Saturday, March 28, 2009
No--we said no whining.
Let's say that GE is about to announce whether it will continue as a conglommerate or spin itself off into 5 separate units. This news could send the stock way up or way down in a hurry. Since you're only willing to bet that it will move--not on the direction--you need to buy both a call and a put with the same strike price. If the stock trades at $30 (I wish), you buy a GE Apr 30 call and a GE Apr 30 put. Unfortunately, both options are at-the-money and, therefore, hugely expensive. Maybe you pay 2 for the call and 2.25 for the put. If so, you just paid $4.25 per share for the "long straddle." Now, let's keep those thinking caps on. If you pay $4.25 for an options position, doesn't that position have to move in your favor by $4.25 to break even, and by more than $4.25 to profit?
Yes, and yes.
So, if the stock goes up or down by $4.25, the investor breaks even. If it goes up or down by more than $4.25, the investor profits. What if GE closes at $37 on the expiration Friday in April? This investor would profit. He would make the difference between $37 and his breakeven at $34.25, which is $275 per contract. If the stock falls anywhere between $34.25 and $25.75, he loses some money. If the stock finishes right at $30, both options expire, and he loses the full $4.25 per share in a hurry.
What about the guy who sells the GE Apr 30 call and the GE Apr 30 put--what's this guy thinking? He's thinking that the stock will sit still, or at least will never move by $4.25. If the stock moves less than $4.25 in either direction, he makes a profit. And if the stock stays right at $30, both options would expire, and he'd make $425 per contract without lifting a finger. How much could this guy lose? Everything. He could lose if the stock drops big-time, and if the stock rises, the loss is unlimited, since he essentially wrote a naked call. How high could GE rise? Hypothetically, it's unlimited, which is why I don't write straddles any more than I engage in free-form rock climbing, hang gliding, or betting on the Chicago Cubs.
So, all you need to do is be able to first identify a straddle. To do that, just remember that everything is the same about the two positions except that one is a call and one is a put. In other words, the following is a straddle:
Long ABC Jun 50 call
Long ABC Jun 50 put
But, this next one is a spread:
Long ABC Jun 50 call
Short ABC Jun 55 call
Or, if the question gives you the premiums and wants to know the breakeven points, just add both premiums and subtract both premiums to/from the strike price. In other words, if the straddle looks like this:
Long ABC Jun 50 call @2
Long ABC Jun 50 put @2.25
Just take $4.25 and add it to 50, then subtract it from 50. The breakevens are at $54.25 and at $45.75.
Are we having fun yet?
Oh. Guess it's just me. Anyway, if you run into a "hard" question on straddles, submit it by email or through the comments section.
To profit, a credit spread needs to "narrow" or "expire." A debit spread investor wants and needs the spread to "widen" or for the options to be "exercised."
So, is the following a debit or a credit spread:
Buy 1 ABC Jan 50 call
Sell 1 ABC Jan 45 call
- Which option is worth more? The right to buy the stock for $45 or for $50? The ABC Jan 45 call is worth more than the ABC Jan 50 call
- Did the investor buy or sell that option? The investor sold the more valuable option.
- Therefore, this is a credit spread
What about this one:
Buy 1 ABC Jan 50 put
Sell 1 ABC Jan 45 put
- Which option is worth more? The right to sell stock for $50 or for $45? The right to sell stock for $50 is more valuable.
- Did the investor buy or sell that option? The investor bought that option.
- Therefore, this is a debit spread
I know, I know. Many of you friggin' hate this stuff more than you friggin' hate reading the instructions that came with your I-POD. That's normal. Unfortunately, the Series 7 is anything but, so keep grinding it out with these spreads. And feel free to submit your questions through the comments field.
Friday, March 27, 2009
Wednesday, March 18, 2009
Fed to buy up to $300B long-term Treasury bonds
WASHINGTON – The Federal Reserve announced Wednesday it will spend up to $300 billion over the next six months to buy long-term government bonds, a new step aimed at lifting the country out of recession by lowering rates on mortgages and other consumer debt.
