THE OPTIONS COURSE- The Big Picture

THE OPTIONS COURSE


The Big Picture

Trading involves a variety of different investment vehicles in addition to options: stocks, futures, commodities, exchange-traded funds (ETFs), and indexes. These financial instruments can be assembled in an infinite number of combinations. My own trading focuses on stocks and options. Yet, an appreciation of all these tools can help build an integrated understanding of what is happening day to day in the financial marketplace. So, let’s take a closer look at the fundamental components of each investment vehicle to see how one differs from the other.

STOCKS

Those of you just starting in the field of investment have most likely heard about one popular financial instrument: the stock. In fact, thousands of stocks are traded on the U.S. stock exchanges every day. But what exactly is a stock? Basically, a stock is a unit of ownership in a company. The value of that unit of ownership is based on a number of factors, including the total number of outstanding shares, the value of the equity of the company (what it owns less what it owes), the earnings the company produces now and is expected to produce in the future, as well as investor demand for the shares of the company.

For example, let’s say you and I form a company together and decide that there will be only two shareholders (owners) with only one share each. If our company has only one asset of $10,000 and we have no liabilities (we don’t owe any money), our shares should be worth $5,000 each ($10,000 ÷ 2 = $5,000). If the company were sold today, together we would have a net worth of $10,000 (assets = $10,000; liabilities = 0).

However, if it is projected that our company will make $100,000 this year, $200,000 next year, and so on, then the value goes up on a cash flow basis as we will have earnings. Investors would say that we have only $10,000 in net worth now, but they see this growing dramatically over the next five years. Therefore, they value us at $1 million—in this case, 10 times next year’s projected earnings. This is very similar to how stocks are valued in the stock market.

Stocks are traded on organized stock exchanges like the New York Stock Exchange (NYSE) and through computerized markets, such as the National Association of Securities Dealers Automated Quotations (NASDAQ) system. Share prices move due to a variety of factors including as-sets, expected future earnings, and the supply of and demand for the shares of the company. Accurately determining the supply of and demand for a company’s stock is very important to finding good investments. This is what creates momentum, which can be either positive or negative for the price of the stock.

For example, scores of analysts from brokerage firms follow certain industries and companies. They have their own methods for determining the value of a company and its price per share. They typically issue earnings estimates and reports to advise their clients. Analyst, or Wall Street, expectation will drive the value of the shares before the actual earnings report is issued. If more investors feel the company will beat analyst predictions, then the price of the shares will be bid up as there will be more buyers than sellers. If the majority of investors feels that the company’s earnings will disappoint “the street,” then the price will decline (also referred to as “offered down”). As stated earlier, the stock market is similar to an auction. If there are more bidders (buyers), prices will rise. This is referred to as “bidding up.” If there are more people offering (sellers), prices will fall.

For example, let’s say Citigroup (C) is expected by analysts to report earnings of $1 per share. If news starts to leak out that the earnings will be $1.25 per share, the share price will jump up in anticipation of the better-than-expected earnings. Then if Citigroup reports only $.75 per share, the stock price will theoretically fall dramatically, as the actual earnings do not meet initial expectations and are well below the revised expected earnings. The investors who bought the stock in anticipation of the better-than-expected earnings will sell it at any price to get out. This happens quite often in the market and causes sharp declines in the value of companies. It is not uncommon to see shares decline in price 25 to 50 percent in one day. Conversely, it is also common to see shares rise in value in a similar fashion.

Dividends

American companies may periodically declare cash and/or dividends on a quarterly or yearly basis. Dividends are provided to the shareholders— otherwise referred to as stockholders—as an income stream that they can rely on. This is quite similar to a bank paying interest on certificates of deposit (CDs) or savings accounts. There are a number of companies that boast that they have never missed a dividend or have always increased dividends.

Companies that distribute their income as dividends are usually in mature industries. You typically will not find fast-growing companies distributing dividends, as they may need the capital for future expansion and may feel they can reinvest the funds at a higher rate of return than the stockholders. As a stock trader, you need to know how this process affects your long or short investment. Basically, a company’s board of directors will decide whether to declare a dividend, which is paid out and distributed to shareholders on a date set by the company.

Also, some companies will declare a special dividend from time to time. This dividend is paid out and distributed to shareholders on a date set by the company, referred to as a payable date. In order to qualify for a dividend, you must be a shareholder on record as of the record date (the date you are “recorded” as the owner of the shares) of the dividend. You can also sell the stock as soon as the next day after the payable date and still receive the dividend.

