OPTION: THE BASICS OF "CALL" N "PUT"

What is an option?

An option contract gives the buyer the right, but not the obligation to buy/sell an underlying asset at a pre-determined price on or before a specified time. The option buyer acquires a right, while the option seller takes on an obligation. It is the buyer’s prerogative to exercise the acquired right. If and when the right is exercised, the seller has to honour it. The underlying asset for option contracts may be stocks, indices, commodity futures, currency or interest rates

What are the types of options?

Broadly speaking, options can be classified as ‘call’ options and ‘put’ options. When you buy a ‘call’ option, on a stock, you acquire a right to buy the stock. And when you buy a ‘put’ option, you acquire a right to sell the stock. You can also sell a ‘call’ option, in which, you will acquire an obligation to deliver the stock. And when you sell a ‘put’ option, you acquire an obligation to buy the stock.

What do you understand by the term option premium?

Option premium is the consideration paid upfront by the option holder (buyer of the option) to the option writer (seller of the option). The option holder gets the right to buy / sell the underlying.

What is the strike price or the exercise price of the option?

The right or obligation to buy or sell the underlying asset is always at a pre-decided price known as the ‘strike price’ or ‘exercise price’, which is linked to the prevailing price of the underlying asset in the cash market. Usually, option contracts are available on the underlying asset on various strike prices (generally, five or more)-divided equally on either side of its spot price.

How does an American option differ from a European option?

In ‘European’ options, a buyer can exercise his option only on the expiration date, that is, the last day of the contract tenure. Whereas in ‘American’ options, a buyer can exercise his option any day on or before the expiration date.In the Indian equity market context, index options are European style, while stock options are usually American in nature.

How do options differ from futures?

In futures, both the buyer and the seller are obligated to buy and sell, respectively, the underlying asset-the quid pro quo relationship. In case of options, however, the buyer has the right, but is not obliged to exercise it. Effectively, while buyers and sellers face a…
: linear payoff profile in futures, it’s not so in the case of options. An option buyer’s upside potential is unlimited,while his losses are limited to the premium paid. For the option seller, on the other hand,his maximum profits are limited to the premium received, while his loss potential is unlimited.

IMPORTANT TERMS TO CHECK WHILE PURCHASING A STOCK

1. P/E:
 

The P/E ratio (price-to-earnings ratio) of a stock (also called its “earnings multiple”, or simply “multiple”, “P/E”, or “PE”) is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share.A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios.The reciprocal of the P/E ratio is known as the earnings yield. Stock having a P/E less than 30 are said to be good investmets

2. EPS:

 
EPS. Total earnings divided by the number of shares outstanding. Companies often use a weighted average of shares outstanding over the reporting term. EPS can be calculated for the previous year (”trailing EPS”), for the current year (”current EPS”), or for the coming year (”forward EPS”). Note that last year’s EPS would be actual, while current year and forward year EPS would be estimates.

3.DVI (Sividend yield):

The yield a company pays out to its shareholders in the form of dividends. It is calculated by taking the amount of dividends paid per share over the course of a year and dividing by the stock’s price. For example, if a stock pays out $2 in dividends over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower ones, and most small growing companies don’t have a dividend yield at all because they don’t pay out dividends

7 WAYS TO SHORTLIST THE RIGHT STOCK

Equity as an asset class outperforms all other asset classes in the long run. True. But, how do you pick the right company?

It’s always important to spend time in knowing a company, its business, financial health and prospects. But do you have the time, resources and energy to study about 1,400 companies listed on the National Stock Exchange (NSE) and about 4,900 on the Bombay Stock Exchange (BSE) before selecting the one to invest?

If these numbers make you uncomfortable, sample these: the market capitalisation of these companies ranges from a few lakhs to over Rs 2 lakh crore and the prices of shares from less than a rupee to over Rs 12,000 per share.

So, how and where do you make a start? We give you seven basic screening criteria, which will help you shortlist companies that are worth researching in the first place.

1. Is the company’s market cap more than Rs 250 crore (Rs 2.50 billion)?

Setting a minimum market cap floor really helps — it eliminates very small companies, or penny stocks. Generally, small companies have a small revenue base and they do not spend too much on investor relations. This makes tracking them difficult. At Outlook Money, we do not look at companies that have a market cap of less than Rs 250 crore. About 500 companies at NSE pass this criteria.

2. Are the company’s trading volumes high?

The company should have a reasonable trading volume — at least a few thousand shares per day. If you buy into a stock that has low volume, it can become difficult to get out when the markets fall. Both rise and fall is sharp in stocks with low volume. Also, the impact cost is high.

