Fundamentals Part Five
Technical Analysis
Technical Analysis is a
method where one studies the market statistics to evaluate the worth of a
company. Instead of assessing the health of the company by relying on its
financial statements, it relies upon market trends to predict how a security
will perform.
It is a method of evaluating stocks by analyzing stock market related activity,
such as past
prices and volume. Technical analysts do not attempt
to measure a security's intrinsic value, but instead use charts to identify
patterns that can suggest future activity. They believe in the momentum that
the scrip/markets gather over a period of time and cashing in on the same.
Technical analysts believe that the historical performance of stocks and
markets are indications of future performance.
This method enables 'short-term' investors to gauge companies who have very
good potential to gather increased earnings in the near future.
Fundamental
Analysis
A method of evaluating a
stock by attempting to measure its intrinsic value Fundamental analysts study
everything from the overall economy and industry conditions, to the financial
condition and management of companies A fundamental analyst would most
definitely look into the details regarding the balance sheets, profit loss
statements, ratios and other data that could be used to predict the future of a
company.
In other words, fundamental analysis is about using real data to evaluate a
stock's value. The method uses revenues, earnings, future growth, return on
equity, profit margins and other data to determine a company's underlying value
and potential for future growth.
Overvalued
Stock or an Undervalued Stock
An overvalued stock can
be understood as an inflated hope that a company will do well. Thus, a stock is
overvalued if its current price exceeds the intrinsic value of the stock. The
market may temporarily price stocks too high or too low and that's how
investors determine whether stocks are being overvalued or undervalued. If a
stock is overvalued, the current price of the stock exceeds its earnings ratio
(PE ratio*) and hence investors expect the price of the stock to drop. A high
PE in relation to the past PE ratio of the same stock may indicate an
overvalued condition, or a high PE in relation to peer stocks may also indicate
an overvalued stock
thus the PE ratio is one of the many ways to determine whether a stock is
overvalued. *A company's P/E ratio is computed by dividing the current market
price of one share of a company's stock by that company's per-share earnings.
For example, a P/E ratio of 10 means that the company has Rs1 of annual,
per-share earnings for every Rs10 in share price
A stock is undervalued when, if is selling at a much lower price than what it
is actually worth. This can be determined based on fundamentals like earnings
and growth prospects. One of the best-known measures for finding an undervalued
stock is the price earnings ratio (P/E).
Consider Colgate and Pepsodent, which are in the same industry and have similar
fundamentals. If Colgate has a P/E of 15 and Pepsodent's is 20, Colgate could
be an undervalued stock.
Value
Investing
Value investing is an
investment style, which favors good stocks at great prices over great stocks at
good prices. Hence it is often referred to as "price driven investing".
A value investor will buy stocks he believes the market is undervaluing, and
avoid stocks that he believes the market is overvaluing. Warren Buffet,
one of the world's best-known investment experts believes in Value investing.
Value investors see the potential in the stocks of companies with sound
financial statements that they believe the market has undervalued; as they
believe the market always overreacts to good and bad news, causing stock price
movements that do not correspond with their long-term fundamentals. Value
investors profit by taking a position on an undervalued stock (at a deflated
price) and then profit by selling the stock when the market corrects its price
later.
Value investors don't try to predict which way interest rates are heading or
the direction of the market and the economy in the short term, but only look at
a stock's current valuation ratios and compare them to their historical range.
In other words they pick up the stocks as fledglings and cash in on them when
they are valued right in the markets.
For example, say a particular stock's P/E ratio has ranged between a low of 20
and a high of 60 over the past five years, value investors would consider
buying the stock if it's current P/E is around 30 or less. Once purchased, they
would hold the stock until its P/E rose to the 50-60 ranges before they
consider selling it or even higher if they see further potential for growth in
the future.
Contrarian
Philosophy
Investing with a value
philosophy can be considered as one form of contrarian investing. Buying stocks
that are out of favor in the marketplace, and avoiding stocks that are the
latest market fad is a contrarian investing strategy. Thus it is an investment
style that goes against prevailing market trends, where investors buy scrip
that are performing poorly now and sell them in future when they perform well.
Contrarians believe in taking advantages that arise out of temporary set backs
or other such reasons that have caused a stocks price to decline at the moment.
