Volatility, the Misunderstood Keystone to Finding Profitable Markets

By Christopher Appleyard | Published: March 12, 2010

Volatility is one of the most misunderstood factors that determine a good investment opportunity. That is unfortunate, because it is also the single most important one. When people think of high volatility markets they think of high risk, dangerous markets that should be avoided. However, volatility in itself is not what determines risk. It is simply a feature that describes a market. For example, speed is an element of travel. You can travel slowly or quickly. Travelling at 200 mph in a motorbike is considered, for good reason, dangerous. However, travelling at 500 mph in an airplane is widely accepted as the safest form of transport.  Speed is like volatility. You can be travelling at 10 mph on the back of a horse and be in more danger than travelling a hundred times faster on the back of jet engine. Higher speed can imply danger and higher risk, but not necessarily. Walking, for instance, might be a safe mode of transport, but if you are walking through the bad part of town you want to be moving faster, and safer, in the back of a speeding car.

Volatility is nothing more than a way of measuring the amount by which an asset is expected to change in any given period of time. If you expect the stocks of Apple to rise quickly in the weeks after the sale of their new Ipod you would say they have a high level of volatility. It simply describes the speed something changes, or is expected to change, in the market. Change can be good for business. If prices of things never changed, or there was a low volatility, there would not be much of a margin for traders and merchants to sell products at a profit.

There are two main types of volatility, historical and implied. Historical volatility is the actual or statistical rate of change an asset has displayed through time. It is calculated by using the standard deviation of an assets price from its price in any given number of days. And you probably thought standard deviation was a useless thing to learn at school, right?

Knowing the volatility of the market you are investing in, is very important when choosing which strategy you are to use. Strategies that work in high volatility markets do not work in their low volatility counterparts.

Implied volatility is very different. It is not based on actual price change but on the current market price compared to an option pricing model. For instance, if the premium of an option increases without the value of the asset changing, its volatility will have increased. This kind of volatility is often a reflection of overpricing or undervaluing of an asset. For example, when the dot. com bubble started, companies without much in the shape of assets, clients, or services to offer, had stocks that did not reflect the real value of the company. This was a case of a high volatility due to serious overpricing.

The beauty of trading is that if done smartly you can make a profit out of applying the right strategies no matter how volatile the market is or in which direction it is going.


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Liquidity, Empty Restaurants, and the Keys to a Good Investment.

By Christopher Appleyard | Published: March 11, 2010

Liquidity is a key element of a good investment opportunity. It refers to how easy it is to trade a commodity or a financial instrument. If liquidity is high the chances of making a profit grow. In low liquidity markets trading can be risky and you might be left holding the bag nobody wants. Therefore, when choosing where you want to take your business, choose markets and investments where liquidity is high.

Let us illustrate that with the way we choose a restaurant. Do you go for the empty restaurant or the one with a queue around the block? Stupid question, but why do you make that choice. Various reasons, right? First you guess that if everybody wants to eat there it must have good food. The shelf life of food there is likely to be short also, making the chances of finding fresh food higher.

Something similar happens to investment options. It is not a case of investing where everybody else is investing. That could be a big mistake. You want to be ahead of the market, riding the trend, not a stupid cow being herded by the masses. However, you also want to make sure you are in an investment you can sell quickly in case you find yourself in prickly position.

In order to get a feel of the liquidity of a certain financial instrument there is nothing better than visiting the exchanges. Check out the actual trading pits where orders and sales are placed. If you see an empty pit with two guys twiddling their thumbs, that is a low liquidity market. Avoid like the plague. However if you see two hundred men, in a pit ten feet wide, yelling at each other and making what seems like very rude gestures, you are probably looking at a great investment opportunity.

This is because you need volume in order to create a good investment opportunity. You also need to have the option of move in and out of positions without difficulty. The easier it is to buy and sell the higher the chances of making a profit.

So, if you are planning to invest a specific market, check the volume of trading and how liquid it is. Again, avoid illiquid markets.