A beginner may think this is a profitable way to buy and sell shares: Buy the shares a few days before the record date and sell them on the day after the payable date. However, before you run out and open a stock brokerage account in order to implement this tactic, you may want to consider that, in most cases, the stock prices will be trading lower on the day that the dividend is payable. That’s because on the dividend payable date(i.e., the date on which you get paid the dividend), the stock should trade at its regular price minus the dividend.

Let’s consider an example. If IBM (IBM) declared a $1 per share dividend payable on June 30, and closed at $90 on June 29, then on June 30, IBM would open at $89. As a stock trader, it is important to be aware of dividends and how they can affect a stock. You can find stocks declaring dividends by looking in the newspaper financial pages or at various financial web sites.

Market Capitalization

Market capitalization is defined as the total dollar value of a stock’s outstanding shares and is computed by multiplying the number of outstanding shares by the current market price. Thus, market capitalization is a measure of corporate size. With approximately 8,500 stocks available to trade on U.S. stock exchanges, many traders judge a company by its size, mwhich can be a determinant in price and risk. In fact, there are four unofficial size classifications for U.S. stocks: blue chips, mid-caps, small caps, and micro-caps.

1. Blue-chip stocks. Blue chip is a term derived from poker, where blue chips in a card game hold the most value. Hence, blue-chip stocks are those stocks that have the most market capitalization in the marketplace (more than $5 billion). Typically they enjoy solid value and good security, with a record of continuous dividend payments and other desirable investment attributes.

2. Mid-cap stocks. Mid-caps usually have a bigger growth potential than blue-chip stocks but they are not as heavily capitalized ($500 million to $5 billion).

3. Small-cap stocks. Small caps can be potentially difficult to trade because they do not have the benefit of high liquidity (valued at $150 million to $500 million). However, these stocks, although quite risky,are usually relatively inexpensive and big gains are possible.

4. Micro-cap stocks. Micro-caps, also known as penny stocks, are stocks priced at less than $2 per share with a market capitalization of less than $150 million.

Some traders like to trade riskier stocks because they have the potential for big price moves; others prefer the longer-term stability of blue-chip stocks. In general, deciding which stocks to trade depends on your time availability, stress threshold, and account size.

Common versus Preferred Stock

Officially, there are two kinds of stocks: common and preferred. A company initially sells common stock to investors who intend to make money by purchasing the shares at a lower price and selling them at a higher price. This profit is referred to as capital gains. However, if the company falters, the price of the stock may plummet and shareholders may end up holding stock that is practically worthless. Common stock-holders also have the opportunity to earn quarterly dividend payments as the company makes profits. For example, if a company announces a $1 dividend on each share and you own 1,000 shares, you can collect a healthy dividend of $1,000.

In contrast, preferred stockholders receive guaranteed dividends prior to common stockholders, but the amount never changes even if the company triples its earnings. Also, the price of preferred stock increasesm at a slower rate than that of common stock. However, if the company loses money, preferred stockholders have a better chance of receiving some of their investment back. All in all, common stocks are riskier than preferred stocks, but offer bigger rewards if the company does well.

Stock Classifications

Another way to classify a stock is by the nature of its objectives. The correct classification often is derived by looking at what a stock does with its profits. For example, if a company reinvests its profits to promote further growth, then it is known as a growth stock. A growth stock is a company whose earnings and/or revenues are expected to grow more rapidly than the average earnings of the overall stock market.

Generally, growth stocks are extremely well managed companies in expanding industries that consistently show strong earnings. Their objective is to continue delivering the performance their investors expect by developing new products and services and bringing them to market in a timely fashion. If a stock regularly pays dividends to its shareholders, then it is regarded as an income stock. Usually only large, fully established companies can afford to pay dividends to their shareholders.

Although income stocks are fundamentally sound companies, they are often considered conservative investments. Growth stocks are more risky than income stocks but have a greater potential for big price moves. Don’t be lured into an income stock simply because it pays a high dividend. During the late 1990s, many utility companies paid high dividends. Then problems surfaced in the industry and stocks in the utility sector became extremely volatile. Many suffered large percentage drops in their share prices.

Therefore, even though these companies paid hefty dividends, many shareholders suffered losses due to the drop in the stock price. Additionally, there has been a surge in the popularity of socially responsible or “green” stocks. Socially conscious investing entails investing in companies (or green mutual funds) that are socially and environmentally responsible and follow ethical business practices.  Green investors seek to use the power of their money to foster social, environmental, and economic changes that will improve conditions on the earth.

Comparison of Common and Perfect Stock


Stock Sectors

Stock market activity is reported each day by certain indexes, which reflect the general health of the economy. Everyone has seen the Dow Jones Industrial Average (DJIA) mentioned on the nightly news as a key indicator of the day’s trading performance. But what is the DJIA and how did it get started? In 1884, Charles Dow surveyed the average closing rices of nine railroad stocks and two manufacturing companies, which, in his opinion, represented the general trends in the national economy. He printed the results in his newspaper, a forerunner of today’s Wall Street Journal. 