A simple example of
Contrarian Philosophy would be buying umbrellas in
winter season at a cheap rate and selling them during rainy days.
Futures
Derivatives
a derivative is a financial instrument whose value depends on the values of
other underlying variables. As the name suggests it derives its value from an
underlying asset. For Ex-a derivative may be created for a share, or any
material object. The most common underlying assets include stocks, bonds,
commodities etc.
Derivatives contract
Anil buys a futures contract in
the scrip "Reliance Ind". He will make a profit of Rs.1500 if the
price of Satyam Computers rises by Rs 1500. If the price remains unchanged Anil
will receive nothing. If the stock price of Satyam Computers falls by Rs 2400
he will lose Rs 2400.
As we can see, the above contract depends upon the price of the Reliance Ind
scrip, which is the underlying security. Similarly, futures trading can be done
on the indices also. Nifty futures are a very commonly traded derivatives
contract in the stock markets. The underlying security in the case of a Nifty
Futures contract would be the Index-Nifty.
What are the different types
of Derivatives?
Derivatives are basically classified into the following:
Futures /Forwards
Options
Swaps
What are Futures?
A futures contract is a type of derivative instrument, or financial contract
where two parties agree to transact a set of financial instruments or physical commodities
for future delivery at a particular price.
The example stated below will simplify the concept:
Case1:
Ravi wants to buy a Laptop, which costs Rs 50,000 but owing to cash shortage at
the moment, he decides to buy it at a later period say 2 months from today. However,
he feels that after 2 months the prices of Lap tops may increase due to
increase in input/Manufacturing costs .To be on the safer side,
Ravi enters into a contract with the Laptop Manufacturer
stating that 2 months from now he will buy the Laptop for Rs 50,000. In other
words he is being cautious and agrees to buy the Laptop at today's price 2
months from now. The forward contract thus entered into will be settled at
maturity. The manufacturer will deliver the asset to Ravi at the end of two
months and Ravi in turn will pay cash
delivery.
Thus a forward contract is the simplest mode of a derivative transaction. It is
an
agreement to buy or sell a specific quantity of an asset at a certain
future time for a specified price. No cash is exchanged
when the contract is entered into.
Index Futures
As Stated above, Futures are derivatives where two parties agree to transact a
set of financial instruments or physical commodities for future delivery at a
particular price. Index futures are futures a contract where the underlying is
a stock index (Nifty or Sensex) and helps a trader to take a view on the market
as a whole.
Lot size
Lot size refers to the quantity in which an
investor in the markets can trade in a derivative of particular scrip. For
Ex-Nifty Futures have a lot size of 100 or multiples of 100.Hence if a person
were to buy 1 lot of Nifty Futures , the value would be 100*Nifty Index Value
at that point of time.
Similarly lots of other scrip such as Infosys, reliance etc can be bought and
each may have a different lot size. NSE has fixed the minimum value as two
lakhs for an Futures and Options contract.
Lot
sizes are fixed accordingly which will be the minimum shares on which a trader
can hold positions.
Expiry period in Futures
each contract entered into has an expiry period. This refers to the period
within which the futures contract must be fulfilled. Futures contracts may have
durations of 1 month, 2 months or at the most 3 months. Each contract expires
on the last Thursday of the expiry month and simultaneously a new contract is
introduced for trading after expiry of a contract.
Uses of Derivatives what are the various derivative strategies
Derivatives have a multitude of uses namely:
1) Hedging
2) Speculation &
3) Arbitrage
OPTIONS
Options before you begin options trading
it are critical to have a clear idea of what you hope to accomplish. Only then
will you be able to narrow down on an options trading strategy. Let us first
understand the concept of options.
An option is part of a class of securities called derivatives.
The concept of options can be explained with this example. For instance, when
you are planning to buy some property you might have placed a nonrefundable
deposit to hold it for a short time while you evaluate other options. That is
an example of a type of option.
Similarly, you have probably heard about Bollywood buying an option on a novel.
In 'optioning the novel,' the director has bought the right to make the novel
into a movie before a specified date. In both cases, with the house and the
script, somebody put down some money for the right to buy a product at a
specific price before a specific date.