For example, MMTC, a state-owned company, has a market cap of over Rs 62,000 crore (Rs 620 billion), but its trading volume is very thin. The 30-day average trading volume of this stock is just about 338 shares and the stock is trading at Rs 12,400 per share. It is always advisable to avoid these kinds of stocks.

3. Does the company make quality disclosures?

 

The company should have good quality disclosures. This is an easy test. All you have to do is visit the company website and see press releases and results for the last few quarters. In the results part, you need not get into numbers in detail as of now, but do see how the developments of last quarter have been explained.

For example, see if cost has increased, or margins have declined, and whether there is an explanation for it.

Large companies, especially in the information technology sector, are generally good at this. Tata Consultancy Services [Get Quote], India’s largest IT company by revenue, has a transcript of analyst conference call on its website, which possibly answers all the questions that investors have.

Availability of information makes tracking easy and decision-making becomes quicker while you are invested in the company.

4. Does the company have operating profits?

Sometimes, companies raise money from the equity markets in their initial stages and hope to cover the costs by generating profits from operations later. Actually, they are in a stage when they spend money for, say, setting up plants, or research and development facilities.

These businesses sound exciting, but can be risky. It is advisable to avoid such companies. New projects involve a lot of regulatory approvals and can get delayed, which can escalate cost. Also, stock prices of such companies are the first to fall during any broader market correction, as there are no earnings to support the prices.

This is exactly what happened with Reliance Power, which does not have any of its plants in operation. Its public issue got heavily oversubscribed (73 times) due to general euphoria in the market, but sentiments changed between issue and listing. The issue went on to become one of the biggest disasters in the markets.

Therefore, it is always safer to be in companies that generate profits from their operations.

5. Does the company generate constant cash flows?

At times, fast-growing companies may show profits without generating cash. These companies are in their expansion stage. They have to generate cash eventually and create value for the shareholders.

Companies with a negative cash flow may have to seek additional capital, either through debt or equity. Debt will increase the risk while equity will dilute the earnings, which will get reflected in the share prices also.

6. Is its return to equity (RTE) constantly above 10 percent?

RTE is the profit a company generates with the shareholders’ money and is calculated by dividing net profits with shareholders’ equity. It indicates how well a company has deployed investors’ money.

The RTE is generally low in case of manufacturing companies and is higher for services companies as the cost of setting infrastructure is low in services companies. Use 10 per cent as the minimum limit for companies to qualify. There are just about 400 companies listed on NSE with a market cap above Rs 250 crore that generated return on equity above 10 per cent in the financial year 2007-08.

7. Is the earnings growth constant or cyclical?

Cyclical earnings implies that profits move up or down depending on the business cycle. Businesses generally move in cycles.

This is commonly seen in commodity companies, where a shortage or sudden rise in demand helps prices to move up, resulting in super normal profits for a while. Sugar is a classic example of cyclical earnings.

Bajaj Hindustan , the largest sugar company in India, saw its share prices soaring from Rs 200 in November 2005 to Rs 550 in April 2006 on the back of rising sugar prices; net sales for the company went up Rs 394 crore (Rs 3.94 billion) in the March 2006 quarter compared to Rs 282 crore (Rs 2.82 billion) in the September 2005 quarter.

But by the end of the December quarter, net sales went down to Rs 286.64 crore (Rs 2.86 billion) and the share price to Rs 140. The biggest risk in investing in cyclical or commodity stocks is that you could enter at the wrong time.

Once the cycle is reversed, it becomes difficult to get out. Commodity prices are interlinked globally, and any demand-supply mismatch in one corner of the world can disturb prices all over.

Companies in the pharma and FMCG space have stable growth in the long term as demand in these sectors depends on the business cycle and macroeconomic movements. The services sector also has stable earnings growth compared to commodity stocks.

If you carry out these seven checks, you will, by and large, be able to eliminate companies that are not worth investing. However, investors must note that these conditions are not fool-proof and there can always be exceptions.

SEVEN DUMBEST INVESTMENT MISTAKES

By Scott Woolley

Emotions can be expensive, especially when you start making investing decisions with your gut instead of your brain. Fortunately, there are ways to avoid–or at least limit–the mistakes that we oh-so-human investors tend to make.

Daniel Kahneman won the Nobel prize in economics seven years ago for his work on how irrational humans systematically make mistakes. Since then, research in the field of behavioural finance has exploded.

Given the recent market turmoil what common, and costly, mistakes should investors be especially vigilant to avoid making today?

One is a direct result of the stock market plunge. People who bailed out of stocks after losing as much as half of their investments are now anxiously sitting out the market recovery, says Amy Barrett, a fee-only financial adviser and director of investments at Savant Capital.

