Today I REALLY Feel Your Pain

We now intend to update each of the five books every year, and I made the decision to start with the Big Kahuna, the Series 7. In order to see what we might be missing that the "big companies" are covering, I have to go through their practice questions and their . . . well, let's call them "books" for lack of a better name.

OMG! WTF?

If you've ever felt overwhelmed and discouraged about studying for your Series 7, I now know why. What a bunch of soulless, joyless, ugly nonsense your firms are forcing you to read. It's as if the writers of the so-called "books" are convinced that their superiority to you is in direct proportion to your confusion. First, they're not superior. You will make more money selling financial services than they do writing mindless drivel about DPPs and variable-rate demand notes. Second, who the heck said that finance and investing are dull topics? Warren Buffett and Charlie Munger hold the Qwest Center overflow audience's attention for 5 or 6 hours . . . why can't these Series 7 "license exam manuals" explain how corporations raise capital without making you want to jam a hot needle in your eye socket every couple of minutes?

Oh well. No use complaining. In fact, I should send the "big guys" a big thank-you note today for guaranteeing that there will always be a market space for us, for readers who want to learn without losing their sanity. Just wanted you to know that if you find your "license exam manual" to be boring and poorly written, it's not just you.

Trust me.

Taxation and Mutual Funds

Let's take a look at a question about mutual fund taxation . . .

All of the following are taxable in relation to a mutual fund investment except
A. undistributed capital gains
B. unrealized capital gains
C. reinvested capital gains distributions
D. capital gains distributions from a tax-exempt municipal bond fund

EXPLANATION: a surprising fact about capital gains that a mutual fund portfolio manager realizes is that even if they're not paid out to shareholders, the shareholders are taxed on their fair share of the gains. If the fund does distribute capital gains, the investor is taxed whether she cashes the check or reinvests automatically. And, municipal bonds are subject to capital gains taxes just like other securities. Of course, if a capital gain is "unrealized," there is no capital gain.



ANSWER: b

Straddle question

Bobby Bobson bought a BCD Mar 55 call @3 and a BCD Mar 55 put @3.50. If BCD becomes worthless, the resulting profit or loss would be
A. loss of $650
B. loss of $5,200
C. gain of $650
D. gain of $4,850

EXPLANATION: the questions on the exam are often not as clear as you'd like. What does it mean "if BCD becomes worthless"? It means the underlying common stock goes to zero, kaput. So, Bobby loses just the total premium of $650, right?
Not right. If the stock becomes worthless, the right to sell it (Mar 55 put) is worth $5,500. $5,500 minus the $650 he paid for the position = a gain of $4,850.

ANSWER: d

Time Value Once Again

On our Facebook fan page, we asked visitors which option would trade for a higher premium here in July: MSFT Aug 30 call or MSFT Oct 30 call. At first, it might seem that you need more information . . . well, what is the underlying stock trading for?

Doesn't matter.

Huh?

No matter what MSFT common stock is trading for, the time value is higher on the Oct 30 call. Why? Because--get this--there is more time on the option. See, the premium is the market's collective opinion on the buyer's chance of winning. Period. The market as a collective is so efficient at assigning a value based on probabilities, in fact, that right after the Sep 11th attacks, the US Government actually floated the idea of creating a "terrorism exchange" on which speculators would bet on where the next attack might occur. Maybe they realized how sick the temptation for market manipulation would have been--go long the Los Angeles Mar 15s and then pay some sickos to blow up LAX--or maybe their sanity suddenly returned. Either way, they did not actually create such an exchange, thankfully, as it would have been, you know, crazy. Still, their premise was correct--a market of speculators is very good at determining a fair price for an option based on its probability of working out for the buyer. If the underlying stock trades at $29, an Aug 30 call is worth more than an Aug 35 call, even though both are out-of-the-money. Why aren't they both worth 0? Because there is a chance the stock can rise above $30 before expiration, and a chance it could rise above $35. Which chance is more likely? Obviously, the Aug 30 call has a more realistic chance of going in-the-money, so its time value is higher than the Aug 35 option. If it's early July, maybe the Aug 30 calls trade for $1.50, with the Aug 35 calls trading at just $.45. It actually depends on how volatile the stock is. If it's the kind of stock that jumps around all the time, the market might charge you $2.00 even for the Aug 35 call. The market is saying the stock could easily rise that high that fast. Google options trade at high premiums, because that stock can easily rise or fall $20 in a week. Microsoft, on the other hand, is so sluggish and predictable that the options are cheap. The market basically says no way is MSFT going up $10 any time soon. You can buy these options dirt cheap.

So, what determines the premium of a call option?