Buying a stock option is quite similar. Options are contracts that give the
holder the right to buy or sell a fixed amount of a certain stock at a
specified price within a specified time. A put option gives the holder the
right to sell the security, a call option gives the right to buy the security.
However, this type of contract gives the holder the right, but not the
obligation to trade stock at a specific price before a specific date. Several
individual investors find options useful tools because they can be used either
as
1) A type of leverage or
2
) A type of insurance.
Trading in options lets you benefit from a change in the price of the share
without having to pay the full price of the share. They provide you with
limited control over the shares of a stock with substantially less capital than
would be required to buy the shares outright.
When used as insurance, options can partially protect you from the specific
security's price fluctuations by granting you the right to buy or sell shares
at a fixed price for a limited amount of time.
Options are inherently risky investment vehicles and are suitable only for
experienced and knowledgeable investors who are prepared to closely monitor
market conditions and are financially prepared to assume potentially
substantial losses.
Different types of
Options, How can Options be used as a strategic measure to make profits/reduce
losses?
Options may be classified into the following types:
1) Call Option
2) Put Options
as mentioned before, there are two types of options, calls and puts. A call
option gives the holder the right to buy the underlying stock at the strike
price anytime before the expiration date. Generally call options increase in
value as the value of the underlying instrument increases.
By contrast, the put option gives the holder the right to sell shares of the
underlying stock at the strike price on or before the expiry date. The put
option gains in value as the value of the underlying instrument decreases. A
put option is one where one can insure a stock against subsequent price fall.
If the value of your stocks goes down, you can exercise your put option and
sell it at the price level decided upon earlier. If in case the stock price
moves higher, all you lose is just the premium amount that was paid.
Note that in newspaper and online quotes you will see calls abbreviated as C
and puts abbreviated as P.
The examples stated below will explain the use of Put options clearly:
Study 1:
Rajesh purchases 1 lot of Infosys Technologies MAY 3000 Put and pays a premium
of 250 This contract allows Rajesh to sell 100 shares of Infosys at Rs 3000 per
share at any time between the current date and the end of May.Inorder to avail
this privilege, all Rajesh has to do is pay a premium of Rs 25,000 (Rs 250 a
share for 100 shares).
The buyer of a put has purchased a right to sell. The owner of a put option has
the right to sell.
Study 2:
If you are of the opinion that particular stocks say "Ray
Technologies" is currently overpriced in the month of February and hence
expect that there will be price corrections in the future. However you don't
want to take a chance, just in case the prices rise. So here your best option
would be to take a Put option on the stock.
Lets assume the quotes for the stock are as under:
Spot Rs 1040
May Put at 1050 Rs 10
May Put at 1070 Rs 30
So you purchase 1000 "Ray Technologies" Put at strike price 1070
and Put price of Rs 30/-. You pay Rs 30,000/- as Put premium.
Your position in two different scenarios has been discussed below:
1. May Spot price of Ray Technologies = 1020
2. May Spot price of Ray Technologies = 1080
In the first situation you have the right to sell 1000 "Ray
Technologies" shares at Rs 1,070/- the price of which is Rs 1020/-. By
exercising the option you earn Rs (1070-1020) = Rs 50 per Put, which amounts to
Rs 50,000/-. Your net income in this case is Rs (50000-30000) = Rs 20,000.
In the second price situation, the price is more in the spot market, so you
will not sell at a lower price by exercising the Put. You will have to allow
the Put option to expire unexercised. In the process you only lose the premium
paid which is Rs 30,000.
Open interest
the total number of option contracts and/or futures contracts that are not
closed or delivered on a particular day and hence remain to be exercised,
expired or fulfilled through delivery is called open interest.
Index Futures
As Stated above, Futures are derivatives where two parties agree to transact a
set of financial instruments or physical commodities for future delivery at a
particular price. Index futures are futures contracts where the underlying is a
stock Index (Nifty or Sensex) and helps a trader to take a view on the market
as a whole.
Option Premium, strike price and spot price
the price that a person pays for a call option/Put Option is called the Option
Premium. It secures the right to buy/sell that particular stock at a specified
price called the strike price. In other words the strike price is the
specified price at which the holder of a stock option may purchase the stock.
