since the values fluctuate between zero and “100”. The indicator chart typically has lines drawn at both the “20” and “80” values as warning signals. Values exceeding “80” are interpreted as a strong overbought condition, or “selling” signal, and if the curve dips below “20”, a strong oversold condition, or “buying” signal, is generated. The Stochastics indicator is composed of two fluctuating curves – the “Green” %K line, and the “Red” %D signal line. How to Read a Stochastics Chart In the example above, the “Green” line is the Stochastics “%K” value, while the “Red” line represents the “%D” signal line that acts like a moving average. Stochastics values below 20 and over 80 are worthy of attention. As with any technical indicator, a Stochastics chart will never be 100% correct. False signals can occur, but the positive signals are consistent enough to give a trader an “edge”. Skill in interpreting and understanding Stochastics signals must be developed over time, and complementing the Stochastics tool with another indicator is always recommended for further confirmation of potential trend changes.

17 UNDERSTANDING MACD Background Knowledge The popularity of the MACD is largely attributable to its ability to be used to quickly spot increasing short-term momentum. As you can see from the chart below, many traders will watch for a short-term moving average (blue line) to cross above a longer-term moving average (red line) and use this to signal increasing upward momentum. This bullish crossover suggests that the price has recently been rising at a faster rate than it has in the past and is a common technical buy sign. Conversely, a short-term moving average crossing below a longer-term average is used to illustrate that the price of the asset has been moving downward at a faster rate and that it may be a good time to sell. Figure 1 The Indicator Notice how the moving averages diverge away from each other as the strength of the momentum increases.. Specifically, the value for the long-term moving average is subtracted from the short-term average and the result is plotted onto a chart. The periods used to calculate the MACD can be easily customized to fit any strategy. A positive MACD value, created when the short-term average is above the longer-term average, is used to signal increasing upward momentum. On the other hand, falling negative MACD values suggest that the downtrend is getting stronger and that it may not be the best time to buy. Transaction Signals It has become standard to plot a separate moving average alongside the MACD, which is used to create a clear signal of when the momentum is shifting. A signal line, also known as the trigger line, is created by taking a nine-period average of the MACD and is found plotted alongside the indicator on the chart. The basic bullish signal (buy sign) occurs when the MACD line crosses above the signal line, and the basic bearish signal (sell sign) is generated when the MACD crosses below the signal line.

18 WHAT IS TRIX? The triple exponential average (TRIX) indicator is an oscillator used to identify oversold and overbought markets, and it can also be used as a momentum indicator. Like many oscillators, TRIX oscillates around a zero line. When it is used as an oscillator, a positive value indicates an overbought market while a negative value indicates an oversold market. When TRIX is used as a momentum indicator, a positive value suggests momentum is increasing while a negative value suggests momentum is decreasing. Many analysts believe that when the TRIX crosses above the zero line it gives a buy signal, and when it closes below the zero line, it gives a sell signal. Also, divergences between price and TRIX can indicate significant turning points in the market. TRIX calculates a triple exponential moving average of the log of the price input over the period of time specified by the length input for the current bar. The current bar's value is subtracted by the previous bar's value. This prevents cycles that are shorter than the period defined by length input from being considered by the indicator.triple exponential averageoscillatormomentumanalystsexponential moving average Advantages of TRIX Two main advantages of TRIX over other trend-following indicators are its excellent filtration of market noise and its tendency to be a leading than lagging indicator. It filters out market noise using the triple exponential average calculation, thus eliminating minor short-term cycles that indicate a change in market direction. It has the ability to lead a market because it measures the difference between each bar's "smoothed" version of the price information. When interpreted as a leading indicator, TRIX is best used in conjunction with another market-timing indicator - this minimizes false indications.

19 THE ADVANTAGES OF TRIX Interpretation On this chart of the Dow Jones Industrial Average covering Sept 2001 to Sept 2002, you can see by the arrows that the TRIX indicator, from the high of Mar 2002 to the low watermark set in Jul 2002, was falling from a level of plus 40.45 to a minus 83.07. This example clearly shows that there no lag time between the DJIA tuning south and the TRIX indicator following this price action. (Tradestation 6 charting software uses a nine-day moving average as the default, which helps dramatically for timing the directional moves.) The shorter the time frame, the more accurate the indicator will signal the move in the issue Using two moving averages offers an advantage: by watching the fast moving average cross over the slow moving average, the trader can recognize the change in direction of price action. In the 2001-2002 chart of the S&P 500 Index above, the first highly visible move was the downturn of the market after the disasters of Sept 11. There was a subsequent rebound in the third week of September, with the 15-day moving average turning quicker than the 30-day moving average. But keep in mind that the confirmation from the 30-day indicator is more conservative, so it assures the average buy-and-hold investor that the trend has truly turned. Look closely at how well the turns in the 15-day moving average line up with the turns in the price action.

