Saturday, January 31, 2009

How to approach options questions

Series 7 candidates often say curious things about options being "hard." Options are not "hard." Options are just freaking weird. When you first read about them, the terminology is confusing. Plus, most people can not for the life of them understand why anyone would actually engage in this sort of reckless activity. Believe it or not, the options exchanges were created in order to reduce the risk of a stock position. Seriously. Just as the commodities exchanges allow buyers and producers to pass off some of their price risk to another party, the options exchanges allow stock traders to pass off (hedge) some of their market risk to another party. But, for many traders, the key word here is "party." See, you can use an option to reduce the risk of a stock position. Or, you can just party or "speculate" as the professionals like to call it. When you buy and sell single options, straddles, or spreads, you are speculating on the short-term movement of a stock, index, or other "underlying instrument." Of course, most students don't like to drill down so hard on the concept of an option, but until you dig in and fully understand how options work, you will be one of those poor people trying to create the perfect chart that will act as some universal options question decoder.
Step one is to stop trying to create a magic chart and start trying to understand why a MSFT May 50 put is in- or out-of-the money and where to enter the intrinsic value in the little T-chart. Just keep it simple. A call is the right to buy something at a set price; a put is the right to sell something at a set price. You can buy those rights, or you can sell them. That is the whole story of options. Everything else involves your ability to break down the question.

Let's look at a question that is similar to what you'll see on the exam:

An investor buys an XRQ Oct 60 call @4 and an XRQ Oct 60 put @3. If XRQ is trading @54 at expiration and the investor closes both positions for their intrinsic value, what will be his gain or loss?
A. $700 loss
B. $700 gain
C. $100 loss
D. $600 gain

Keep it simple. He paid $7 a share total for this straddle, so the stock will have to rise by more than $7 or drop by more than $7 for him to gain. I like to know the breakeven points before solving the problem, because they provide excellent guidance. For example, I already know that if this stock can't make it above $67 or below $53, there is a loss here, not a gain. Do you see how knowing that will eliminate two answer choices? Two of the choices say "loss," while two say "gain"? So, did the stock go above $67 or below $53? No--so he has a loss. Eliminate the choices that have a "gain" in them. Answers "B" and "D" are gone--dismissed.
All right. You should probably use a T-chart here, although, really, at this point you can probably see that the loss is only $100. The stock only missed hitting the breakeven by $1, so he can't lose all $700. In fact, he could only have lost the full $700 if the stock had remained right at $60. And that makes sense, too--he's betting on volatility. By definition, if the market sits still, he's screwed.
But, again, using the T-chart is the fool-proof method. So, in your "debit" or "money out" column, you enter $400 for the call and $300 for the put that he purchased. Now, in your head you have to figure out what the "intrinsic value" of each option is now that the stock has dropped to $54. Many students struggle with this notion that the premium can, like, change. That's because they've never bought an option for $350 and then watched it drop to $10 in, like, an afternoon. Remember that as the stock is jumping around, so is the premium of the option. So, with the stock now trading at $54, the October 60 call is worthless--write a zero in the "money-in" side of the T-chart. The right to sell this stock at $60 would be worth exactly $6, so write "$600" in the money-in column, as well. Add it all up, and you see that he lost $100.

I'd say the dude got off easy, but who am I to judge? Maybe he has his reasons for risking $700 per contract speculating on volatility. To me, it seems a little weird. Like, maybe some counseling might be in order. But, again, it's not my job to judge. When I'm answering an options question, my job is to try to figure out what's going on and start eliminating wrong answers. If you can boost your score on options (derivatives), the pressure will come off on some of the other sections. Don't work on options exclusively, since they account for only about 38 of 250 exam questions. But, get these things down cold--it will boost your confidence big time. And, you can turn what is often a weakness into a strength with just a few extra hours of effort.

Monday, January 26, 2009

Bond yields and prices

I just received a good, tough Series 7 practice question from a customer. She must be using a different company's questions, but this one is worth looking at in some detail:

QUESTION:
An investor bought 6% and 7% 15-year municipal bonds at a 5.50 basis. Which bond will have the greatest price appreciation if the market moves to 85.40?
a. 6% bond
b. 7% bond
c. both will appreciate equally
d. neither, since the market moved down

Answer is d. my question is how do we know that 85.40 means the market moved down?