If you decide not to use the option to buy the stock, and you are not obligated
to, your only cost is the option premium. Premium of an option = Option's
intrinsic value + Options time value The stated price per share for which
underlying stock may be purchased (for a call) or sold (for a put) by the
option holder upon exercise of the option contract is called the Strike price.
Spot Price is the current price at which a particular commodity can be bought
or sold at a specified time and place.
Settlement price
the last price paid for a contract on any trading day. Settlement prices are
used to determine open trade equity, margin calls and invoice prices for
deliveries.
Determine the price of an option
A variety of factors determine the price of an option.
The behavior of the underlying stock considerably affects the value of an
option. Investors have different opinions about how a particular stock will
behave in the future and hence may disagree about the value of any given
option.
In addition, the value of an option decreases as its expiration date approaches.
Thus, its value is also highly dependent on the amount of time left before the
option expires.
Intrinsic & Time Value
an options price is composed of its intrinsic value and time value.
What a particular option contract is worth to a buyer or seller is measured by
how likely it is to meet their expectations. In the language of options, that's
determined by whether or not the option is, or is likely to be, in the money or
out-of-the-money at expiration. Intrinsic value is how far an option is 'in-the-money.'
Thus, the phrase is an adjective used to describe an option with an intrinsic
value. A call option is in- the-money if the spot price is above the strike
price. A put option is in the money if the spot price is below the strike
price.
It is calculated by subtracting the options strike price from the spot price.
An out-of-the-money option has an intrinsic value of zero.
For example if XYZ is trading at Rs 58 and the June 55 call is trading at Rs 4,
to calculate the intrinsic value subtracts Rs 55 from 58, leaving you with Rs 3
of intrinsic value. The remaining Rs 1 is known as extrinsic or time value.
Time value is the amount over intrinsic value that a buyer pays for the option.
While buying time value, an options purchaser assumes that the option will
increase in value before it expires. As the option nears expiration, its time
value starts decreasing toward zero
Theoretical Value
Theoretical value is the objective value of an option. It shows how much
time-value is left in an option. The most commonly used formula to calculate
the theoretical value of an option is known as the Black-Scholes model.
This model considers the price of the stock, the options strike price, the time
remaining before expiration, the volatility of the underlying stock, the
stock's dividends and the current interest rate while arriving at the
theoretical value of the option.
Although an option may trade for more or less than its theoretical value, the
market views the theoretical value as the objective standard of an option's
value. This makes the price of all options tilt toward their theoretical value
over time.
The Components of Theoretical Value
Volatility
the volatility of the underlying stock is one of the key factors in determining
the value of an option. Often, the options price increases as the volatility of
the stock increases. The difficulty in predicting the behavior of a volatile
stock permits the option seller to command a higher price for the additional
risk.
There are two types of volatility, historical and implied. As the term
suggests, historical volatility is a measurement of the stocks movement based
on its past behavior.
By contrast, implied volatility is calculated using option prices. It is a
measurement of the stocks movement as implied by how the market is currently
valuing options.
Dividends
As an owner of a call option you can always exercise your right to the stock
and receive any dividend it might pay.
Interest Rate
if you buy an option rather than a stock, you invest less money upfront.
Days until Expiration
An option, being a wasted asset; wastes a little as each day lapses. Thus its
value is calculated in accordance to the amount of days left in its life.
Swaptions
A Swaptions is an option on an interest rate swap. Swaptions are options
contracts, which give you the right to enter into a swap agreement at the
option expiration, in return for a one-off premium payment.
Covered Call, Covered Put, In the Money, Out Of the Money, At the Money?
1 In-the-money
a call option is in the money if the strike price is less than the market price
of the underlying security. A put option is in-the-money if the strike price is
greater than the market price of the underlying security.
2 Out of the money
A call option is out-of-the-money if the price of the underlying instrument is
lower than the exercise/strike price. A put option is out-of-the-money if the
price of the underlying instrument is above the exercise/strike price.
3 At-the-money
At the money is a condition in which the strike price of an option is equal to
(or nearly equal to) the market price of the underlying security.
4 Covered Call
you can take a covered call if you take a long position in an asset combined
with a short position in a call option on the same underlying asset.
5 Covered Put
the selling of a put option while being short for an equivalent amount in the
underlying security.
