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

Broker Check

So, I got a call yesterday from a registered representative at TD Ameritrade. Apparently, he was going through a list of customers who never talk to any of the brokers and reaching out to us "self-directed" investors. Nice guy. Seems to know what he's talking about, so I accepted his invitation to come on in for a sit-down in a few weeks. At the very least, I'll learn something, I figure, and it might be fun to track the story on this blog. Frankly, I thought the "kid" would have been more impressed with some of my answers. For example, he asked "which strategies I'm using to pick stocks for my accounts," and I told him that I typically look at a company's 10-K, focusing on the income statement primarily, and I try to buy equity in solid companies trading at reasonable valuation ratios.
Nothing. Not even a semi-impressed "hmmfff" from the guy. Clearly, he was on a mission to sell bonds through the idea of "asset allocation," so he pressed me a bit on why a 46-year-old investor is 100% invested in stock. Well, I said, interest rates have to go up from here, so I don't want to receive historically low yields and then watch my bond holdings plummet when interest rates rise. Bonds can still be an important part of your portfolio, he countered. It was then I remembered that registered representatives are not engaging in academic discussions--they are SELLING. Period. If they've been told to talk about "asset allocation" and push bond investing, then, by golly, that's what they're gonna do. And that's okay. I'll still learn something by playing the role of the customer to a registered representative--up to now, since 1999, I've been buying and occasionally selling stock and options without anybody's assistance. So, I've never had a broker try to do a needs analysis with me or hand me product literature on variable annuities or mutual funds. It will be interesting to hear how many of you will be explaining investment products and strategies to your clients. I did have to deduct some coolpoints from the guy when he asked which email he should send the invitation to. "Should I use 'walker@passthe7.com'," he asked. I let him think about that for a second, but, alas, no connection to the SERIES 7 was ever drawn, not even after all I had just spewed about inverse relationships and valuation ratios. I'm thinking that maybe some registered reps go into auto-pilot mode when smiling and dialing and are not so much listening as waiting for their turn to speak. Oh well. I'm still going to the meeting. I figure I'll learn something to help my investing as well as a thing or two that relates to the Series 7. Sure hope the guy is as ethical as his background implies, because if he tries to violate any FINRA rules, I will definitely be blogging about it.

Build America Bonds

Just in case the Series 7 throws a question at you about "Build America Bonds," let's say a few words about them here. BABs are issued by states and cities, but, unlike typical municipal bonds, these are taxable to the investor. The issuer has to, therefore, pay a higher nominal yield to investors, but the issuer receives a big chunk of the interest they pay right back from the US Government. The Build America Bonds are designed to stimulate the rebuilding of infrastructure (roads, bridges, sewers, etc.), and are authorized under the American Recovery and Reinvestment Act of 2009. Basically, the federal government is helping municipalities to rebuild infrastructure by allowing them to sell bonds to a bigger group of investors compared to those who typically buy the tax-exempt municipal bonds. See, since the interest payment the investor receives is taxable, any bond investor might be interested, not just high-bracket investors who typically buy tax-exempt municipal bonds. As the US Treasury explains, low-income investors, corporate bond investors, and pension funds--who would normally not buy municipal bonds--will in many cases be interested in buying the taxable municipal bonds called "BABs." How does the issuer benefit by paying a higher interest rate? The federal government reimburses the issuer for 35% of the interest paid to investors. As the US Treasury explains, if an issuer sells a 10% bond to an investor, the issuer receives 35% of that back from Uncle Sam, making their net borrowing cost just 6.5%, while being able to sell bonds to a wider spectrum of investors. The way I just described BABs actually applies to just one type of them, which we could call the "BABs - Direct Payment." There is another type in which the tax credit is given to the investor, and we could call these "BABs - Tax Credit." The investor's tax credit is also equal to 35% of the interest payable on the bonds. The effective savings that the bond issuer realizes is not as high on the "tax credit" BABs, but these bonds also don't carry as many restrictions. Basically, as long as the "tax credit" bonds would normally pay tax-exempt interest and are issued before January 1, 2011, they can be used for virtually any purpose. On the other hand, with "direct payment" BABs issuers have to use virtually all the money raised to build something (capital expenditures), while the money raised through "tax credit" BABs can be used for both capital expenditures (building stuff) or working capital (paying bills). They can also be used to perform refundings and no more than one advance refunding.
If the test brings these Build America Bonds up at all, I would anticipate that it would focus on the main points:

• they pay taxable interest to the investor
• the issuer receives a direct payment (refundable credit) from the US Treasury of 35% of the interest paid on the bonds for "direct payment" BABs
• the investor receives a tax credit of 35% of the interest received from the issuer for "tax credit" BABs
• BABs are not guaranteed by the federal government/not direct obligations

Reg SHO

I'm up early on a Saturday doing my weekly visit to the FINRA website. I see that two broker-dealers have decided to provide me with real-world examples of Reg SHO violations, and pay a total fine of $925,000 to FINRA. Remember that Reg SHO requires broker-dealers to determine that actual securities are available to be borrowed and sold short before executing a short sale. Stock prices are based purely on supply and demand, so if short sellers get to sell phantom shares short, that artificially depresses the price of a stock and distorts the market.

I'll let you stretch a little bit by reading the news release yourself at:

http://www.finra.org/Newsroom/NewsReleases/2010/P121482

Half again as much

Many Series 7 candidates struggle with the initial credit created in a short margin account. The way to check your work--if you get such a test question--is to make sure that whatever the amount of the stock, the margin customer's initial credit is "half again as much." If he sells $40,000 short, his initial credit is $60,000. If he sells $100,000 of stock short, his initial credit is $150,000.
Why?
Because Reg T is 50%. He receives the cash for the sale of securities, plus he deposits half that amount in cash, and ends up with "half again as much." So, the following question should be fairly easy:

A customer sells 1,000 shares of ABC common stock short @45. Therefore, his initial credit in the short margin account is:
A. $45,000
B. $67,500
C. $50,000
D. $90,000

EXPLANATION: again, the short seller receives the proceeds of $45,000, plus he deposits half that amount ($22,500) to meet the Reg T requirement. Add those two numbers together, and you see that the answer is . . . .



b.