RESPONSE:
Denise, thanks for sending in this question--not sure who wrote it, but it's about as tricky as it can possibly be. To ask about "the greatest price appreciation," when, in fact, the market price dropped is pretty evil. How do we know that "85.40 means the market moved down?" We have to use reasoning skills. If the coupon/nominal yield on a bond is 6% or 7% when the investor bought it at a yield/basis of just 5.50%, that is a premium bond. Right? If the yield is lower than the nominal/coupon rate, the price is above par. The question then gives you a market price well below par--$854.00. So, the market prices went from above par (premium) to below par (trading at a discount).
Wow. Not sure the actual test will be this evil, but I'm glad somebody's preparing you for even the most evil approach to a tough concept.

Saturday, January 24, 2009

What's the difference between a covered and a naked call?

Series 7 candidates frequently ask me what the difference is between a so-called "covered call" and a "naked call." The difference is immense. In fact, the covered call is so much more conservative than the naked call that you can actually write covered calls in your IRA. Fortunately, the regulators don't let people risk unlimited loss by writing naked calls in their retirement account.
So, what's the difference between the two positions? First, remember that whenever you write a call, you take on the obligation to sell a stock for a set price, no matter what. If you write an XYZ Mar 50 call, you are obligated to sell somebody 100 shares of XYZ for $50 per-share, regardless of what you have to do to get the shares. If you don't have the shares when you write the call, you are totally exposed to the risk that the stock price will rise, since the rising market price is what you have to pay to get the stock that you then have to sell for $50. What if the stock pulls a Google on you and rises to $450 a share?
You will be very, very sad. Imagine paying $45,000 for 100 shares of stock that you have to sell for $5,000. Per contract. Oh, wait—what’s that? Oh, you collected $200 in order to lose the 40 grand; I stand corrected. So, since the stock price can rise to an unlimited value, and since that unlimited and unknown value represents your purchase price on the stock, you are standing out there naked and exposed to the harsh elements, all in exchange for a premium. If you wrote that XYZ Mar 50 call "at 2," you took in $200 per contract for your maximum gain. Your maximum loss? Unlimited. Think about that risk-reward ratio. I can make $200 per contract or lose my house—gee, where do I sign up? I wanna write naked calls.
On the other hand, if you already owned 100 shares of XYZ, you would be covered. If the stock rises above $50 per share, you just deliver the shares you already own and walk away. If you had bought those shares for, say, $30, you would actually make a nice profit when the stock is called away from you at $50 a share, plus the little premium, as well. Now, please don't make the mistake so many students do in assuming that if you write an XYZ Mar 50 call, you will sell the stock at $50. No! You will sell the stock at $50 only if it rises above $50 per share. If the stock drops, the call expires. That's the idea when you write a naked call--take the premium and watch the other guy lose the bet when the stock drops faster than the Chicago Cubs in late August. But, when you write a covered call, you have to remember that you own that stock which is now dropping. And that's a bad thing. If you bought XYZ common stock for $50 and wrote an at-the-money XYZ Mar 50 call @2, you took in $200. Covered call enthusiasts would point out that earning $2 immediately on a $50 stock is a 4% return. If the call expires in 2 months, you could multiply that 4% by 6 and call it a "24% annualized rate of return." I prefer to call it "$200.” And, in this case, $200 is your maximum gain. If the stock goes up, it's called away, end of story. You make nothing on the stock--the premium is all you get. Your risk would be on the downside in this covered call position. If the stock drops, it just keeps dropping. You don't "get to" sell your stock @50; you were obligated to do that, and only if the stock had gone up, above $50. On the way down, you're in the same boat as anyone who owns the stock all by itself. If the stock drops to zero, I doubt you'd feel special having lost only $4,800 while you woulda' lost $5,000. Now we can see why Series 7 questions will talk in terms of "increasing overall return" and "limited protection" in reference to a covered call. The premium does increase your overall return/yield. In other words, while the stock is just sitting there in your account, why not use it to generate some premium income? But, remember that the premium income is all you get. If you collect $2 a share, then $2 a share is the full extent of your "protection." If you buy 100 shares of XYZ for $5,000, you could lose $5,000; if you wrote a covered call for $200, you could then lose $5,000 minus that premium ($4,800). So, the covered call is not about protection so much. It provides the premium. That means you get some extra income, minimal downside protection, and if the stock should ever rally, it is called away, capping your upside potential.

Thursday, January 22, 2009

Correspondence, sales literature, advertising

A customer just emailed me a very common question. Chances are, you've wondered about this one a few times yourself.

QUESTION:
Can you clear up the concept of correspondence and sales literature by pointing out the difference between the two?

