The Stock Market Cash Flow Read online

  Most investors understand the basic concept of going long, which is buying a stock at current market price based on good fundamental and technical analysis in anticipation that it will increase in value. Buying stocks at market price, however, can get expensive—especially if we want to buy a lot of shares. That’s why investors who become properly educated know how to use the leverage available in the stock market through buying or selling stock options.

  Leverage and Options

  The principle of leverage allows us to accomplish big things with just a little effort. Have you ever tried to steer an old car without power steering? It can be a little difficult and requires strength to turn the wheel. A power steering unit makes it almost effortless to keep your car heading the right direction. Pulling an old nail out of a piece of wood with your bare hands is almost impossible. But when you use the claw end of a hammer pressed against the wood, it pops out almost effortlessly. Using leverage intelligently can make life a lot easier for us.

  It’s useful to remind ourselves just how powerful the concept of leverage is. Archimedes famously said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”

  Regardless of where you stand currently, related to using leverage, the possibilities are limitless. They are literally infinite. It’s a shame that this concept is not taught properly in school, for it is one of the keys that can allow people to move from poverty to affluence, and from survival to abundance. It’s worth studying and practicing.

  In the stock market, we have a very unique kind of leverage available to us in the form of options. With options, we are not buying or selling a stock. Instead, an option is an agreement—with another trader through a market maker—that gives us the right to buy or sell a certain stock at a pre-determined price.

  Here’s an analogy to help you understand how options work:

  The owner of a tailor shop has just put a new tuxedo on display with a price tag of $1,000. You happen to be walking by the store and see the suit in the front window. It’s one of the best-looking tuxedos you’ve ever seen, and you’re interested in it. As you go into the store, you’re already thinking about pulling out $1,000 and buying the suit on the spot because you think you could turn around and sell it for a good profit later.

  As you approach the store owner, however, you have an idea. You decide to use the principle of leverage. Instead of buying the suit right now, you ask the owner to put it on layaway for you (also known in the U.K. as putting it on reserve). By putting it on layaway, you’re asking the merchant to hold the tuxedo for you at the price of $1,000. The owner agrees and writes down this agreement on an invoice, you shake hands with him, and you strike a deal with him at $1,000. Even if the store owner decides to raise the price of the tuxedo the next day, you’re still locked in to buy it at the $1,000 price, if you so choose.

  With that layaway paper in your hand, you have a choice—an option. You can go back to the shop before the agreed-upon deadline and buy that tuxedo for $1,000 or you can decide to walk away from the deal. The merchant, however, has an obligation. He’s given you a promise. If you come back to buy, he must sell it to you for $1,000, even if he has raised the price for other customers.

  After you have put it on layaway, suppose George Clooney is spotted at some red-carpet event wearing that same tuxedo. Orders for this tuxedo begin flooding in from Hollywood and New York. The store owner quickly realizes that he needs to raise the price of the tuxedo to maximize his profits, so it quickly shoots up to $5,000.

  For you, though, the merchant has made a binding promise for $1,000. Which means that before you even fork over the cash, you can find a buyer willing to give you $5,000 for the suit and then pocket a nice $4,000 profit. That extra $4,000 in the tuxedo’s value is called the intrinsic value of the deal you struck.

  In this situation, we can see that it would have been risky to immediately buy the tuxedo for $1,000 and then hope there is a buyer available later willing to buy it from you. We can see that the power in this transaction isn’t in the tuxedo. The power is in your option contract. Notice that when the value of the tuxedo increased, so did the value of your agreement.

  At first your agreement was nothing special. You could by the suit for $1,000, but so could anyone else.

  Now notice how the value of your contract increased as the value of the tuxedo went up.

  The $4,000 of intrinsic value comes from your ability to buy the tuxedo at a very low price because of your contract with the tailor. The exciting thing is that to put that $4,000 in your pocket, you don’t ever need to go to the tailor again. In fact, you don’t even need to go through the hassle of buying that suit and then delivering it to your buyer. All you need to do is to sell your contract. Your agreement is worth $4,000 in cash to any one of the many people in the market who desperately want that tuxedo.

  Let’s look at the transaction again to calculate your rate of return:

  •Money out = $4,000

  •Money in = 0

  You’ve made $4,000, but what was your initial investment. Zero.

  Suppose you had bought that suit for $1,000 and sold it for $5,000. That’s still a good rate of return:

  (5,000 – 1,000) ÷ 1,000 = 400 percent

  Earlier I said cash flow is about positioning ourselves. The following diagram helps us compare two different positions we could take on the suit. If we compare these two strategies we can see two dramatically different results.

  This is a simple example to show you how a simple agreement can work to reduce the initial amount of money you put into the investment to achieve a position of leverage.