At the same time, the Fed left a key short-term bank lending rate at a record low of between zero and 0.25 percent. Economists predict the Fed will hold the rate in that zone for the rest of this year and for most — if not all — of next year.
Fed purchases should boost Treasury prices and drive down their rates. That would ripple through and lower rates on other kinds of debt. The last time the Fed set out to influence long-term interest rates was during the 1960s.
The article didn't mention "fed funds rate," but it hinted at it with "a key short-term bank lending rate." As always, you have to be patient and flexible when studying the test material or the real world version thereof. Try to see the Series 7 connection in the Jim Cramer show, the morning newspaper article, maybe even the late-night comedian's monologue.
The FOMC is purchasing Treasuries, which will lower their yields and probably help push down mortgage rates. It's not just a bullet point--it's going on right now.
Monday, March 16, 2009
Somebody who wrote the SBUX 20 put. He sold you the put a while back because he was convinced the stock would stay at $20 or higher (bullish/neutral). Turns out, he was wrong, and now he has to let you sell him the stock @20. He has the "obligation to buy the stock at 20," in other words. Notice how I try to focus on the buyer's perspective--he has the right to sell the stock for $20, so the seller of the put has to honor that contract. Or, we could say that the put writer is "obligated to buy the stock at the strike price."
Okay, so if I am "bullish" on Starbucks (SBUX), I can buy calls on SBUX. If the stock drops, I could lose the entire premium paid for the call options. Or, I could sell/write puts on SBUX, thinking the stock will either rise or stay where it is. Some people prefer to take money in from an option by selling, but if the stock drops, the put writer can get bruised pretty bad. If you sell a SBUX Sep 20 put @2, the stock could drop to 0. And then you'd have to pay $20 to somebody for a worthless stock, with only a $2 premium to show for it. And, the higher the strike price, the bigger the risk to a put writer. I don't want to be "obligated to buy" a worthless stock for $80, $90, $100. Of course, I don't write options, or buy them. We have plenty of riverboat gambling in the greater Chicago area if I feel a need to throw my money away.
Saturday, March 14, 2009
Wow. See, I knew that options involve extreme mental gymnastics, but I've always thought that stretching the brain in so many different directions felt, you know, good. Not just good, in fact, but really good. I guess I didn't realize that many people experience the very same mental processes as a form of, like, pain. It's similar to the divergent views on physical exercise shared by me and my assistant. This week my assistant took the brave step of accompanying her much younger friend to the gym and the even braver step of letting some "personal fitness expert" assess her "body age" and recommend her weight-loss goal. The fact that the guy added 14 years to her actual age to figure her "body age" and added 10 pounds to her own weight-loss goal would be fodder for a different blog. Point is, no matter what I suggest to her about which machines she might like, or which group classes she might enjoy, she just shakes her head stubbornly and says, "No way--that hurts. Forget it." I've tried to explain that the pain lasts for two or three workouts maximum, but right at that point, I lose the argument. That's the point to her--it hurts! Not just once, not just twice, but three times in a row--hello!
Then again, she does have the computer-generated image of her body at her ideal weight to motivate her, to tempt her toward a seemingly impossible goal, so maybe a little pain is worth it?Sound familiar? My assistant was never an athlete in school; exercise is not her thing. For many candidates, the Series 7 is, similarly, not their thing. They're sales people. They like action, meetings, goals and results. They hate wishy-washy answers and boring, bookworm stuff about convertible debentures trading below parity and debit put spreads narrowing, widening, or whatever the hell a debit put spread is supposed to do. But, you either experience this mental marathon known as the Series 7 as pleasure--the way I do--or you figure out how you're going to deal with the pain. Unlike for my assistant, you don't have the option of not trying. You're already in the game.
Welcome to the Series 7.