But, how can you tell if a market is liquid or not. Well, if you cannot actually visit the pits where sales are being made you can check the Wall Street Journal, the Investor’s Business Daily or your favorite financial website. It is difficult to give a specific quantity that describes a liquid market, but it is a good idea to keep to stocks that are trading at least 300,000 a day. It is important to understand that markets change daily. What is a liquid market today can quickly change tomorrow. As a successful trader you must keep your finger on the pulse at all times, or your investment might just die in an illiquid market.

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Understanding the Three Elements of an Options Trading Position

By Christopher Appleyard | Published: March 10, 2010

Options trading is the most flexible financial instrument that exists. This is a financial instrument which can be used to buy or sell in the future at a specific price, but without having necessarily to go ahead with the deal if you no longer feel it is a good deal for you.

Let us illustrate it with a more mundane example. Imagine you see a house you would like to buy. You have a hunch that the neighborhood it is in will become popular in the next year and you think the interest rates will drop, and drive house prices up. So you tell the owner you want to buy his house in a year at the current market price with a percentage premium on top to sweeten the deal. He agrees, and you give him a deposit to close the deal. The year goes by, and your prediction does not materialize, the neighborhood is still part of the ghetto, so you just drop the deal and walk away. However, if the market had gone your way and the house was worth ten times its initial price, the owner would still have been obliged to sell at the agree price.

You do not need much imagination to see how this trading instrument can provide a unique opportunity for traders to create profitable trading strategies. However, it can also be a daunting and confusing place to find yourself if you are beginner to this type of trading. This is because options trading is a multidimensional process. If you do not understand one of the stages you are not going to get the whole picture, and you are very unlikely to become a successful trader.

In order to understand options trading you must be comfortable with three of its main elements: direction, duration and magnitude. Understand these three factors, and you are one your way to becoming a successful options trader.

Direction.

This refers to what the underlying security, stocks, bonds, or whatever you are trading, is doing. It can move up, down or even sideways. This is where an investor has to make his educated guess of how the market will behave.

Duration.

Duration is the time it will take for the change in direction to occur. It is not only a matter of predicting if the underlying security will raise or drop, but when it will happen also.

Magnitude.

This element refers to how big the move will be. Will the price drop by a few points or a hundred.

A profitable options trading position requires all three elements to work together. It is no good being able to predict the direction of the price of a particular stock if you do not know when a move will happen or how big that move will be. Not understanding how these three elements work together is the main reason people lose money on the market.

In order to create an edge for yourself in such a competitive market it is important to not only be able to place a put or a call but be able to combine options. So, before you start making calls to your broker it is a good idea to at least have a working knowledge of what spreads, straddles, and various options combinations are. In this blog we will be looking at a few of these elements and explaining how they can be used to further your investment.

However, there are some general guidelines on how to use direction, duration and magnitude to your advantage when trading with options.

1)      Give yourself time. If you are going to bet on the direction a security is going to take give yourself time to be right. Long term equity anticipation securities, also known as LEAPS are good for this strategy because they are options that have expiration dates that are further than nine months away.

2)      When getting involved in options combinations make sure you sell expensive options, with a high volatility, and buy cheap options, with a low volatility. This is a principle used by all merchants, whether of stocks, potatoes or wine bottles. Buy cheap; sell expensive.

3)      Time can be your friend. Always buy options that have plenty of time left till expiration. This way you can play with the leverage it provides and take advantage of the time decay factor of an option.

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3 Basic Steps to Reduce The Risk Of Trading on the Stock Market

By Christopher Appleyard | Published: March 9, 2010

Many people do not trade on the stock market because they are scared of the risk involved. A healthy respect of risk is good for an investor, just as a professional motorbike racer must be aware of the dangers of making a mistake. However you will never be a successful trader, or a professional motorbike rider for that matter, if you are not willing to push yourself to the limit and try to make the most of every turn in the market.

