The VIX, VXN and VXO are volatility indexes often used as indicators of how investors feel about the market’s future volatility. All are indicators of perceived market risk over the next 30 days. According to Investopedia, the VIX may sometimes be referred to as the “investor fear gauge” or “Wall Street’s fear gauge.”

Photo by martinhoward, courtesy of flickr

Each volatility index is reported as an annualized standard deviation (of the returns of the underlying index). The value of the volatility index is based on options traded on the corresponding index.

Here are the three most popular volatility indexes:

VIX - The VIX tracks options traded on the S&P 500.

VXO - The VXO tracks options traded on the S&P 100.

VXN - The VXN tracks options traded on the Nasdaq 100.

The indexes are trading currently at 29.78, 29.41, and 30. So as of today, the Nasdaq 100 is barely the riskiest of the three.

Generally speaking, a volatility index of greater than 30 is a sign of risky times ahead. According to Bloomberg, the VIX average value (since inception in 1990) is 20.18, but there have been some extreme levels in times of uncertainty.

Just to put things in perspective, the VIX rose to 31.47 on the day that Lehman Brothers filed for bankruptcy. Last October, the index reached a record 89.53. Less than 10 days ago, the VIX finally returned to pre-Lehman bankruptcy levels.

Gauging risk is important because risk is a determinant of an option’s value. All else held constant, riskier options will cost more so keep an eye on the VIX!

Post from: Bizzia

Finding the premium starts with the option’s intrinsic value. The intrinsic value is simply the difference between the current price of the stock and the strike price in the options contract.

Photo by Katrina.Tuliao, courtesy of flickr

For call options, the intrinsic value equals the current price minus the strike price.

For put options, the intrinsic value equals the strike price minus the current price.

Above and beyond the option’s intrinsic value, it’s premium will depend on risk, interest rates and time.

Increasing risk increases the value of call and put options. Risk is measured by the historical standard deviation of a stock’s returns. So, stocks with a history of more volatile returns will have more expensive options.

Increasing interest rates has a different effect on call and put options. The interest rate used in option pricing models is the risk-free rate of return. It represents the time value of money. Since options will be exercised at some point in the future, the cash flows must be discounted. The higher the rate, the greater the discount, so higher rates make call options more valuable and put options less valuable. 

Increasing time increases the value of both call and put options. The longer the option has to expire, the more opportunity there is for prices to fluctuate. All else held constant, a lengthier option will have a higher premium.

So, there you have it. Option premiums are based on the current price, the strike price, risk, interest rates and time. Tomorrow, I’ll post on “Wall Street Vixens” to discuss indicators of risk in the options market.

While I did not provide the formulas, the option pricing model I described is the Black-Scholes Option Pricing Model. Here is an option pricing calculator on blobek.com.

Post from: Bizzia

By visiting Yahoo! Finance, you can view the options chain for a particular stock. The following example uses The Home Depot, Inc. (Ticker: HD) as the stock and “HDGC.X” as the option. The stock is currently trading for $22.40.

Let’s examine the quote in detail:

Photo by Perpetualtourist2000, courtesy of flickr

Symbol: Option tickers have several parts. The first part of the options ticker, HD, represents the underlying stock. The second part is a letter to represent whether the option is a call or a put and when it expires.

A-L represents call options, M-X represent put options. The order of the alphabet represents the month of expiration. A and M represent January, B and N represent February, and so on. (View the code at Investopedia)

In our Home Depot example, the letter “G” indicates that this a call option which expires in July. ”X” is an extra character used by Yahoo! to identify options.

Expiration: Only the month and the last two digits of the option’s expiration year are displayed. Options expire on the third Friday of each month. So, the “Jul 09″ options expire on Friday, July 17, 2009.

Strike: $15.00 - This is the price specified in the contract. The call option gives you the right to buy shares of Home Depot at $15 per share regardless of the stock’s market value.

Last: $8.35 - This is the most recent trading price (per share) for the call option.

Change: 0.00 - The difference between yesterday and today’s closing prices.