  Notice how you were able to reduce the initial amount of money you put in to zero without going into debt.

  It’s important to note that you don’t have to reduce the amount of money put into the deal all the way to zero to receive a great benefit. In fact, if the merchant would ask you to give them $400 to hold the tuxedo at the thousand-dollar price, you would have still received a far better return with less money at risk with a layaway agreement than actually purchasing the suit for a thousand dollars and then trying to sell it later.

  Stock Options

  Now let’s look at a stock market example. Suppose you are looking to buy a particular stock at $50 per share. You’ve done your fundamental analysis, you’ve done the technical analysis, and you think the stock is likely to go up.

  The next question is: How will you best harvest a profit with that information? How will you decide to position yourself for the greatest benefit?

  The most common path for the typical investor would be to purchase shares of the stock. Perhaps someone might buy 100 shares at $50 each. When they do, they risk losing up to $5,000 if the stock does poorly or the company goes bankrupt.

  Another possibility is to buy the option for that stock. Perhaps you want to establish a position of leverage. Just like when you put that tuxedo on layaway for a certain period of time, you can do the same thing on shares of stock with a contract called a call option.

  To buy a call option you will start by making a few decisions:

  1.At what price do you want the choice to buy the shares? (strike price)

  2.How long do you want the option to last? (expiration date)

  3.How much will the contract cost? (option premium)

  So for this example, let’s get the information we need:

  1.Let’s purchase a call-option contract that gives us the choice to buy this stock at $50.

  2.Let’s choose an option contract that expires in two months.

  3.Let’s say that this “layaway” cost—or option premium—is $3 per share.

  Unlike the tailor who just wrote you an invoice, when you buy an option contract there is a small premium involved to give you the choice to purchase that stock at a set price. For our example, the premium here is $3 per share.

  In the U.S. markets, a single option contract gives you control over 100 shares. Other world marke
ts have option contracts that control up to 1,000 shares.

  In our example, this means that instead of having to fork over $5,000 to own the stock, you will only have to risk $300 (100 shares at $3 per share) to buy a call option that controls $5,000 worth of stock (100 shares at $50 per share). This charge for the option contract is called the premium, which you pay to buy the call option. In this situation, your maximum risk is just the $300 you paid for the premium.

  If the stock goes down, you are not obligated to buy it. Remember that “option” is another word for “choice.”

  Now let’s look at what happens if that stock price shoots up from the original $50 to $100.

  Just as in the tuxedo scenario, you do not need to buy the shares any more than you needed to buy the tuxedo. Remember that you can sell the actual agreement all by itself. And because the options market is liquid, you can sell your call option contract at market value right from your computer with the click of a button.

  If you sell the call option for $5,000 then your profit is $4,700 ($5,000 - $300) and your initial cash outlay and risk was only $300.

  With this simple example, you can see there is a big difference between the large cash outlays required when you buy the stock itself and buying the options for that stock. With the option, you are leveraging a small amount of money. If we compare strategies of buying the stock versus buying the call option, this is what we get:

  You can see there is quite a difference between buying the stock where you risk a lot of money and choosing the option where you are leveraging a small amount of money for large profits. And when we calculate the rate of return, options offer far greater potential returns than buying shares of stock.

  Call Options and Expiry Date

  Call options are dependent upon price and time. And it is the time element that carries much of the risk. If you hold that option until its expiration date without selling it or exercising it, it will be worth nothing. When it expires, you no longer have the right to buy the underlying stock at the predetermined price.

  Since all options expire at some point, for the deal to work in your favor the underlying stock price must move in the direction you desire before expiration.

  You might now be able to see more clearly why your ability to effectively position yourself rests on your skill with fundamental and technical analysis. Using these tools to see what is likely to happen (and when) is how you determine how to position yourself in the market. Of course, there is always an opportunity for an investor to look forward and buy whatever duration option is interesting.

  To help investors keep track of all the different options available for a specific stock, there is a useful table called an option chain.

  I remember when I took my first look at an option chain. It looked very complex, and I have to admit I was a little intimidated. But option chains are actually very easy to learn. The key is simply to know what you’re looking for.

  This particular option chain is for Microsoft (MSFT) and shows the call options that expired during Sept 2012.

  When looking to buy an option you need to consider three things:

  1. Strike price: the price at which you want the choice to buy the shares of stock

  2. Expiration date: the day the option expires

  3. Premium: the amount of money the option seller is asking for the option contract

  Let’s look at the above option chain and find the information we need. First is the strike price. This part of the option chain helps us identify all of the different contracts that the option sellers are offering.

  You can see that on this option chain there are call options that will give you the choice to buy shares of MSFT (Microsoft) at a set price of $23 per share all the way up to $33 per share. Notice that next to the price you can see the date of Sep 12. This expiration date is selected by you. At the top of the option chain there are spaces to select what company stock options you want to see, the last price paid for the shares, and which expiration month you want to view.

