AskDong

My investment update missed the big rally from yesterday, and big decline today. Given that yesterday and today are a wash, my results are actually quite current. May was an uneven month. The market neither rallied or tanked. Though the Nasdaq and the Dow diverged. The Nasdaq outperformed the Dow.

Below is my historical performance. I’ve added the the performance of my complete portfolio to the chart.

Brokerage Accounts: Accounts in which I pick individual stocks and some mutual funds. My IRA account(s) are amongst these accounts.
Asset Account: Accounts in which I managed on basic asset allocation principles. These accounts accounts consist of my 401k and Vanguard accounts.
All Classes: Total from all accounts

This is the long “awaited” last part of my five part series on Investing Basics. I last covered Mutual Funds I would not even categorize options or futures as basic. I personally do not invest directly in futures (at least not in my home portfolio). I dabble with options. Most people, I would think, can skip these and other derivative investments and be more than OK.

Both options and futures are considered derivatives. Warren Buffet has called derivivatives financial weapons of mass destruction. Of course, these are weapons that Mr. Buffet enjoys stockpiling. While it may seem on the surface inconsistent that Warren would slam derivatives one day, and praise their use the next, Berkshire Hathaway use of derivatives is completely consistent with it’s role as one of the largest insurers and re-insurers in the world. Selling insurance is not too different from selling options.

So what are derivatives? Derivatives encompass wide variety of financial products. Options, futures (forwards) and swaps constitute the vast majority of derivatives. Derivatives all have one thing in common. They are nothing in themselves. The value of any derivative contract is tied to the value of a real underlying product. In the case of stock options, the value of the option is directly tied to what a particular stock trades at. In this regard derivatives are the most akin to gambling. When you make a bet, the bet itself doesn’t have any intrinsic value. Rather the value is in the cards that are played, or who wins the basketball game. The bet is secondary to the actual event.

Options
So what is an option? An option is exactly what the name implies, it gives the owner of option the opportunity to buy or sell at a given price. A call option grants the right to buy, and a put option grants the right to sell. While a share of stock only really has one attribute – price, an call option on particular stock has number of attributes.

There are two types of option expiration conventions, European and American. American options can be exercised on any date before the expiration date, and European options only on the expiration date. In practice, there is nary a difference as there’s almost no reason to ever exercise an option before expiration. By excercising an option, you’ve basically given up the value of the “option” to exercise.

Below is chart of example value of call option with a strike price of 20 given the trading value of the underlying stock.

An option will never be worth less than 0, and at all points should have some value reflecting the option premium, and the intrinsic value. For example if the stock is trading at 20 and the strike price is 20, the option premium might be $2. $2 reflect the value of having the right to buy the stock for $20. The intrinsic value at that time is 0 because there’s no value in exercising the option to buy at $20 when the stock can actually be had for $20. However if the stock were to move to $30, then the intrinsic value would be $10. I could use my option buy the stock for $20, and turnaround and sell it for $30 – instant $10 profit.

Futures
Futures are standardized forward contracts. Forward contracts have two of the same components as an option. 1) Price 2) Date. Unlike an option a forward contract is an obligation to transact at a certain price. In many regards an option is modified forward contract. A future is a forward contract in standard form and can be traded on an exchange. For example oil futures that are traded on the New York Mercantile Exchange have given specifications for method of delivery, quantity, and the type of product.

So a if I were to buy an oil future for $200 a barrel with a delivery date of June 2009, in June 2009 I would be obligated to pay $200 a barrel even if oil prices at the time were $50. Forward and future contracts developed originally in the agricultural world to allow producers and users to get price certainty for goods that would be delivered later. Many companies such as Airlines still use futures to hedge future uncertainty, but there are just as many investors who buy and sell futures purely for financial reasons.

I’m a little late on my investment update as I’ve been trying to get it out around the 1st of the month. The month of April pretty much continued how it started. The market rallied while I lagged relative to market. My lagging is not very surprising given that I have quite few put options on the NASDAQ and the DOW. Those haven’t worked out very well recently, but I guess that’s what hedges are for.

I am finally up for the year. Almost all of that can be attributed to the calls on AAPL that continue to race onward an upward. Last month AAPL shot past $150. The stock is up above $180 now….

Now that I have a few months of data for my historical performance chart, it’s actually beginning to look like something.

I have a couple stocks in my portfolio brightly colored red. Yet, every time I see them I have stop myself from buying more. The two common cliches that prevent me from doing so are. 1) Don’t Catch A Falling Knife 2) Don’t Average Down. I’ve managed to resist the temptation, and in the past this resistance to my own nature has served me well with two other stocks I used to own, WM and AHM. I took my 20% loss on Washington Mutual and avoided losing another 60%. I took my 50% loss on AHM (American Home Mortgage) and avoided losing everything as the company declared bankruptcy within a few weeks of when I sold out my last shares.

While fortunate in those transactions, my losses also highlight the biggest trap of investing/trading - Falling in love with your stocks. I fell in love with AHM and WM when I should have sold much earlier. I only take solace in that in the end I realized the relationship could not work because the love was not returned. As with relationships, it’s better to cut your losses than try to make an untenable relationship work.

So what do I own today that I need to think seriously about selling? Mylan Pharmaceuticals (MYL) and United Health (UNH). MYL is a company I’ve owned at some point another in some account or another for over 12 years. It’s loved me in the past, but it no longer loves me today. Fundamentally, I should own neither MYL or UNH. I don’t know the first thing about the pharmaceutical or health care industry. I’m not much of a consumer or connoisseur of either.

I like many other employees I am partially paid in the form company stock. Companies rightly choose to pay their employers by stock options or outright stock grants as means to better align company and employee interests. Enormous stock option packages get a lot of press as they often pad CEO pay excessively, but stock options and outright grants are an important part of the pay package for many individuals. Stock options have made millionaires out of many Microsoft employees in the 80s and 90s. Today we have Google millionaires.

The real question of stock denominated benefits is are we to treat them like cash or are we to treat them as something more? I think most people treat them as something more. Some of this makes sense given that stock compensation typically have to become vested. Usually it takes at least a year before options or stock grants are vested. If an employee is terminated or leaves before the vesting period is over that employee forfeits his or her claim. That’s one issue - stock options and grants that have a lengthy vesting periods are only claims on compensation rather than outright compensation. For that reason, an employee might not want to count (reinvest) too early the chickens before they’ve hatched.

However, aside from the vesting issue which most employees have a pretty good sense if they will fulfill or not, there aren’t really all that many good reasons to hold onto stock grants or options unless required to by rules even when those grants haven’t vested. An employee can easily sell short company shares, or options without actually owning the shares or options. This might be seen as a vote of no-confidence, but it’s really an act of diversification. Most employees don’t have that much influence on the stock a price. If an employee were promised a cash payment, it would be generally be ridiculous for that employee to go and buy options or shares of the company. Effectively that’s what we do when we do nothing and hold onto shares or the options.

The risk because of the vesting period is that we never receive those grants or options. However, the only situation in which the hedges (i.e. selling short shares or options, or buying put options) would be out of the money is when the company is chugging along nicely, i.e. the stock price has risen. Under these circumstances, the most likely reasons for a employee not to meet shorter term vesting requirements are under the employee’s control. Either the employee chooses to leave or is terminated because of performance issues. The sensible thing for an employee with short term vesting options or shares is to hedge. This action would’ve certainly served the many employees at Bear Stearns well. Of course by hedging, it’s possible to miss out on millions like the ones reaped by employees of MSFT and/or GOOG. However for every Google there are dozens of pets.com. Keep the stock or options only if you think you would actually buy those same options in the open market.