Saturday, March 28, 2009

Straddles

Multiple options include the spreads we just discussed and also the straddles we're about to discuss. While I'll allow that spreads can be difficult, I simply will not accept any whining over straddles. If you can understand the long call and the long put, you can understand the so-called "long straddle." You just have to put both positions together and put on your thinking cap.
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.

Spreads

Spreads can stretch the brain in directions it doesn't really want to go for many Series 7 candidates. Of course, we've already discussed how some people view this stretching as a pleasurable activity, so let's focus on the other 95% who would rather pound bamboo chutes under their fingernails than decipher a debit call spread. First, what the heck is a "spread"? A spread is simply the purchase of one option and the sale of another. Rather than selling an ABC Aug 50 call by itself, which would leave the writer exposed to unlimited loss, the investor also purchases an ABC Aug 60 call. He'll collect more writing the Aug 50 call than he'll spend on the Aug 60 call, so we call it a "credit spread" or a "credit call spread." Of course, what I just wrote baffles and annoys most candidates--they don't see any premiums attached, so how can I just, like, know that the Aug 50 call is worth more? Because an ABC Aug 50 call is a contract giving someone the right to buy ABC common stock at 50, which is better than the right to buy the stock at 60. For intrinsic value, think from the buyer's perspective. A "call" lets someone buy stock--they want to buy low, so the lower the call's strike price, the more valuable it is. Once you can see that the Aug 50 call is worth more than the Aug 60 call, you just have to remember that if the individual buys the Aug 50 and sells the Aug 60, he'll start out with a debit--why? He had to have paid more for the Aug 50 call than he received selling the Aug 60 call. So, we call it a "debit spread."
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

  1. 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
  2. Did the investor buy or sell that option? The investor sold the more valuable option.
  3. Therefore, this is a credit spread

What about this one:

Buy 1 ABC Jan 50 put
Sell 1 ABC Jan 45 put

  1. 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.
  2. Did the investor buy or sell that option? The investor bought that option.
  3. 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

FINRA Podcasts

Click on the title to this post, and you will find several helpful podcasts by FINRA. I just finished listening to the podcast discussing the new issue of registered rep's using Blogs, Bulletin Boards and Chat Rooms. When registered rep's say anything about investing or securities in these electronic forums, the firm has to treat the communications as communications of the firm. Most of the topics covered in the FINRA podcasts are either directly testable or related to testable points. And, the best part is that each one is relatively short and to-the-point.

Wednesday, March 18, 2009

Monetary Policy in the Real World

I know I harp on this a bit, but too many candidates fail to see the real-world importance of what they're studying for the exam. I was teaching a Series 65 online class this afternoon, talking about monetary and fiscal policy, hoping I could tie it to something going on in the news today. Boy, did I get lucky! Just after I told them that the FOMC can purchase Treasuries to help a faltering economy, I found the following news item at http://news.yahoo.com/s/ap/20090318/ap_on_bi_ge/fed_interest_rates:

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.
Amazing.

Monday, March 16, 2009

Writing Puts

Writing puts is probably the strangest of the four single options positions. First, it's hard enough for most people to understand what a "put" is and why someone would want to buy a put, which is the "right to sell stock at a set price." But, if you feel that Starbucks is about to drop, you can buy a put to see if you're correct. If so, the put becomes more valuable. Or, if you already own Starbucks common stock and are afraid it could drop, you could buy a put to protect yourself. If you have the "right to sell SBUX @20," it doesn't matter if SBUX drops to 5, or even 0--somebody has to let you sell the stock to him for $20. Who is that somebody?
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

No pain, no gain

This morning I did some tutoring for a gentleman who said something that really opened my eyes. He said, "Sometimes when I think about these straddles and these spreads, it's like a brain freeze, like when you eat ice cream too fast, and it just keeps hurting and hurting . . . until I figure out the question, and then the pain stops."
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

Options Question

Let's enjoy a really hard options question early on a Friday morning, shall we?