Friday, March 13, 2009
Johanna sold an Xyz Mar 50 call @3 and an Xyz Mar 50 put @2.25. Therefore, Johanna would profit if Xyz trades at all the following prices except:
First--what the heck is going on? Johanna sold/wrote a "straddle." She was willing to sell a call and sell a put with a strike price of $50 because she's convinced the stock won't move by very much up or down from $50. She's collected $5.25 per share. That means that she will make a profit if the stock fails to move up or down by $5.25 or more. At $51.75, the put expires worthless, and the call has an intrinsic value of just $1.75. She would make a nice profit of $350 at $51.75, so "A" is eliminated. At $45.75, the call expires, and the put is worth $4.25. She would make a small profit of $100 at that price, so "C" is eliminated. At $53 the put expires, and the call is worth $3. She makes a profit of $225 in that case. What about "B"? She breaks even at $55.25, which is not a profit, making the answer to the question . . . B.
Wednesday, March 11, 2009
Of course, I didn't. I just eliminated the wrong choices and then asked--who was a true "80's band"? And, what would this test want me to say?
I also just got a 100% on a "name that 80's tune" challenge. On the first 9, I simply knew the answer. But I would have only gotten a 90% if I had not used process of elmination on the last one, avoiding "The Bangles" and choosing "Debbie Gibson," not because I have a clue what Debbie Gibson actually sang or looked like, but because "The Bangles" had one or two hits, and the title of the song in the question wasn't one of them.
Always use the multiple choice format to your advantage. Always focus on eliminating wrong answers to improve your odds. Never indicate "single" for your facebook status unless your spouse has a really good sense of humor.
Try not to do that, but remember that you can miss 75 questions on the test and still pass. With many options questions, you'll just add or subtract the premium from the strike price, so you won't need to be so darned cagey and analytical there. But on a huge percentage of questions, you'll find yourself feeling lost and confused, as if you've parachuted into a rainforest somewhere. Don't panic. Step one, read the four answers--where is this going? Step two, read the question carefully, picking apart the words and twisting them around--does it always work that way? Is that true in all cases? Step three, which answers can I eliminate based on something I know? Step four, which choice is the hardest one to eliminate? That, of course, is your answer for that particular question. If you think you might do better on a second go-round, confirm and mark it for review. If you've done your best, confirm it and keep moving. Again, I can't give you insider information or assure you that choosing the longest answer or choosing "C" will help you. But I've taken these exams enough times and gotten ridiculously high scores using the methods I write about in these blogs. I also have stacks of thank-you emails from people who point out that "your method of eliminating the wrong answers was key for me."
Try it. If you have the Kaplan, STC, etc. questions, build a test of 50 or more questions and try the above approach. Try to do it on the unfamiliar questions, though--too many of you are banging out the same darned practice questions again and again. But we'll save that bad habit for another post.
Tuesday, March 10, 2009
Mr. Walker, When I took the series 6 test, my class instructor told us that we should do the math questions last. He says that math questions are a different mind set and should be done after you finish the other word problems. The instructor also said that people generally miss the next 1-3 questions after a math question has been thrown in the mix of questions. Do you find that to the case?
Something about the test prep industry attracts pontificators who have no basis for their pontifications. Luckily, their pronouncements are usually harmless, like this one. I wouldn't be surprised if he told you that Procter & Gamble pays dividends in the form of soap and toothpaste, too. Many of these urban legends are repeated for decades, even though maybe 2% are based in truth. Like "when in doubt, choose the longest answer" or "choose Answer C."
There's no science behind any of that. If there were some good science I could use to give you an edge on the exam, I would do so. But, there isn't any science behind it. It's just like investing--we can pretend that our efficient frontier, standard deviation, and sharpe ratio give us scientific precision, or we can admit how far from science we actually operate and just use sound "money management" practices. If the stock is going down, sell it. I don't need a formula--just sell my losers, and hold my winners. I take a similar approach to the exams. I recommend that you simply manage your time wisely. After 30 seconds, if you're still baffled by the question, give it an answer and mark it for review. Keep moving. Maybe you'll have 30 minutes left and 15 questions that were marked for review. Now you can really fight with those 15 hard ones and only change your answer if you're SURE you've seen the light.