20 TSV AND HOW TO USE IT Time Segmented Volume A proprietary technical indicator developed by Worden Brothers, Inc. TSV is an oscillator, which is calculated by comparing various time segments of both price and volume. TSV essentially measures the amount of money flowing in or out of a particular stock. The horizontal line in the middle, which extends across the entire length of the indicator window, represents the zero line. When TSV crosses up through the zero line it signals positive accumulation or buying pressure. This action is considered bullish. Conversely, when TSV crosses below the zero line it indicates distribution or selling pressure, which typically precedes a move down in price. Another important thing to look for when interpreting TSV is a contradiction of trends between price and TSV. Look for positive or negative divergences between price and TSV in order to determine potential tops and bottoms. Several consecutive divergences increase the reliability factor in trying to pinpoint price reversals. For instance, if price has been making successively higher highs while TSV has been making successively lower highs, this would constitute a series of negative divergences. This would be an indication of a possible top. TC2000 gives you the ability to calculate a TSV on a wide variety of moving averages, which simply allows you to smooth the indicator, thereby filtering out the less significant swings. You will notice that as you increase the value of the moving average (and this applies to any indicator, not just TSV) the result is a smoothing effect. However, there is a trade-off. As you increase the length of the moving average, the indicator becomes less sensitive to daily fluctuations. And as a result, the indicator will have a greater tendency to lag price. One of the new features of this indicator is the ability to calculate a moving average of another moving average. This addition has made TSV more effective and easier to use. Now you can calculate a moving average of an already smoothed TSV and use it much in the same way the MACD indicator is used. Positive and negative TSV crossovers are one more thing to consider when trying to form an opinion on a particular stock or market index. Example Settings: Short Term Trading: TSV period between 9 and 12 Intermediate Term Trading: TSV period between 18 and 25 Long Term Trading: TSV period between 35 and 45

21 RSI AND HOW TO USE IT Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend. Despite being developed before the computer age, Wilder's indicators have stood the test of time and remain extremely popular. Wilder's formula normalizes RS and turns it into an oscillator that fluctuates between zero and 100. In fact, a plot of RS looks exactly the same as a plot of RSI. The normalization step makes it easier to identify extremes because RSI is range bound. RSI is 0 when the Average Gain equals zero. Assuming a 14-period RSI, a zero RSI value means prices moved lower all 14 periods. There were no gains to measure. RSI is 100 when the Average Loss equals zero. This means prices moved higher all 14 periods. There were no losses to measure. Parameters The default look-back period for RSI is 14, but this can be lowered to increase sensitivity or raised to decrease sensitivity. 10-day RSI is more likely to reach overbought or oversold levels than 20-day RSI. The look-back parameters also depend on a security's volatility. 14-day RSI for internet retailer Amazon (AMZN) is more likely to become overbought or oversold than 14-day RSI for Duke Energy (DUK), a utility. RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted to better fit the security or analytical requirements. Raising overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold readings. Overbought-Oversold Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.


23 SUMMARY IMPORTANT RULES TO REMEMBER 1.LEARN STOCK INVESTING FIRST a.Where is the Market? i.What are the hot Sectors ii.What are Promising Stocks i.CANSLIM – Fundamental Analysis ii.Build a Watchlist b.Select Entry and Exit Points – Technical Analysis 2.Read 1 good paper daily [IBD] and 1 good book per month [Financial Markets in general] 3.Paper Trade at first – Practice makes Perfect 4.HAVE A TRADING PLAN!!! – You won’t get to a goal without having it planned and documented. 5.KISS – There is too much information and too many strategies so you need to focus on a simple plan. 6.HAVE REALISTIC EXPECTATIONS. It takes time and experiences to perfect a trading plan. Neither Warren Buffet nor Bill Gates got there overnight.



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