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:
A. 51.75
B. 55.25
C. 45.75
D. 53.00

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

Test-Taking Strategy, A Facebook Confession

Facebook has been a great thing for me so far. I can place links to these blogs and other websites, and I can also update my status with "Robert is blogging for his Series 7 students at 5:30 on a cold morning in March," in order to mention my business as often as possible. Another connection to the business comes from all the quizzes that I receive from my old high school friends challenging me to "name that 80's band" or "name that 80's tune." I'm flattered that they think of me as someone to challenge to a quiz, and I also see an opportunity to put my test-taking strategies to the test. The first quiz I took was called "name that 80s band," and I have to admit, I was a little nervous. The first question had me up against the wall--it was a picture of a heavy metal band, and that was really not my forte. I actually thought of my customers at the testing center panicking over the very first question. In honor of them I took a deep breath and said, what are the four choices? We had: Scorpions, Black Sabbath, Dio, Judas Priest. Wow--talk about an advantage! Okay, first, the difficulty level of this facebook-based quiz can not be that freaking high; they would not put a picture of Black Sabbath here unless Ozzy were clearly visible--Sabbath was eliminated. A Judas Priest photo would have to have at least one guy on a motorcycle or wearing motorcycle garb, so Judas Priest was eliminated. Now I'm down to Dio and the Scorpions? What's the name of this quiz? "name that 80's band." Who was a bigger force in the 80's, the Scorpions or Dio? The Scorpions--I win. I now have a comment on my "wall" from the friend who sent me the challenge after seeing the score of 100%. He wrote, "How on earth did you know the name of the guy from the Split Enz?"
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.

Test-Taking Strategy

Too many Series 7 candidates forget to develop their test taking skills. I do a lot of online 1-on-1 tutoring, and I am often shocked to discover that the client who failed the exam before contacting me is still reading the question, thinking about what the answer must be, and then looking at the four choices to see if it's there. OMG is this a bad approach! The correct answer to the question will often be different from what you want it to be. If you're looking for the word "tranche," the exam might actually want you to call it a "companion bond issued in connection with a collateralized mortgage obligation." My customers routinely report that exam questions will go around in circles to avoid using a standard term. For example, if "inflation risk" is too simple for the test question, it might talk about an investor who is primarily concerned with a general reduction in purchasing power. You have to find the best of the four choices, not necessarily the one you were picturing as the right answer. To deal with this reality, I've always turned the tables on the exams at the testing center. I read the four answer choices first and see what sort of pattern develops right there. More than half the time I know where the question is going based on the four answer choices. But, I take my time because I know how easy it is for one word to change the direction of the question. I now read the words in the question itself carefully, the way I read contracts involving thousands of dollars. Is there a catch? Does it mean what it seems to mean? Is that statement true in all cases? I'll spend 10-30 seconds picking apart the words like this until I know exactly what the question is going for. Then, I start eliminating answer choices. If the question is talking about a bond, I'm eliminating the "preferred stock," choice. If I eliminate one answer choice, I've raised my odds from 25% to 33.3%. Another choice says "bankers acceptance." Hmm. That's a debt security, but based on the remaining three choices, maybe you eliminate the "BA" because it's a short-term/money market security. What if you just eliminated the right answer?
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

Urban legends from the test prep industry

A customer just sent me an email that is very useful in bringing up the urban legends that surround the world of the Series 7, 6, 65, etc.

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?

RESPONSE:
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.

Bond prices, bond yields

Have you seen the yields on T-bills lately? Last time I checked, you could get yourself a 1/4 of 1% yield, which is also called "25 basis points." Why would anyone accept such a low yield? It's called a "flight to quality." When the stock market started to plummet around September, investors did what they usually do--they panicked. They pulled their dollars out of the stock market and lined up for a chance to buy Treasuries. The more willing investors are to pay for quality, the higher they drive the price of the T-bills, T-notes, and T-bonds. A T-bill is purchased at a discount from its face value. If you buy a $1 million T-bill, you'd prefer to buy it for $960,000 to a price of $999,400. When rates are high, you can make the $40,000 difference; when people are scrambling to put their money in T-bills, suddenly, you can make only $600 on your $1 million. So, the herd mentality doesn't just trample the stock market; it also messes with the bond markets. Mortgage rates are related pretty closely to the yield on 10-year Treasury notes, so as investors scramble to buy the government-guaranteed T-notes, they also push down yields, which then pushes or keeps down mortgage rates.
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

Capital Gains

Mary Ann purchased 1,000 shares of ABC on January 1st, 2009. On December 31st, 2009, she sells the shares for a $500 capital gain. If the trade settles on January 4th, 2010, which of the following accurately describes the tax consequences?
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

Tough Question on Bond Yields

Bond yield questions can really give people fits. Let's enjoy one that draws boos and hisses from any live class I've ever taught:

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

Withdrawals from a Traditional IRA

Here's a good practice question for you:

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
C. 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.