RESPONSE:
The reason the regulators distinguish the two is that for correspondence the firm just needs a monitoring program. With sales literature (or advertising), the materials must be pre-approved.
So, letters/faxes/emails to existing clients = correspondence, regardless of the number of recipients. But, you can only send letters/faxes/emails to 24 PROSPECTS in a 30-day period and call the communication "correspondence." If it's sent to 25+ recipients (and it always would be), it becomes sales literature subject to pre-approval.

Sales literature is different from advertising in that sales literature is delivered to a targeted, controlled audience. It includes research reports, market letters, flyers, brochures, cold-calling scripts. Advertising is blasted out to the masses: tv, radio, newspaper, billboards, websites.

See the actual rule and definitions at:
http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=3617

Wednesday, January 21, 2009

dilution of shareholder equity

A Series 7 candidate just emailed me a question he had seen somewhere among his large stack of materials. The question is good and, like many on the exam, a little bit tough.

Current common shareholders' interest would be diluted by:
I. A 3 for 1 split of the common stock
II. A sale of 500,000 shares of previously unissued stock by the company
III. 20,000 debentures converted by their holders into common stock
IV. A 25% stock dividend on common
(A) I and IV only
(B) II and III only
(C) II, III and IV only
(D) I, II, III and IV

RESPONSE: stock splits don't dilute anything. We used to have 1,000 shares worth $30 each. After a 3-for-1 split, we'd have 3,000 shares worth $10 each. So, eliminate anything with a "I" in it. And then eliminate choice "IV" because stock dividends and stock splits don't change any value, actually. They just manipulate the per-share price that a stock is quoted on the exchange. It "sounds cheaper" to hear about a stock trading for $10 than for $30, maybe, but it's all an illusion. If the company sells convertible debentures, those bondholders will eventually receive shares of stock without bringing anything to the party. The same profits at the company will suddenly be divided into more shares because of these freeloading former bondholders. That's dilution. So is selling more shares of stock.

Dilution just means that there is a total profit at the company, and common stock is worth a share of those profits. If they keep cutting the profits into more and more shares, it's just like a pie being cut into more and more slices--pretty soon it gets too thin to enjoy.

Do you have the actual exam questions that I'll see?

Customers often ask if I have the actual Series 7 questions that they will see on their exam. It's a good question. I mean, if somebody has the actual questions, why don't we just memorize them and be done with it?

Unfortunately, nobody has the actual Series 7 questions. And if they did, they could get into serious legal hassles if they tried to provide or sell them. NYSE owns the Series 7--it's their intellectual property. If you damage that intellectual property, they will sue you. They did it not so long ago to the bigger firms, back before I got into the business, and they won a fairly large monetary settlement, plus an agreement to stop trying to obtain actual Series 7 questions.

So, how do these "test prep" companies come up with their questions? By looking at the outline and getting feedback from test-takers. Unfortunately, people mis-report their exam experience as a general rule. I just got a nice phone call from a nice young woman who had passed her Series 7 and was very troubled about seeing some funky securities called "PAOs" on her exam. I have to admit, my stomach dropped, but then I realized that if we substituted a "C" for an "O," we'd be talking about a PAC or "planned amortization class," which is a type of CMO. Point is, she was smart enough to pass the Series 7 but still unable to accurately report what she had seen on the test. Multiply that kind of "information" times a few thousand callers and it's no wonder so many books are so loaded up with bullet points and possible test questions too numerous to memorize, let alone understand.
Second, knowing that the phrase "PAC" was "on the test" doesn't help me determine if it was an important concept, or just the obviously wrong answer choice on one or two questions. If you fill a 900-page book with all the bullet points ever reported to show up on the Series 7 through the rumor mill, what are you actually accomplishing? The Series 7 doesn't just ask you to spit back bullet points. It's mostly about applying concepts. Obviously, if the question simply asks "what is regular-way settlement for common stock transactions," you do, in fact, spit back "T + 3." But , more likely, they'll tell you some long story and see if you can apply the concept of settlement/clearing of transactions to something you weren't quite expecting.

By the way, here is what the regulators say about the question of whether any company has the "actual exam questions."

Does NASAA or anyone else give out the exam questions?
Questions from NASAA exams are not available outside the exam setting. Doing so would compromise the exams and turn them into memorization tests rather than tests of competency.

Oh well.
Guess we'll all have to study, after all.

