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INVESTMENT STRATEGIES 

 

Investing reaches far beyond basic stocks, bonds, and mutual funds. There are many complex investment products designed to suit the needs and wants of more sophisticated investors. From options and futures to commodities and hedge funds, savvy investors attempt to maximize their earnings potential with a wide variety of financial instruments.


In this section, we will cover the following:

 
  Derivative Securities
  Options, Warrants, and Futures
  Commodities
  Real Estate and Collectibles
  Hedge Funds

 

DERIVATIVE SECURITIES 

Often investors have two distinct motivations for investing in derivative securities, leveraging and hedging.

Leveraging to speculate

For individuals with a high tolerance for risk, derivative securities allow them to take larger bets and earn higher rewards with smaller sums of invested money. In other words, derivatives enable investors to leverage their bets by using a small amount of money to control a greater size investment.

In the simplest terms, buying an option gives investors the right to either purchase or sell securities at a pre-determined level in the future. For example, you pay five dollars to acquire the right to buy a security at $100 before a set date. If that security rises above $100, you can buy that security at the pre- determined price of $100. In this example, as long as the stock rises above 9105, you will make money. If the current market price rises to $L25, you earn twenty dollars on a five dollar investment (excluding transaction costs) - a pretty fantastic return!

But if the stock had not risen above $100 during the set period of time, your option would have expired worthless and you would have lost 100 percent of your five dollar investment. It might not sound like a big loss, but had you bought the stock for $100 and it fell to ninety-five dollars, you would have only lost five percent of your total investment. So derivatives allow you to make a lot of money from a small investment, but they also make it possible for you to lose everything if the stock reacts differently than anticipated.

Hedging

For investors who use derivatives to protect against risk (to hedge), the strategy is different. Simply put, hedging is a way to limit the downside risk in your portfolio. Let's say you own stock XYZ and you expect it to go up, but you want to be cautious in case the price falls. If the stock is trading at $100 today, you might want to buy a "put," for say, five dollars, with an exercise price of $100. This means that no matter what happens, you have the right to place, or sell, that security to someone else for $100. Additionally, you are guaranteed not to lose more than the five dollars you paid for the put.

Here's how it works

If the price of XYZ rises above $100, you will make money on the stock you hold, but the put you own will expire worthless. As a result, even though you make money on the stock, you have still lost the five dollars protecting that position. So by protecting your position you will never "win" as you could have, but you also never have the downside risk that you would otherwise encounter.

Now, consider what would occur if the XYZ stock price were to fall to eighty dollars. In this case, you can still make money on the stock by "putting" it to someone else at the $100 strike price. You will earn twenty dollars on the transaction, minus the five dollars you spent on the option. In this situation, you win whether the stock price rises or falls, and the most you will ever lose is the five dollars you paid for the downside protection. Now, that's downside protection!


OPTIONS, WARRANTS, and FUTURES 

Options

Options are contracts that give the holder the right to buy or sell a stated amount of a particular security at a fixed price (also known as exercise price or strike price) within a predetermined period of time (expiration date). Options expire on the third Friday of each month. Investors pay a premium for the right to hold an option, and one option contract represents 100 shares of stock. Options are not issued by the underlying company.

Warrants

Warrants are like options, but they are issued directly by a corporation, rather than an outside issuer. Futures on the other hand, are contracts that must be exercised at a future date. There is no premium charged to enter the futures contract, and money only changes hands at the time of expiration. Unlike options, which give the holder a right to transact, futures obligate the parties to transact. Because of the complexity of trading derivative securities, investors must have an approved option and future accounts before transacting in these products.

There are four basic option plays

  Buying Calls
  Buying Puts
  Selling Calls
  Selling Puts

Buying Calls

Purchasing calls is considered a bullish strategy because investors buy calls in anticipation of prices rising. A call option gives the holder the right to buy a specific number of shares of a stock at a particular price within a specified period of time. If exercised, the payoff to a call buyer is the strike price less the current stock price, and the premium paid for the option. For example, if an investor expects the price of a fifteen dollar stock to rise, they might pay one dollar for a three-month call option that gives them the right to buy that stock for fifteen dollars at a later date. Simply put, they paid one dollar to lock in the right to buy at the fifteen dollar price for three months. If the stock rises to twenty dollars within the three month time frame, the option holder can exercise their right to buy the shares for fifteen dollars, keeping the four dollar profit per share owned. An option contract represents 100 shares of stock, so they could make a $400 profit on their $100 investment. This example excludes transaction costs.

Buying Puts

Purchasing puts is considered a bearish strategy because investors purchase puts when they expect the price of a stock to fall. A put option gives the holder the right to sell a specific number of shares of a stock at a particular price within a specified period of time. If exercised, the payoff to a put buyer is the current stock price minus the strike price minus the premium paid for the option. To expand, if an investor thinks that the price of a fifteen dollar stock will fall, they might pay a one dollar premium to buy a three-month put with an exercise price of fifteen dollars. If the stock falls to ten dollars within the three month time frame, the put owner can exercise their right to sell stock at fifteen dollars. In this way, by paying one dollar for the right to sell a ten dollar stock for fifteen dollars, they were able to make four dollars per option. (This example excludes transaction costs.) An option contract represents 100 shares of stock, so they could make a $400 profit on their $100 investment. On the other hand, if the stock price goes down, they could lose their entire g100 investment.

