All center fielders are baseball players but not all baseball players are center fielders. In much the same way, stock options are derivatives but not all derivatives are stock options. A derivative is a financial instrument whose value is “derived” from the underlying asset. It is a contract between two or more parties and the value is determined by fluctuations in the value of that asset. The most common of these assets are stocks, bonds, currencies, interest rates, commodities and market indexes.
Types of Derivatives:
Option Contracts– a contract that gives the owner the right, but not the obligation, to buy or sell a security or an index (basket of securities) at a certain price within a specified time frame.
Futures Contracts or Futures) – A contract that obligates one to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. This market is regulated by the Commodity Futures Trading Commission. These contracts may require the actual delivery of the asset while others are settled in cash. Futures can be used to hedge or speculate on the price movement of the underlying asset. For example, a farmer expecting a crop of 50,000 bushels of corn may opt to hedge his position by selling 10 futures contracts (5000 bushels/contract) to “lock in” the price. This market is regulated by the Securities and Exchange Commission (SEC).
Swap– This is the transfer of risk through the exchange of payment streams. For example, fixed interest rate may be exchanged for floating interest rate. Also, maturtites may be traded or stock and bond qualities can be exchanged based on new investment objectives. This market is UNREGULATED and is traded off-exchange on the over-the-counter (OTC) market.
Types of Derivative Traders:
1- Hedgers– These investors have a cash position in a commodity and need to protect against an adverse price change by purchasing an offsetting position. An example is the “corn crop” example I gave above or an owner of a stock who buys a put, giving him the right to sell the stock at a certain price even if the market value is much lower.
2- Speculators– These are investors who have no interest in the underlying commodity but will accept the risk the hedger is reducing FOR A PRICE. They assume this higher risk level in order to profit from an anticipated price movement. They provide liquidity for hedgers.
Covered Call Writers- Both Hedgers and Speculators:
That’s right. We are so special that we can be both hedger and speculator in the same investment. When we purchase an equity, we are speculating that the price of the stock will maintain or achieve a certain level so as to generate a profit. The risk is in the stock price falling to the point where we are losing money. That is the reason we have a complete set of exit strategies in place to activate if required. We then hedge this speculative position by selling the call option and creating downside protection. The protection for the position, in general, is the premium generated from the sale of the option. There is another protection we can access as well. That is the protection of the option premium itself which we can produce by selling in-the-money strikes. This “insurance” is paid for by the option buyer.
All options are derivatives but not all derivates are options. Derivative contracts are bought and sold by both hedgers and speculators. We, as covered call writers, are actually both hedgers and speculators and that is why we have an opportunity to generate outstanding returns with minimal risk.
Flash Trading Update:
In August, I wrote an article regarding flash trading and how the SEC was investigating its impact on retail investors. This is where certain Wall Street insiders get to see an order a brief moment before the public does. Here is a link to that article:
Recently a recommendation has been made to the SEC to end all flash trading on the stock exchanges. This is expected to be approved early in 2010. It is, however, unclear whether this will also apply to options trades. Flash trading plays a major role in what is known as options “step-up” orders. Here is how step-up orders work: An investor’s order to buy or sell an option contract is routed to one of several options exchanges, such as the CBOE or International Securities Exchange. If a better price for the option has been placed at another exchange, the CBOE will briefly “flash” the order to other traders on its exchange, giving them a chance to “step up” and match the better bid. If no such bid transpires, the order is routed to the other exchange. Many traders believe that step-up orders benefit industry insiders and destroy competition, resulting in poorer prices for investors. Proponents of step-up orders claim that they provide a steady stream of volume thereby producing favorable prices for traders. Bottom line: Flash trading will likely be eliminated on the stock exchanges but may not be for options trading. The trend politically and legislatively is definitely in our favor. This represents a small but palpable silver lining in the ugly sub-prime cloud that is beginning to dissipate. I will update this information when decisions have been finalized.
Chart of the Week- AIXG:
This near-perfect chart shows the following:
- Uptrending 20-d ema (red arrow top)
- 20-d ema above the 100-d ema (100d ema denoted by blue arrow)
- Price bars at or above the 20-d ema
- MACD positive (green box)
- Histogram positive (Red rectangle)
- Stochastic oscillator above 80% but dipping (purple oval)
- Positive indicators on significant volume (orange box)
Although this stock has dipped slightly over the past few days, the moving average seems to be a reliable area of support. I currently own this stock in two of my accounts and have sold both the $30 and $35 calls. In the world of Blue Collar Investing we realize that a strong chart is not a guarantee of success but it does throw the odds in our favor. It sure beats a hot tip at the water cooler! Put this together with only selecting equities with strong fundamentals, plus other more esoteric rules (ERs), an organized portfolio manager and watchlists and planned exit strategies, if needed, and we have a formula for success.
Last Week’s Economic News:
The unemployment rate decreased to 10% in November from 10.2% in October while payrolls shrank by merely 11,000, the best performance since the start of the recession in December of 2007. In addition to this GREAT news, the previous two months job losses were revised downward. Let’s hope this trend continues. Total construction spending was flat in October which was a positive surprise. The Federal Reserve’s Beige Book reported modest economic growth in 8 of its 12 districts and little change in the others. U.S. non-farm productivity rose an annualized 8.1% in the 3rd quarter, the largest increase since 2003. The only negative signal was from the manufacturing and service-sectors which showed a slight reverse in economic growth. For the week, the S&P 500 rose 1.3% for a year-to-date return of 25%.
This Week’s Economic Reports:
- Monday: Consumer credit report
- Thursday: International trade report
- Friday: Retail sales and business inventory reports
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PREMIUM MEMBERSHIP UPDATE:
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Wishing you all the best in investing,