Those people have “anchored” themselves to the value of the stock market at its trough, where they bailed out. They’re having a hard time accepting the fact that stocks might really be good values at their new, higher levels. In the past that behaviour has been a sure recipe for missing a market rebound, says Barrett.

“I’d like to shake these people and tell them to get out of their rut,” she says.

Emotional Investors’ Seven Dumbest Mistakes

Here are descriptions of the most common cognitive errors investors make–and some tips for getting your rational mind to override your potentially costly emotions.

WHAT IS OPEN OFFER ?

Open Offer: Perhaps the most above board of takeover bids, in which the bidder makes its intention known through an open advertisement, followed by letters of offer to shareholders, to buy the shares of the target company at a stated price, usually quite above the ruling market price. The bidder may thus acquire a sufficiently larger number of shares to have a controlling interest in he target company, paving the way for a merger.

What is Technical Analysis ? How is it different from Fundamental Analysis ?

The stock market used to be filled with technical analysts deciding what to buy and sell, until it was decided that their success rate is no better than chance. Now technical stock analysis is virtually non-existent.

Research and examination of the market and securities as it relates to their supply and demand in the marketplace. The technician uses charts and computer programs to identify and project price trends. The analysis includes studying price movements and trading volumes to determine patterns such as Head and Shoulder Formations and W Formations. Other indicators include support and resistance levels, and moving averages. In contrast to fundamental analysis, technical analysis does not consider a corporation’s financial data.

Technical analysts study trading histories to identify price trends in particular stocks, mutual funds, commodities, or options in specific market sectors or in the overall financial markets. They use their findings to predict probable, often short-term, trading patterns in the investments that they study. The speed (and advocates would say the accuracy) with which the analysts do their work depends on the development of increasingly sophisticated computer programs.

Technical Analysis supposes markets have memory.If so, past prices, or the current price momentum, can give an idea of the future price evolution. Technical Analysis is a tool to detect if a trend (and thus the investor’s behavior) will persist or break. It gives some results but can be deceptive as it relies mostly on graphic signals that are often intertwined, unclear or belated. It might become a source of representiveness heuristic (spotting patterns where there are none)

Technical analysis has become increasingly popular over the past several years, as more and more people believe that the historical performance of a stock is a strong indication of future performance. The use of past performance should come as no surprise. People using fundamental analysis have always looked at the past performance of companies by comparing fiscal data from previous quarters and years to determine future growth. The difference lies in the technical analyst’s belief that securities move according to very predictable trends and patterns. These trends continue until something happens to change the trend, and until this change occurs, price levels are predictable.

There are many instances of investors successfully trading a security using only their knowledge of the security’s chart, without even understanding what the company does. However, although technical analysis is a terrific tool, most agree it is much more effective when used in combination with fundamental analysis.

Fundamental Analysis

Fundamental analysis looks at a share’s market price in light of the company’s underlying business proposition and financial situation. It involves making both quantitative and qualitative judgments about a company. Fundamental analysis can be contrasted with ‘technical analysis’, which seeks to make judgements about the performance of a share based solely on its historic price behavior and without reference to the underlying business, the sector it’s in, or the economy as a whole. This is done by tracking and charting the companies stock price, volume of shares traded day to day, both on the company itself and also on its competitors. In this way investors hope to build up a picture of future price movements.

THE STOCK i BUY goes Down !!!

Most people think that after they buy a stock, that stock tends to move down rather than moving up. This always anticipates them to think before purchasing any stock or share that they are likely to loose money in a script invested in.

I have heard people say that luck & patience plays a very important role for Stock Market players and Investors. This is very true, irrespective if the concerned person is a trader or a investor. But, one should also remember that thinking positive for the money invested in any investment actually tends to give huge profits.

In other words, a Short term trader should start thinking that after purchasing say a Stock named “A”(Always invest after studding the company fundamentally personally), the price of the Stock should easily increase by 100% in Short term rather than thinking what will happen if it manages to go down. This is what most of the successful Investors till date have followed and earned huge profits over the time.

It is very important to have positive beliefs & attitudes. This is not something that I say and use, but this should be rule followed by all the traders and investors. Warren Buffett quoted “I always knew I was going to be rich. I don’t think I ever doubted it for a minute “.

This statement clearly states that Buffett wanted to be rich, and his mind us always thinking about being rich, being rich, being rich, being rich all the time. Our subconscious minds control most of our behavior, and when you have such strong conviction of being rich, it is difficult not to be rich eventually.

Your thinking should note be “That whenever I purchase a script, I dream of it to be a Multibagger.” instead your thinking should be “That whenever I purchase a script, I Believed it to be a Multibagger.”

There’s no harm in thinking that the investment you made in quality stocks will fetch very good returns, In-fact this shall actually help you to earn more in the Long run, this is worth a try..