Bid: $7.30 - The price a dealer is willing to pay for the call option.

Ask: $7.50 - The price a dealer wants to receive for selling the call option.

Volume: 44 - The number of contracts traded today.

Open Interest: 114 - The number of contracts which have not been exercised and have yet to expire.

One options quote contains a lot of information, all of which you should know before you buy any options. Tomorrow, I will explain how the prices are generated.

Post from: Bizzia

Today, I’ll examine some options basics: calls vs. puts, American vs. European, contract sizes and settlement.

Photo by ndevilTV, courtesy of flickr

Call - A call option gives its owner the right to buy shares of an underlying stock at a specified price (known as the strike price) within a set time frame.

A person who buys a call option believes the market price of the stock is poised to rise above the strike price. A rising stock price will allow the person to buy shares at a discount to their market value and profit from the difference.

Put - A put option gives its owner the right to sell shares of an underlying stock at the strike price within a set time frame.

This person believes that the market price of the stock is going to fall below the strike price. If so, the person will be able to sell the shares at a premium to their market value and profit from the difference.

American vs. European - This has nothing to do with geography! American options can be exercised at any point up to, and including, the expiration date. European options can be exercised at expiration only.

Contract size - Option contracts are standardized. Each contract represents 100 shares of stock.

Settlement - You may elect to have shares move (by actually buying or selling them once you exercise the option) or you can opt for cash settlement, in which case only the payoff would be transferred.

An example: Shares of Dell are currently trading at $13.42 per share. A call option on shares of Dell with a strike price of $15 and August 2009 expiration is currently trading for $0.15/share. (View the quote)

Purchasing one of these call contracts would cost you $0.15 x 100 = $150 (ignoring any commissions). If Dell’s shares rose to $20, you could exercise the option and buy them for $15.

You could then hold on to the shares, or immediately sell them at $20 to collect the $5 payoff. With cash settlement, the option writer would just pay you the $5 per share. In both cases, after accounting for the $150 premium, you would walk away with $500 - $150 =$350.

If shares of Dell fell to $10 each, you would not exercise the option since it would force you to pay $15 for a share of Dell that is only worth $10. Since it would not be profitable, you wouldn’t have to exercise the option. You will lose the $150 premium.

In a nutshell, options provide flexibility. You pay a premium up front for the freedom to buy or sell shares later and at a set price. Tomorrow, I’ll cover how to buy options.

Post from: Bizzia

Buying stock options gives you the choice to buy shares of an underlying stock at some point during a designated time period. Buying stock automatically makes you an owner.

Photo by NightPRStar, courtesy of flickr

There is a big difference!

The choice between buying call options and taking a long position in a stock depends on your goals, your risk tolerance and your resources.

This week, I’ll explore the basic types of options, their pricing, the cash flows surrounding them and the risk associated with them.

Here’s what’s coming next:

Monday - Option Basics

Tuesday - How to Buy Options

Wednesday - How Options Are Priced

Thursday - Wall Street Vixens

Friday - Option Strategies

If you have any questions about options, please leave a comment and I will address your question(s) in one of my posts this week.

Post from: Bizzia

Sometimes we take independence for granted because we have always had it, but it can be taken away. The tough economy has caused many people to learn about, and live through the loss of financial independence.

Photo by ralphunden, courtesy of flickr

Here are some basic steps to help you along the way to financial independence:

1. Get out of debt - Paying the minimum is not going to get you there. Attack the balances with the highest rates first and after you have paid them off, avoid situations that will tempt you to run them back up.

2. Save for a rainy day - Keeping cash on hand can help you stay out of debt. Setting up an automatic withdrawal can help you work around the temptation to spend money as soon as you get it.

3. Be prepared for the worst - Losing a job, suffering an illness or being involved in an accident can all jeopardize your financial independence. Having the proper insurance can lessen the blow of unexpected unfortunate events. Examine your existing policies and if there are gaps, perhaps you should explore supplemental insurance.