Selling Calls

Selling calls is considered a bearish strategy because the "call writer," or seller, gives up the upside potential on the security in exchange for the premium received. For example, let’s say Investor A sold a call with a strike price of $110 on XYZ security (current stock price $100) to Investor B for five dollars. By selling the call, Investor A is obligated to sell Stock XYZ to Investor B if Investor B exercises their right to buy the stock from Investor A for $110. Let’s say the stock price rises to $122 and Investor B exercises their right to buy the stock from Investor A at $110. In this example, Investor B makes seven dollars on the transaction ($12,2 - $110 - $5) and Investor A loses seven dollars ($110 - $122 + $5), Consequently, selling calls is a very risky strategy. This example excludes transaction costs. For a call seller, the only upside is the premium collected from the call sold. The downside loss can be virtually unlimited because as the underlying stock price rises, the call seller’s losses increase

Selling Puts

Selling puts is considered a bullish strategy because the "put writer," or seller, collects a premium in exchange for accepting the obligation to purchase the underlying security at the strike price should the put buyer exercise the right to sell. The put writer sells the put and hopes that it will expire unexercised. The risk they take is that the option will ultimately be exercised and they will be obligated to transact for a loss. For example, let’s say Investor A sold a put to investor B for five dollars that gave investor B the right to sell share XYZ to investor A for $105 (strike price). If the stock rises in value to $107, Investor B will likely not exercise their option to sell at $105 because they could sell it at a higher price ($107) in the open market. Consequently, Investor A collected the five dollar premium and lost nothing in return.

On the other hand, had the price fallen to ninety dollars, Investor B would have had the right to sell the share to Investor A for $105. In this case, Investor A would have lost ten dollars ($90 - $105 + $5) and Investor B would have profited ten dollars ($105 - $90 - $5). This example excludes transaction costs. Selling puts is deemed less risky than selling calls because the seller of puts has, at most. A limited loss potential, whereas a call writer’s losses are theoretically infinite. This is because if the stock price falls to zero, the share can be put to the seller at the strike price. Because shares cannot have prices less than zero, the total loss can never exceed the strike minus the premium collected. With call writing, on the other hand, there is no limit on how high a stock price can rise, so there is also no limit on a call writer's losses.

Making Money with Options - understanding some of the payoff jargon

Options may be "out of the money" "at the money" or "in the money."

Call

Put

Out-of-the- money

K>S

K<S

In - the – money

K<S

K=S

At-the-money

K<S

K>S

Where K= Strike Price,

S=Current Stock Price

An "out of the money" option is one where it would be unprofitable to exercise the right to buy or sell the underlying security given current stock prices. In the case of a call option, this means that the exercise price is greater than the current market price. Consequently, it is unprofitable for the option holder to exercise their right to buy the underlying security. In the previous example, the fifteen dollar stock has now decreased to ten dollars. The holder of the call would not exercise their right to buy the security at fifteen dollars because they could buy it in the open market for ten dollars! As a result, the option expires worthless because they spent the $1 premium and got no benefit in return. Likewise, a put that is "out of the money" is one where the exercise price is lower than the market price for the underlying security. In the previous example, the fifteen dollar stock has now risen to twenty dollars. Why would they sell it for fifteen dollars if they could sell it in the open market for twenty dollars? Chances are they wouldn't. The holder of the put is not able to make any money, and loses the entire one dollar premium paid, or 100o/o of their investment.

  An "at the money" option is one where the exercise price of the option is equal to the market price of the underlying security. For example, the stock price is currently fifteen dollars and the option gives you the right to buy it at that price, so you are indifferent about exercising your option right to buy and just buying the security in the open market.

  An "in the money" option is the opposite of an "out of the money" option. With an "in the money" call, the exercise price is below the market price so the buyer can exercise their right to buy the security at a price below what they'd find in the open market. In the previous example, the fifteen dollar stock has now risen to twenty dollars. The holder of the call is able to make money from their investment by getting a four dollar bargain. Likewise, the put that is "in the money" is one where the exercise price is significantly above the market price for the underlying security. In the previous example, the fifteen dollar stock has now decreased to ten dollars. The holder of the put is able to make four dollars on their investment by selling a ten dollar stock for fifteen dollars.

Pricing

The price at which an option sells is called the "option premium." The main factors that determine the price, or the premium, of an option are:

  The price of the underlying stock
  The length of time the option remains open
  The volatility of the underlying security
  The exercise or strike price at which the underlying stock or commodity
    can be bought or sold
  Interest rates

 

Changing Variable

Value of PUT

Value of CALL

Rationale

Increased underlying stock price

Lo

Hi

Because a call allows you to buy a security at a pre-determined price, you benefit when the price of the underlying security rises. The opposite is true for the put.