Unfortunately, there is no insider information to disseminate on how to pass the exams. Just learn the concepts, use good test-taking skills, and try to keep a cool head at the testing center.
Why would interest rates start rising again? When the folks currently wimping out in Treasuries suddenly decide that the economy is about to take off again, they'll start pulling money out of the bond markets in order to buy stock. If they really want to sell the bonds, they'll accept lower and lower prices, which is the same thing as saying that the bonds will start trading at higher and higher yields.
I'm not sure why people panic so much over current interest rates or stock market levels. Most economic situations are a good news-bad news scenario, anyway. If yields are down now, that is bad news for the fixed-income retiree earning 2% on her bank CD if she's lucky. However, it also keeps mortgage rates down, which should eventually bring buyers back to the housing market. If mortgage and other interest rates creep back up, that will push down home values, but then the fixed-income retiree may be able to earn 6% on her bank CD and 9% on a T-bond. In any case, the "bond see-saw" is more than just something to draw on your scratch paper at the testing center.
Monday, March 9, 2009
A. the gain will be considered long-term
B. the gain will be considered short-term
C. the gain will be treated as dividend income
D. Mary Ann will report the gain or loss for tax year 2010
EXPLANATION: a long-term gain happens when you hold securities for one year plus one day. As the IRS explains at http://www.irs.gov/, your holding period starts the day after you buy the stock and stops with (and includes) the day you sell it. So, if Mary Ann buys stock on January 1st, 2009, she needs to sell it no sooner than January 2nd, 2010 if she wants a long-term capital gain. Settlement has nothing to do with holding period. When you execute the sale, you no longer hold the stock. The answer is B, the gain will be considered short-term.
Friday, March 6, 2009
One of your investing clients purchased an ABC 5% debenture yielding 6.5%. Three years later the investor sells the bond when current interest rates are at 4%. Therefore
A. I have no idea what the hell you're talking about
B. The investor broke even on the investment
C. The investor suffered a capital loss
D. The investor realized a capital gain
Obviously, we have to rule out "A," no matter how tempting. Then, we have to break down the question slowly. If you buy a bond yielding more than the nominal yield printed on the bond, that means the bond is purchased at a discount. Yields can only go up because bond prices are dropping. So, step one, the investor bought at a discount. If rates then drop below the nominal yield, the price has to rise. The investor sold at a premium. This is just a funky way of saying "bought low--sold high." The answer is "D," the investor realized a capital gain. Before working on a question, spend some time figuring out what is being asked and what is going on in the question--what is it saying? What does it mean? Interpret the "5% nominal yield purchased at a 6.5% yield" into "discount" or "bought low," and then proceed. If you're not 100% sure on the next step, you have to fall back on something like, "Well, every other time rates go DOWN, bond prices RISE, so I pretty much have to go with that."
And, you do. No brain can absorb all the information on the Series 7, not even the folks who write the questions. You have to know the vocabulary, know the fundamentals, and make up for the surprises with some really good test-taking skills.
Wednesday, March 4, 2009
Which of the following represent tax-free withdrawals from a Traditional IRA?
I. withdrawals pursuant to a first-time purchase of a primary residence
II. withdrawals pursuant to permanent disability
III. withdrawals before age 59 1/2
A. I, II
B. I, II, III
D. none of the choices listed
This question is designed to look easy--most people in the business know that withdrawals used toward a purchase of a first home or because of disability are not subject to the 10% penalty, and, therefore, they start heading down that dead-end. The question asked which withdrawals from a Traditional IRA are not taxable. The answer? None of the choices listed.
Withdrawals from a Traditional IRA are taxable. Some withdrawals result in a 10% penalty tax, some do not, but you can't answer the question you thought you were being asked; you have to make sure you see what the angle is. Read practice questions carefully and try to spot any possible tricks before proceeding.