1. the market price of the underlying stock

2. the amount of time left on the option

3. the volatility of the underlying stock

An army of computer-modeling, big-brain speculators plug those factors into their software and, voila, an options premium becomes X, Y, or Z. I know it hurts to think this hard about the concept of an option. But, trust me, your score will go up if you understand options well beyond any little chart or cheat-sheet.

Tombstone

The Series 7 could ask you what information is contained in a "tombstone ad." First, remember the context: we're talking about a new offering of securities. Once the registration statement has been filed with the SEC, the issuer and underwriters go into a cooling off period. During this period, no sales or advertising is allowed. Tombstone ads, however, are okay, since they don't really entice anyone or make any claims. They just provide the bare bones facts about an offer of securities. They simply announce that an offering of common stock, preferred stock, bonds etc. is available from a particular issuer. The number of shares is listed, as is the offering price. Then, we see the underwriters, with the lead underwriters in larger text than the syndicate members taking a smaller percentage of the offering. And, there is the disclaimer that this announcement is not an offer to sell the securities or the solicitation of an offer to buy the securities. It's just an announcement. It might help to look at one, which you can do at this link: http://www.buec.udel.edu/pollacks/Acct351/handouts/AT&T%20tombstone%20ad.jpg.

Time Value Again

A "call" option is the right to buy a stock at a set price known as the "strike price" or "exercise price." If the stock is worth $3 more than that strike/exercise price, the call option is worth that $3 difference, always. That's the intrinsic value of being able to save $3 when buying that stock. But, the option would be worth more than just that $3, as long as there is still some time left. If there is still a month to go, an ABC Aug 50 call might be trading for $4 a share, when ABC common stock is only trading for $53. The intrinsic value is $3, but there is still time for ABC to keep rising. If you want to buy this call option, you pay $4 a share, which is $3 of intrinsic value and $1 of time value. If the stock stops moving at $53, that time value will begin to evaporate quickly, as time runs out on the option. If you buy this option for $4 today, you can only win if the stock rises, and rises fast enough to outweigh the negative effects of time.

Let's work with the concept of time value in a rather annoying practice question:

Which option below has the most time value if ABC currently trades at $51 a share?
A. ABC Aug 50 call @$1.50
B. ABC Oct 50 call @2.50
C. ABC Oct 50 put @2.00
D. ABC Oct 55 put @4.25

EXPLANATION: step one, find the intrinsic value in each option and subtract that out of the premium. An Aug 50 call @1.50 has $1 of intrinsic value, 50 cents of time value. An Oct 50 call (which HAS to have more time value on it than the Aug 50) also has $1 of intrinsic value and, therefore, $1.50 of time value. Choice A is eliminated. An Oct 50 put has ZERO intrinsic value, so the time value is $2.00. Choice B is eliminated. An Oct 55 put has $4 of intrinsic value, so only 25 cents per share of time value. D is eliminated. The Answer is . . .









c

Time Value

Remember, not all Series 7 questions concerning options involve calculations or even numbers. Many of the tougher options questions look like the one below:

Which of the following represents an accurate statement about put options on ABC common stock?
A. If ABC common stock drops from $45 to $40, an ABC Aug 40 put goes in the money
B. If ABC common stock drops from $45 to $40, the premium on an ABC Aug 40 put would likely increase
C. If ABC common stock drops from $45 to $40, an ABC Aug 40 put goes out of the money
D. If ABC common stock rises from $35 to $40, the ABC Aug 40 put premiums should increase

EXPLANATION: as always, try to eliminate some answer choices. Choice A says that an ABC Aug 40 put would be in the money with the stock at $40. That makes no sense, so eliminate it. Choice C says that an ABC Aug 40 put would be out-of-the-money with the stock at $40, but, actually, it would be at-the-money. Choice D says that put premiums increase when the stock price rises, but that's backwards. Strike prices are fixed--the puts only become more valuable as the underlying stock drops, making the right to sell it more valuable. Eliminate Choice D, and you're done. Why is Choice B accurate? Remember that even though the ABC Aug 40 put would not go in the money if the stock dropped from $45 to $40, the "time value" would increase, the speculative component of the premium. With the stock at $45, the right to sell it at $40 is not worth much, but if the stock then drops to $40, the market would assume it could easily keep dropping, and any little drop makes the put go in-the-money. The premium would reflect the 50-50 chance that the option will go in-the-money, and, of course, the premium would be 100% time value. So, a seller might like to write an at-the-money option, and then if the stock simply stops moving, that time value will evaporate, letting the seller keep the whole premium without lifting a finger as the option expires.



ANSWER: b