The best way to maximize profits and minimize risk is to create your own system or plan that fits your personal circumstances and perception of risk. A good trading plan consists of three basic steps or elements. First you must define the risk you are prepared to accept, second you have to develop a flexible investment plan and third you need to build your knowledge base of trading in a systematic way.

Let’s see how this can be done in practice:

Define your risk.

This is one of those simple principles that are easy to understand but very difficult to put into practice. It is no secret that traders have the potential to make huge profits and huge losses. Traders need to decide what level of risk they can accept. The idea is not to risk more than you are willing to lose. In other words do not bet the farm when trading. You need to decide what the maximum risk you are willing to take is and stick to it. Because trading can be so much fun it is easy to get carried away; self control is one of the hardest lessons to learn.

Once you have decided what your maximum position loss is you can create strategies that maximize your profits based on the risk you are willing to accept.

Develop a Flexible Investment Plan.

Too many traders shoot themselves in the foot by being too rigid when following an investment technique. Maybe they are happy with the results a particular technique has provided and want to stick with it. However, there is not one right strategy for all circumstances. It is much better to have a box full of tools that are right for each situation.

This will allow a trader to have a flexible matrix of strategies that allow him to respond to market movement in any direction. The market is full of traders that respond to changes in the market in a predictable way. Every change in the market resets the expectations of where it will go next. Bear traders will bet for a drop in the market while bullish traders will look for a rise. These two extremes in trader personalities will constantly try to outmaneuver each other.

This mood in the market creates potential for profitable investments if you are capable of taking a step back and seeing opportunities where others see obstacles, instead of just sticking to one trading technique.

Build your knowledge base.

The best doctors are those that never stop learning. If they do not keep up-to-date they will soon be outdated and will not be able to offer the best treatment. The same applies to traders; the most successful are those that never stop learning new and improved trading strategies.

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Single Stock Futures, The Easier and Cheaper Stock

By Christopher Appleyard | Published: March 8, 2010

It was not until November 8, 2002 that the United States opened their financial doors to single stock futures. Needless to say it was big news, one of the most anticipated financial news in the world.

Single Stock Futures have been traded for some time in the London Financial Futures and Options Exchange, now part of Eurnext.liffe, the international derivatives business arm of Euronext.

What are single stock futures? They are future contracts that are based on single stocks and not on physical or financial commodities. Let’s begin with what a futures contract is? A futures is a contract to buy or sell a product at a certain price at a specific time in the future. This is a binding contract. If you purchase a future and the assigned time to pay for it arrives and you have not sold it you are required to pay and receive the physical (corn, oil, steel) or financial (bonds, stocks) commodities you bought.

Single stock futures do the same thing all futures do, that is to fix the price at a future date, but in this case it is stocks that are being sold not soya beans or gold. One single stock future represents 100 shares of a company’s stock. If you purchase a single stock future in a company and the future expires you will be forced to buy it at the agreed price. In a similar way to other futures, SSFs have specific expiration months, March, June, September and December, these are busy months for speculators that want to sell their futures before they expire.

There are two kinds of single stock futures traders, speculators and hedgers. Speculators buy stock futures because they think the share price of a company will increase and sell when they can make a profit on their lower stock price.

Hedgers on the other hand will purchase futures because they really want to own the stock. This can be done as a way to secure a stock position. For instance, if a put or call seller has sold stock options on a stock for a certain price he can buy futures of that stock at a price that will cover his costs if he is assigned to provide the stock at the put or call price.

At the moment there are around 115 stock futures that are traded. These are blue chip companies that have an outstanding record or are very likely to be profitable. This exclusive list includes companies like Microsoft, IBM, Johnson & Johnson and Citigroup.

So what is the difference between buying stock futures and outright stock? To start with the price of stock and its future will generally not trade at the same price. There is a formula that determines the price of a single stock future.

SSF = Stock price x (1 + time to expiration x interest rate) – dividends.