4. Draft a budget - Your budget may not be airtight, but planning ahead can help you curb impulsive spending and thus avoid getting into debt.

Whether it is freedom from debt or dictatorship or freedom from addiction or abuse, remember that freedom is not free. Independence is a product of sacrifice! Happy Independence Day!

Freedom is nothing but a chance to be better. ~ Albert Camus

Post from: Bizzia

If managers held a substantial ownership stake in the company, they would be more inclined to behave in ways that would add value to the stock. Maybe their own personal greed could help their employers succeed?

Executive compensation and aligning the interests of owners and managers will always be hot button issues.

In the movie, Wall Street, Gordon Gekko (Michael Douglas) delivers a passionate speech to shareholders of his latest takeover target. “Greed is good” may be the most often referenced quote of the speech, but there are other points worth considering i.e. wasteful behavior, overstaffing and lack of management ownership.

Watch the clip below of Mr. Gekko exposing managers for their behavior at a shareholder meeting.

Post from: Bizzia

EDGAR isn’t a finance guru, it’s the SEC’s Electronic Data Gathering and Retrieval archives.

The Securities and Exchange Commission requires publicly traded companies to periodically file certain documents, and the archives are kept electronically on EDGAR.

Photo by dannysullivan, courtesy of flickr

The required filings include:

Form 10-Q - Must be filed each of the first three quarters of each fiscal year. This form contains unaudited financial statements including the balance sheet, income statement and statement of cash flow.

Form 10-K - Must be filed annually. The report contains audited financial statements as well as an overview of the company’s business and financial standing.

Form 8-K - Known as a “current report,” the 8-K must be filed when shareholders need to be made aware of a major event. The events requiring an 8-K range from “completion of acquisition or disposition of assets“ to bankruptcy or receivership. (View the complete list)

EDGAR provides timely versions of these filings and EDGAR is free. You can access EDGAR by visiting www.sec.gov.

Post from: Bizzia

As an investor, a stock split or a reverse stock split does nothing for your overall position. Let’s take a look at both.

Photo by Barrybar, courtesy of flickr

In a normal stock split, the number of outstanding shares is increased, typically by a 2:1 ratio. So, for every one share you owned prior to the split, you will own two after the split. However, since the number of shares doubled, the value of each share is now cut in half.

Cutting the shares in half maintains the company’s market capitalization and the size of your investment.

Think of it as taking two fifty-cent pieces to the bank and asking for four quarters. Even though you end up with more coins, you still have one dollar.

In the case of a reverse stock split, the number of outstanding shares is decreased and the value of each share is increased. So if you had ten shares worth a total of $100 prior to a 1:2 reverse stock split, then you will have five shares worth a total of $100 after the split. Each share has gone from $10 to $20 in value, but the overall value of your holdings remains unchanged.

Shares of AIG closed yesterday at $1.16 per share and are currently trading around $18 each, which is less than 20 times the pre-split price. Each share of AIG’s stock is now more expensive, and there are now fewer shares available, but the market capitalization has actually declined.

The bottom line: If a cake tastes bad, it doesn’t matter how you slice it.

Post from: Bizzia

There are two types of accounts you can open with a brokerage firm: cash and margin.

If you have a cash account, then you are the owner of the securities, because their purchase was funded entirely by you. However, if you have a margin account, your stocks will probably be held in street name.

Photo by matze_ott, courtesy of flickr

Why would the broker want to own the stocks in your account?

In the case of a margin account, some cash comes from you and the remainder of the funding comes in the form of a loan from the broker.

If the stocks in your account lose substantial value, then you could receive a margin call from the broker.

You may be asked to contribute more cash or liquidate other securities in order to improve your equity position.

If you can’t comply, having securities registered in street name allows your brokerage firm the right to go into your account and sell stock.

Selling stock will improve your equity position and guard against the possibility of the securities in your account being worth less than the value of your loan.

With margin accounts, your broker is wearing the hats of a broker and a lender. Holding stocks in street name helps the broker maintain safety as a lender, in case you do not comply with the terms of your margin account.

Post from: Bizzia