Types of Stocks


Over the next 12 years, he honed that list until he finally settled on 12 industrial stocks. In 1896, Charles Dow began to publish this list and the overall average every day. Today’s DJIA reflects the performance of 30 major companies representing key manufacturing, technology, energy, financial, and service industries worth approximately 25 percent of the total value of all stocks listed on the New York Stock Exchange. It is widely regarded as an accurate assessment of the daily trends in the American economy. However, many investors believe the DJIA is too narrow with only 30 stocks in the index. 

The Standard & Poor’s 500 Index (S&P 500) is followed very widely these days as it represents a more diversified portfolio of 500 different companies. However, if you track the performance of the DJIA to the S&P 500 you will find that they are highly correlated. While the Dow Jones Industrial Average and the S&P 500 track the performance of the stock market as a whole, some indexes are used to track sectors. In fact, there is a wide variety of stock sectors from which to choose. The following list is a general outline of the most popular ones.


Instead of using indexes, some traders watch the performance of individual stocks to gauge trends in an industry or sector. Some sectors and gauges follow. For example, Intel (INTC) is often considered a gauge for the semiconductor group.

• Technology:

Computers (e.g., Dell, Hewlett-Packard).
Internet-related (e.g., Amazon.com, Yahoo!).
Software-related (e.g., Microsoft, Adobe).
Semiconductors (e.g. Intel, Applied Materials).

• Health-related:

Pharmaceuticals (e.g., Merck, Pfizer).
Biotech (e.g., Amgen, Biogen).

• Defense industry (e.g., Boeing, Lockheed Martin).

• Retailers:

Clothing (e.g., Gap, Wal-Mart).
Sportswear (e.g., Nike, Reebok).
Automakers (e.g., General Motors, Ford).

• Transportation (e.g., Delta Air Lines, Continental).

• Financial services (e.g., Citigroup, J. P. Morgan).

This list is not meant to be an exhaustive list; rather, it is meant to reflect the diverse range of fields and individual stocks within each sector. This may very well be why many prospective investors shy away from making their own investment decisions. The plethora of opportunities can be overwhelming to many people.

The IPO System

The equities market generates wealth in several different ways. As private companies expand, they come to a point where they need more capital to finance further growth. Many times the solution to this problem is to offer stock in the company to the public through an initial public offering (IPO).

To do this the company hires the services of a brokerage firm to under write its stock, which means the brokerage will buy all the shares the company is offering for sale. The brokerage then charges a commission for managing the IPO and generates cash by selling the shares to investors. The commission is usually about 10 percent of the total value of all shares.

There is a misconception among many people who believe a company makes money every time a share of its stock is traded after its IPO, but that simply is not true. Companies get the IPO money, and that is it. From that point on, the money derived from the buying and selling of a company’s stock is passed back and forth between the actual buyers and sellers.

The IPO is an avenue provided by the stock market for a company to fund expansion. If the expansion succeeds and the company prospers, it will hire more people and buy more raw materials from other companies. This process contributes to the expansion of the economy as a whole, generating wealth that would not have existed without the stock market.

Investors who profit from a successful IPO also create wealth for the overall economy. If they buy low and sell high, they have made a profit that improves their standard of living and their ability to buy goods and services. They also use stock profits to start small businesses, reinvest in the stock market, or add to their savings. This process of putting stock profits back into the economy helps the economy grow over the long term and is a vital component of economic prosperity.

If a company increases its profits year after year, its stock price will rise. The increase in price is the result of the law of supply and demand. When the company went public it issued a limited number of shares, called a float or the number of shares outstanding. As the demand for these shares increases, the supply decreases. In this situation, the price will rise.

Companies definitely benefit when their stocks are in great demand. A company’s market capitalization, the value of all shares of its stock, will go up. Market capitalization is computed by multiplying the current stock price by the number of outstanding shares. The equities market is a powerful mechanism of the capitalist system. It has an enormous influence on the business cycle, because it creates wealth and stimulates investment in the future.

This is also why it should be no surprise that the stock market is so sensitive to economic news such as an interest rate change. The economy is a fluid system, one that evolves through predictable ups and downs. Investors will buy stocks when it appears that companies will be able to use the capitalist system to improve their earnings. They will sell stocks when it seems that economic woes are on the horizon.

This buying and selling is prompted by economic news that provides the clues to the direction the economy is taking. All that said, the IPO market is one of capitalism’s greatest gifts because it provides a mechanism for companies to expand and create wealth in the future.

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