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Friday, August 03, 2012

 

Musings on Option Plays

We got two anonymous comments posted to our last entry.  I am sorry but I still have not figured out how to get blogspot to display comments where they can be easily found and seen.  But they are there.  The second one - a quickie - pointed out that Docks in New York has a great raw bar like Philly's Oyster Bar, and jazz twice a week, notably for Sunday brunch.  I have long been a Docks customer at their East Side location, which is convenient to my office.  I would also point out that it has a lively and comfortable cocktail bar as well.

The first comment took issue with my posting of the Moore excerpts from the WSJ and my stand against the greens and in favor of industrialization.  One part of the comment criticised Moore's complaint about green energy subsidies and compared them to the costs of Middle East wars, which greens claim have been fought to secure oil supplies.  I would certainly dispute that propaganda, but even if it were true, the only reason we need to import foreign oil is that the administration, catering to Green anti-industrialism, has refused to do the simplest things that would supply our needs from the Americas, including the Keystone Pipeline, restarting off-shore drilling, and commissioning nuclear plants.

I really don't want to get into another rant on this subject (and I am reserving judgment on the conversion of a global warming skeptic whose conclusions were printed to much fanfare in the Times this week, though I like his methodology - but we'll wait for the peer review), but people seem to get upset about my stance and feel compelled to try to convert me.  I don't understand why anyone cares what this layman thinks is causing or not causing global warming, but people do.  My advice to them is get over it.  Frankly, I don't care whether global warming is man made or not, it would not impact my policy choices either way.  I am in favor of industrialization and modernism, simply because it erases poverty and combats hunger and disease, and makes the world more comfortable.  If the price for that is that the earth heats up a degree or two, fine.  I think there might be as many or more positives as negatives from that, and anyway, I doubt these things are particularly within our control.  The earth has been much warmer in its history and also much colder.  There was a time in earth's history when a day was about 16 hours long and a year about 480 of those shorter days.  Some day, a day will be even longer than 24 hours.  Will longer exposure to alternating sunlight and darkness change earth's temperature?  Maybe.  The point is that today's conditions are no more the natural state of things than any other set of conditions in earth's history.  Man will have to adapt or follow other species into extinction if and when conditions become more harsh.  We won't improve our chances by retreating to Walden Pond, that's for sure.

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One request received not long ago was for some info and opinions relating to stock options - calls and puts, that is, and why they are not part of the redwave investing strategy.  When are they appropriate and for what purposes? So we'll start with a short primer, and continue for a couple of posts. 

A call is an option to buy a hundred shares of a stock at a given price (the strike) within a certain time, ending at the expiration date.  A put is an option to sell a hundred shares of a stock at a given strike price for a limited period of time.  Where do puts and calls come from?  A market participant may decide to "write" an option and puts in an ask price.  If a bidder emerges and a transaction occurs, the option becomes part of the market inventory, called the "open interest."; At any given time, the inventory of puts and calls is available from whatever exchange handles that particular option. The ratio of puts to calls transacted is closely followed by technical analysts for clues to the market's direction.  Some believe that a decent put to call ratio is a bullish sign, because too much call interest is considered a sign of a frothy market.

Option pricing is very tricky business, and there are a number of theoretical calculations and computer programs developed to try to assign values to options, depending on the relationship of the strike price and the market price, the time left to expiration, etc.  The best known valuation calculation is the Black - Scholes method.

Here's an example of the call buying experience.  Let's say a stock is trading at 50 and you are bullish in the short term.  So you buy 10 call options at 55 expiring in October.  You have just bought options to buy 1000 shares.  If the option was trading at 1.50, you just paid $1,500 plus commissions to control this right to buy.  Today the option is "out of the money" because it  is trading below the strike price.  Say you've made a good call and the stock shoots up to 57 in September.  Now you are two points in the money.  The option price might go to around 2.30 or so, to reflect its enhanced value, but also reflect its nearing expiration.  The fact that option prices drop as you get closer to expiration is called "time decay."  Think about what has happened.  You started off paying about a 6 and a half point premium - you were 5 points below the strike price and paid an additional 1.5.  The stock went up so you are ahead, but the premium decayed to 0.3.  The stock is two points over the stock price but the option price is only 2.30.