The price of SSFs is normally higher than the stock price because of the extra leverage they provide. Another advantage is that stock futures are cheaper to trade with. This is because when buying a future you do not have to put forward the entire price of the stock but only a margin or small portion. This margin is generally around 20 percent of the cash value of the stock you are purchasing, or promising to purchase.

Option traders love stock futures because they easier and cheaper to trade with. Even for traders in stock they are a great tool because of the added leverage they provide. If you purchase single stock futures wisely you can profit from them whether the stock price moves higher or lower in price. Needless to say this is a great way of managing the risk of trading on the stock market.

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Futures Markets, The Art of Trading with Time

By Christopher Appleyard | Published: February 18, 2010

Futures Markets are very confusing for the beginner in stocks trading. However they provide a great opportunity to make a good profit in today’s volatile markets.

What are Futures Markets?

A Futures Contract is an agreement to purchase or sell a quantity and quality of a commodity, whether physical or financial, for a specific price at a set time in the future. The market consists of physical commodities like gold, soybeans, coffee and oil, and financial commodities like bonds, currencies, indexes, and single stock futures.

Hedgers and Speculators

There are two types of futures traders, hedgers and speculators.  These two types are as different to each other as traders can be. Hedgers are generally farmers and manufacturers that actually want to sell or buy the products traded. Farmers use the futures markets to lock the price of a crop and guarantee a minimum profit on their work. Manufacturers use them to guarantee they have the raw materials they need to operate.

It is important to understand that futures prices are a direct result of consumer supply and demand. If a farmer likes the current price of wheat he can sell his crop before it is farmed and lock the price and the current price. Oil companies also do this, to take advantage of high oil prices.

Speculators are a completely different type of trader. They don’t want to buy or sell the commodities. They are out to make a profit off the buying and selling of futures and are not interested in locking prices.

Today most traders in the futures markets are speculators. The idea is to make money on an educated guess of what the prices of commodities or financial commodities will be in the future. For instance if you think corn prices are going to rise you buy, or as it is also called go long in the hope that you can later sell at higher price. If on the other hand, you think prices will drop then you go short, or sell futures for corn three months down the road.

Hedgers and speculators have a very interesting symbiotic relationship. Hedgers look for security while speculators live off risk. Together they keep the futures markets active so that everybody can have a chance of making a profit.

An interesting type of futures trading is that of financial commodities like bonds and currencies. In this case money is the commodity traded. The price of money varies depending on a number of factors like interest rates and the price of reference currencies like the US dollar.

As with all types of trading risk is a serious factor. Although futures can be highly profitable it does require a steep learning curve to understand, and losing money is easy to do. Talk to your financial advisor if you think this might be a good option for your portfolio.

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The IPO System, How to Profit from an Initial Public Offering

By Christopher Appleyard | Published: February 16, 2010

IPO stands for initial public offering. This financial procedure is often misunderstood. This article explains what an initial public offering is, and how investors and companies alike can profit from it.

The equities market is a flexible beast that can generate profits in a variety of ways. It can also be a pool of cash growing companies can “dip into” when they need resources to continue growing.

This is how it works. A company will divide its assets into shares and hire the services of a brokerage firm, which will buy the entire stock of the company, and sell it for a profit. The commission charged by a typical brokerage firm is around 10% of the sale price.

To illustrate imagine you own a small business in the Bookbinding industry. You need cash in order to continue growing. Maybe you need a new press or a larger workshop. You have $10,000 in assets and $5,000 in debt. Your company is worth $5,000. If you sell 100 shares of your company each one would be worth $50. Once you have sold these shares to investors their price will rise or drop depending on how well or how badly your business does.

This is where the most common misconception of the IPO system occurs. Many people think companies profit every time one of their shares is bought or sold. This is not true. The company only profits from the initial sale of stock options. It is then individual investors that go on to buy and sell the shares that profit or lose money depending on their skill and the behavior of the market.