  We can see that the last trade on MSFT was $29.64.

  Once you see a strike price you desire, you can see how much in premium the option seller is asking for the contract. Since MSFT is trading around $29, you can find out how much premium the option seller wants for a call option with a strike price of $29.

  On the option chain you can see that for a call option with a strike price of $29, the option seller is asking $1.20.

  At any given time, you can select a given expiration month in an option chain and see the option contracts that will expire that month along with all the strike prices and premiums.

  A call option provides an opportunity for profit when a stock price goes up because that gives you the choice to buy the stock at a set price no matter how high the share price may rise.

  At the top we can see that the last price paid for shares of Microsoft stock is $29.64. That is the market price we would pay to buy the shares at that moment. But we are interested in buying an option on Microsoft.

  As we go down the option chain table, notice that the call option contract with the strike price that is closest to the stock price on the day we were looking at the chain is highlighted. It’s the Sep12 29.00 strike.

  We can see that the ask price on that line is 1.20. This ask price is the premium you would invest for the choice to buy Microsoft at $29 any time between the time we took a picture of the option chain for our example and the expiration date in September of 2012.

  Remember that each call option contract controls 100 shares of stock. In this example, you would buy this option for $120 ($1.20 × 100 shares). You would now have the option to buy 100 Microsoft shares for $29 per share at any time before expiration, no matter how high the share price might actually go during that time.

  Based on your fundamental and technical analysis, you might have set a target price for Microsoft to hit $32 before it expires. The power of the option is that if you can buy 100 shares for $29 each, and the price goes up to $32 at expiration, your option would have $3 of intrinsic value for each of the 100 shares. The option you paid $1.20 to buy you can now sell on the open market for $3.

  Remember the story of the real estate investors Mr. Cash and Mr. Credit? With a 10 percent move in the value of the asset, Mr. Cash gained a cash-on-cash return of 10 percent and Mr. Credit doubled his money. We could tell a similar story here with stock investors named Mr. Stock and Mr. Option. Except Mr. Option achieves his position of leverage with no debt.

  Using a computer can make this very easy to see. Below is a risk graph that shows how much value your option will gain or lose as the price of MSFT moves.

  With this graph you can see that your maximum risk is a loss of $120. That makes sense because that is all you paid in premium for the call option contract. No matter how far MSFT might fall, you can’t lose more than you put in. But the upside can be very exciting.

  These graphs show the position of leverage achieved by reducing the amount of money you have in the investment. You can see that your profit soars by about $100 with each dollar MFST moves in price. In fact, your profit increases as if you already owned 100 shares of the stock because your option contract guarantees you can buy MSFT at $29 at any time during the term of the option. Also notice that this was a leveraged position achieved without going into debt. That is the power and leverage that’s available with options.

  Why Have I Been Told Options Are so Risky?

  When you purchase shares of stock, you own shares of a company. When you purchase option contracts, you own agreements that have an expiration date. In order for you to lose 100 percent of your money in the stock example above, Microsoft would have to go bankrupt or experience some other event that would cause the share price to fall to zero. It’s much easier to lose the money invested in your call option contract. Why? Because your option is comprised of time, and like an ice cube, it will melt away.

  The risk here is that Microsoft shares will be trading below $30.20 ($29 + 1.20 pre
mium) at the expiration date. If that happens, then your option will expire without sufficient intrinsic value. It’s probably much more conceivable that MSFT will trade below $30.20 than the likelihood that MSFT stock shares will be trading at zero. On the one hand, you are much more likely to lose all your money invested in an option than in the stock, but on the other hand you can lose far more money by investing in one hundred shares of the stock than buying one option contract to control the same hundred shares. We will cover the really big lessons on how to manage the risk in both trades in the next chapter when we talk about exit strategies and other ways to mitigate risk.

  For now, remember that part of the value of an option is that it buys you time for the stock to make its move. Discovering how time works in relation to option contracts is vital.

  Time Value

  Options have both intrinsic and time values. As time gets closer to the expiration date, the value of that time shrinks. To illustrate this important concept let’s use another example.

  You see a stock that looks promising, so you conduct a fundamental analysis and find the company to be financially strong and growing. Your technical analysis of the stock chart shows a strong bullish pattern. In fact, the stock has just broken out of an ascending triangle and is now trading at $52. How do you want to position yourself?

  You begin by finding the three important pieces of information:

  By choosing to buy the call option you achieve a position of leverage because you have put less money into the trade than if you bought the stock shares outright. And you still control the shares. Remember that you now have the choice to buy the stock at $50 anytime between now and the expiration date, which is five months out.