Increased volatility

Hi

Hi

The higher the volatility, the greater the chance that the security will take a large swing away from the strike price (in either direction)

Increased time until maturity

Hi

Hi

The longer the time, the greater the chance that you will make money on the option

Increased strike price

Hi

Lo

The higher the strike price the less valuable the call option is because this is the price at which you have the right to buy the security. The opposite is true for the put.

Increased interest rates

Lo

Hi

Higher interest rates mean that the value of the strike price that you set today will be lower in tomorrow’s dollars. This is equivalent to setting a lower strike price. So higher interest rates mean the future investment is worth less and the call is worth more. The opposite is true for the put.



Option strategies

When investors buy and sell options, they often do so with a specific strategy in mind. Some strategies involve purchasing shares in various ratios to achieve desired results.

1-Straddle: A strategy in which the investor buys an equal number of put and call options, all with the same underlying stock, stock index, or commodity future and all at the same strike price and maturity date. Each option may be exercise separately, but the combination of options is normally bought and sold as a group. The buyer of a straddle is anticipating the stock moves in either direction and will benefit from any move in the stock. The opposite is true for an investor who sells a straddle.

2-Strangle: A strategy in which the investor buys or sells a put and call option, both with the same underlying stock, stock index, or commodity future, and both with the same maturity date. Unlike the options within a straddle, the strangles’s options have different strike prices that are equally out of the money. The investor profits when the underlying instrument makes huge swings in either direction

3-Overwriting: A strategy in which the investor writes options and collects premiums when they believes the underlying security is either over- or under- priced. For securities believed to be under-priced, the seller writes puts, and for securities deemed overpriced, the seller writes calls. The writer sells these options in large quantities and assumes that they will not be exercised. This is a speculative strategy and the writer makes money when the options are not exercised.

4-Buy and write: A strategy in which the investor buys the underlying security and writes covered calls on the securities held to cover them. In other words, investors collect the premium for selling the call and receive any dividends earned on the securities. However, the investor gives up potential upside because they will be required to sell the security should the call buyer exercise their right to buy at the strike price. This is a conservative options strategy because the investor owns the underlying security and is therefore protected should the option buyer exercise their right to buy the security at the strike price.

COMMODITIES

Commodities are investments made in bulk goods such as grains, metals, and foods. For the most part, the price of the commodity is determined by supply of the commodity and the risk factors that may affect supply. Commodity risk is unique to the product being sold. For example, drought would have a bigger impact on grain prices than on copper. All commodity prices can be subject to acts of nature: fire, wind, drought, flood disease, and insect. They can also be affected by unpredictable governmental legislation, like import-export quotas, embargoes, subsidies, and foreign exchange re-valuations.

Some of the most popular commodities include farm products such as cotton, hogs and their derivatives like cottonseed oil and hog bellies, orange juce, wheat, rice,lumber, edible oils, oil and gas,electricity.

Because the supply of commodities is erratic, some commodities must be stored for future delivery. Contracts to deliver stocks of stored commodities are called "commodity futures contracts" or simply "futures". Futures contracts that are near expiration and are ready for the commodity delivery are called "spot contracts" instead of futures. The spot price is the price at which you can buy the commodity in the open market today, so it makes sense that spot and future prices should be near each other as they reach maturity. This is because prices won't change much over that short period of time. Both spot and future contracts are traded on the commodity exchanges.

REAL ESTATE and  COLLECTIBLES 

In addition to stock, bond, and commodities investing, some individuals prefer more tangible investments, such as that of real estate and collectibles. Although these investments can feel less risky because they can be physically seen and touched, you should evaluate real estate and collectibles as carefully as you would evaluate any other investment you make.

Historically, both real estate and collectibles have produced good returns for investors, even without consideration of the tax benefits. Real estate is referred to as investments in land, and all physical property relating to it. This includes homes, barns, trees, and the rights to the air above and below the property. Those assets not directly associated with the land are not real estate, but personal property. This includes furniture, clothing, and cars.

The term "collectibles" refers to items that increase in value such as coins, stamps, rare art, and books. Like real estate, they have produced measurable positive returns over time. The markets for real estate and collectibles are not always liquid, and can be subject to less quantifiable determinants of value. Additionally, the market for art and collectibles varies with trends, supply, and taste. These markets can be extremely speculative at times and are most often included in the portfolios of wealthier individuals seeking to balance their holdings.


HEDGE FUNDS 

A hedge fund is a fund that is not limited to owning one specific type of investment. Unlike stock or bond portfolios that fill themselves with a single security type, hedge funds invest in many diverse securities and world markets. Most hedge funds employ strategies aimed at achieving positive returns regardless of the market directions. Hedge fund managers typically have a significant personal stake in the fund and are rewarded on the basis of assets under management and fund performance.

Typically, investors in hedge funds are high net worth individuals, endowments, and institutional investors. Hedge funds require that sixty-five percent of all investors be "accredited" defined as an individual or a couple with a net worth of at least $1 million, or an individual with income in the previous year of at least $200,000, or a couple with an income of at least $300,000. Also, the funds usually require substantial minimum investments that can make it difficult for smaller investors to take part.

 Keep in mind that although these vehicles might increase your profit potential, they can also expose you to higher risk. Be sure to assess your own risk tolerance and needs before investing in any of the products.


 

 

 


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