This is why the game is so hard.  Even if you get the direction of the stock right, you still face time decay, which accelerates as the expiration date nears.  Let's say you decide to realize your gain and sell.  You will get $2,300 minus commissions when you sell the options.  If you deal with a discount broker, the round trip commissions might be around $60, so you will net $740, all of it taxable.  Alternatively, you could exercise the option and require the seller of the option to deliver the 1000 shares of stock to you at a price of $55.  Of course you will now have a paper gain of 2000 on the stock to offset the price you paid for the options.  But almost no one exercises options until expiration day.  They simply buy and sell the options. 

Puts work exactly the same way except in the opposite direction - the buyer of the puts hopes the stock will go down.

What happens if an option expires out of the money?  It is worthless.  This is the fate of an awful lot (probably the vast majority) of options written.

Next post, we will talk about the one viable option strategy for the ordinary individual investor - covered call writing.
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Last night was one of those great jazz nights that will stick in my memory for a long time.  First I went to my usual Wednesday night 5 PM Birdland show where David Ostwald had a very good ensemble that played two great sets of tunes associated with Louis Armstrong.  Then I took the E train three stops to the West Village and the Blue Note where I had a reservation to see Jane Monheit.  She was in top form and had the full house thoroughly entranced.  Especially good was a new version of Michele LeGrande's "What Are You Doing for the Rest of Your Life?', which will, I think, be on her next CD.  She is there through Sunday, and I would make the effort to see her and her excellent trio this weekend if you can.

August will be a great month for NYC jazz.  Even Iridium has a good show - Pat Martino headlines the 23rd-26th.  Birdland has Steve Kuhn this weekend and the last weekend of the month, a tribute to Charley Parker starring the trumpeter Tom Harrell with Vincent Herring (alto sax) and George Cables (piano).  Our friend Brandon Wright will lead a quartet August 18 at Oceana Restaurant.  Bucky Pizzarelli joins the Marlene Verplanck Quartet at Kitano, August 23.  On August 7, the Cedar Walton Quartet starts a two week run at Dizzy's. And Jazz Standard has the Freddy Cole Quartet Aug. 9-12.  This is barely scratching the surface.
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On July 25, we bought 25 shares of Roper (ROP) at 94.30, a "zero buy."  On the 27th, we bought 20 more shares of TIP for the IRA at 120.93.  Monday, we sold 100 shares of News Corp. (NWSA) at 23.36, that were purchased 2/9/09 for 6.97.  We'll take the profit according to formula, and not worry that the stock has an additional pop when it splits into two companies.  We have most of the position left.  Yesterday, we sold 100 shares of Presidential Life (PLFE) clearing the IRA of that issue.  Presidential is the subject of a pending takeover at 14, but we took 13.91, since the commission plus the 9 dollars we gave up is less than what E Trade will charge to execute the takeover transaction.  We paid 8.84 on 6/17/09.

Monday also brought good news concerning Shaw Group (SHAW), part of our "Tulane portfolio."  Shaw will be bought out by Chicago Bridge and Iron at a nice premium.     

 

Comments:
The ironic bit is that you claim to be about modernism, as you go about trashing investment in new renewable energy technologies. The most recent technology you are willing to embrace is nuclear. Otherwise you are all for burning stuff, a tried and true source of energy.
You’re correct that I, and others like me, should not care greatly what you think. We don’t. We simply care that you, via your blog, are attempting to spread a point of view that is potentially very harmful to the future of our species. You doing that is not the sort of thing that we can simply agree to disagree over. Each time you put your environmentalist bashing propaganda out there. It will likely draw a response and yes it would be nice if our comments were more readily viewable.
 
Tom Harrell will also perform with his piano-less quartet featuring the great drummer Billy Hart at the Village Vanguard, August 14-19.
 
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