Saturday, January 17, 2009

Using real-world sources to study for your Series 7 exam

If you find yourself feeling frustrated that the exam material has "nothing to do with the real world," you might enjoy visiting some "real world" sources such as http://www.sec.gov/, http://www.finra.org/, http://www.nasaa.org/, http://www.federalreserve.gov/, http://www.cboe.com/ and http://www.cboe.org/, http://www.msrb.org/, http://www.bondbuyer.com/, and http://www.morningstar.com/.

If you're studying for the Series 7, http://www.msrb.org/ and http://www.bondbuyer.com/ can help you take your understanding of municipal securities to a much higher level. Use the MSRB's glossary to study. I suggest typing in vocabulary words that pop up in practice questions and the textbook to see how the so-called "real world" regulators define terms such as "general obligation," or "broker's broker."

At http://www.finra.org/ you can find (after many clicks) the outline to your exam. You can also download the recent enforcement actions taken against firms, principals, and agents over violations of NASD/FINRA/SEC rules and securities laws.

Series 7 on DVD

video

This is what the Pass the Test DVD's look and sound like. We didn't record an instructor's talking head because we're convinced you'll learn more through animation and other images with which you can associate the concepts. We cover the fundamentals on the DVD sets as opposed to presenting bullet point lists that are better covered in the books. Practice questions are broken down step-by-step for an interactive feel. Use this as a supplement to the materials you already have, or buy it within our full package plus DVD option.

Types of corporate bonds

This is the type of question I would expect to see on the Series 6, 7, and 65 exams. Notice how it makes you think as opposed to asking you to recall memorization points.

The XTZ Corporation will issue three series of bonds. Each offer is of the same size and term to maturity. XTZ will issue secured bonds, a series of debentures, and a series of subordinated debentures. Therefore,
A. The subordinated debentures would offer the lowest yield to investors
B. The secured bonds would offer the lowest yield to investors
C. XTZ is reducing the leverage component of its capital structure
D. The debentures would offer the lowest yield to investors

EXPLANATION: when bond investors take on more risk, they demand a higher yield. The secured bonds, backed by collateral, are the safest in terms of default risk, so they would offer the lowest yield here. Subordinated debentures put the investors at the bottom of the pecking order in bankruptcy and, therefore, have to offer a higher yield. Whenever a company issues bonds, they are using and, therefore, increasing leverage. The other way to capitalize is to sell ownership positions called "equity securities," which include common and preferred stock. Notice how analytical one needs to be to get the difficult exam questions right.

ANSWER: B

Sales literature

Here is a potential exam question (a facsimile, that is) . . .

Under NASD/FINRA rules, which TWO of the following are considered sales literature?
I. web page
II. letter sent to a client
III. group e-mail sent to 33 recipients
IV. prepared script for a seminar

A. I, II
B. III, IV
C. II, IV
D. I, III

EXPLANATION: a letter/fax/email sent to fewer than 25 prospects in a 30-day period is correspondence, but if it's sent to 25 or more prospects, the communication becomes sales literature subject to pre-approval and filing by a principal. Materials that are broadcast to an unknown audience are considered advertising. Therefore, a web page, a billboard, or any TV, radio, newpaper, magazine,etc. advertisements = advertising. Sales literature is delivered to a targeted/controlled audience. Sales literature includes: market letters, circulars, scripts for cold-calling or seminars, computer slide shows, and research reports.

ANSWER: B

Syndicate and selling group

A Series 7 candidate just emailed me a question with which many test-takers could probably use a little help. The question comes from another vendor's software and goes like this:
Question: a member of a selling group in an eastern syndicate is:
Answer: not liable for a percentage of the unsold shares.

The Series 7 candidate then asked me:Wouldn't that answer pertain to a western syndicate?
Please explain.

RESPONSE: The key phrase is "a member of the selling group." The selling group is not in the syndicate--they're just broker-dealers out there with customers. Only SYNDICATE members (underwriters) ever have any liablity. So, if Citi is the syndicate manager, maybe Merrill, Morgan, Goldman, and JP Morgan Chase are syndicate members. Only these underwriting firms can have any liability for unsold bonds. And, they'll work it out in their agreement among underwriters/syndicate letter, which states whether it's an "eastern" or "western" syndicate account. The selling group includes a few smaller broker-dealers, who can sell some bonds and earn the selling concession. But, those selling group members have no liability. Ever.
Underwriters/syndicate members have liability in any firm commitment underwriting. Selling group members are exactly what the term suggests: sellers. They aren't responsible for anything. They can help the syndicate, period.