If a company consistently increases its profits over the years its stock price will grow. Why does this happen? This is a natural result of the most important law of economics, that of supply and demand. When a company goes public and sells a limited number of shares, also called a float, the price is set by the perceived value of the firm. If the firm does well the demand for shares in that company will also grow. However, the supply of shares is limited, so the demand grows increasing the price.

This is why the stock market and the price of shares is so sensitive to financial news like the slightest variation in the interest rate. The economy is a very fluid system that moves through trends, waves and ripples. Successful investors will buy stocks when a company’s performance is promising and sell when financial woes are in the horizon.

Knowing when a company will do well or when the writing is on the wall for their fall is determined by economic news that provides investors and analysts with clues on where the economy is going and at what speed. Needless to say, this is a risky and difficult game to play. Regardless, the IPO system is one of the best gifts of Capitalism to the economy, because it provides companies with a tool to expand and create wealth in the future.

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Top 3 Retirement Planning Mistakes You Probably Already Made

By Christopher Appleyard | Published: February 10, 2010

“An Investment in Knowledge Pays the Best Interest” These words were true when Benjamin Franklin first uttered them and hold true now, especially in the realm of Financial Investments.

It is astonishing how we will spend hours researching and choosing for a new laptop or flat screen but we will make knee jerk decisions about long term financial planning that could mean hundreds of thousands of dollars.

This article will look into other people’s mistakes to help us learn from them and invest with confidence.

Mistake 1. Save for Retirement Without Actually Having a Plan.

We now live longer, much longer. This means the average Joe will spend around 30 years in retirement. This is such a large percentage of our life that it is worth planning for, being retired and poor is not fun. In order to make good decisions you need hard data, facts you can work with. Here are the basics:

-          What age do you want to retire at? – Now be realistic please.

-          How much income do you need at retirement? – Same applies.

-          What is your life expectancy? This is an interesting one. Find a ballpark answer for this at www.census.gov

-          What is your current situation in relation to what you need? How much do you have saved in relation to how much you want? In order to do this you are going to have to look at the current value of all your assets. Some might be hidden in pension funds, company tax-deferred saving plans and future social security benefits. Once you have this information you will know where you are and how much need to get where you want to be.

Mistake 2. Not Starting Early Enough

Albert Einstein is claimed to have said that compound interest is the most powerful force in the universe. I’m not sure if he said it or not but in financial terms he was right on the money. Compound interest makes it possible for an average earner to be a millionaire by the time he retires, and starting earlier makes a big difference.

To illustrate this ask yourself think about this financial scenario, and assume for a fixed 10% return.  John starts contributing towards his saving plan a fixed amount for 8 years and then does nothing for 35 years. Jane on the other hand contributes nothing for the first 8 years and then contributes the same amount as John for 35 years. Who is going to be better off?

Amazingly, at least it was for me, John would be better off even though he contributed so much less towards his pension fund. That is the power of compound interest, the trick is to use it early.

Mistake 3. Not Taking Enough of A Risk

We are not asking you to bet the farm on your retirement fund but you are going to have to assess realistically your risk tolerance and what is the ideal level depending on your age, assets and willingness to take a chance.

The general rule is that the younger you are the more risks you should be willing to take. This means investing in stocks and mutual funds when you are starting a retirement fund and bonds when you are getting on in years.

Even when you are knocking on retirement door you still need some stocks in your portfolio in order to have a chance of outpacing inflation.

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FOREX, A Hedge Fund Haven or A Free Market Utopia

By Christopher Appleyard | Published: February 9, 2010

Forex, The Foreign exchange market is one of those entities you either hate or love, what nobody argues about is that it is vital for international trade and investments to function.

Interestingly, Forex is not a centralized institution but a network of financial centers that manage currency trading between buyers and sellers around the clock from Monday to Friday. The role of this market is to enable businesses and individuals to convert one currency into another.

If a French company, for instance, wants to buy surfboards in the United States they will have to pay in dollars. However, the company’s income is in Euros. Thanks to Forex this is not an issue and the operation can be carried out instantly.  As you already guessed there are a lot of companies that use this service and not only from France.

Forex, is huge. The last Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007 reported that the average daily turnover was 3.2 trillion dollars. This year we will receive the 2010 Triennial report figures and nobody is expecting them to be dropping.

It is not only big it is also highly liquid, because the product being traded is cash. The profit margins are low compared to other markets and it can be accessed from practically anywhere at any time, except weekends.

This has made some analyst describe it as the market closest to the ideal perfect competition, the Utopia of a capitalistic free market society. However, others would beg to differ and accuse the whole market of being an unchecked speculative playground for the rich and powerful.

Hedge Funds have received their fair share of criticism are Hedge Funds. Hedge Funds are basically clubs of investors that pool their resources and invest strategically in an effort to “hedge” or reduce the risk of market movement. These funds often have billions of dollars in their portfolios and are very willing to use the leverage this affords them in their own interest.

The most serious accusation against Hedge Funds and other large investors is that their aggressive speculation can often overwhelm central banks effort to intervene to assist any specific currency. What makes them so dangerous, in some analysts eyes, is that because they overlap various definitions and categories some of their activities are lightly regulated or not at all.

This is, of course, the natural effect of market forces that control Forex and most other economic entities. However, it must be said that hedge funds are allowed to continue in their pseudo-regulated existence due to specific exemptions created by lawmakers.

Should Hedge Funds and other large investors be regulated in their use of the foreign exchange market? Does this market provide a haven for rich and powerful investors giving them an unfair advantage? Probably.  Nevertheless, this is also an issue in other strictly regulated markets.

A fair comment might be that like democracy the foreign exchange market is the worst type except for all the rest that have been tried.

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Margin Lending Is Being Regulated, What Is The New Deal?

By Christopher Appleyard | Published: February 5, 2010

As from the 1st of February issuers and advisers of Margin Lending facilities can start applying for an Australian Financial Services Licence (AFSL). The period for Margin Lending licence applications will end the 30th of June 2010.

If you are a margin lender or adviser you must apply to the Australian Securities and Investment Commission (ASIC) for a licence within this timeframe if you want to stay in business. Margin Lending providers that don’t apply for an Australian Financial Services Licence will not be able to continue providing Margin Lending services.

These procedures are in line with the approval of the Corporations Legislation Amendment Act, also known as the Financial Modernization Act, approved last year.

What does the new Act require?

1)      Issuers and advisers of Margin Lending facilities must be licensed by ASIC with an AFSL.

2)      Advisers must only give advice that is in the interest of their client’s individual circumstances.

3)      Margin Lenders must comply with the new responsible lending requirements.

4)      Clients must have the option of accessing external dispute resolution services.

5)      Advisers and Issuers must by transparent in their communication with clients in the case of a margin call.

These new regulations on conduct, disclosure and responsible lending take effect from the 1st January 2011.

You can see a more detailed timeline of the changes to margin lending regulation at the Australian Securities and Investment Commission website.

If you are an adviser or issuer of Margin Lending in Australia now is the time check if you are captured by the new requirements, comments Dr Peter Boxall, ASIC commissioner.

These new regulations come with an updated policy and regulatory guide to help issuers and advisers of Margin Lending facilities to fall in line with new requirements. Time is of the essence if you want to make sure you can stay in business after the 30th of June 2010 when the new licensing rules come into play.

These changes are designed to apply to Margin Lending the same licensing, conduct and disclosure requirements that other financial services are required to follow in an effort to regulate the credit industry as a whole. These efforts have been intensified in the light of the recent credit crisis worldwide.

For more information you should visit the Australian Securities and Investment Commission website where up-to-date copies of regulatory guides are available.

These new requirements will help in providing a more secure environment for investors that rely on the services of advisers and issuers of Margin Lending. If you are investing in Margin Lending, do you know if your broker and adviser are licensed or are in the process of applying for a new AFS licence?

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