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The Efficient-Market Hypothesis is a fairy tale of perfectly objective human beings operating in the stock market when in actuality human beings are exactly human. The market is made up of buyers and sellers willing to buy and sell their stocks at different prices that meet and thus provide liquidity. After trading for years - executing thousands of trades in my personal account and watching the market for thousands of hours - my experience has shown me how largely inefficient human beings are and furthermore the distinctively predictable rational and irrational patterns they continue to create. By understanding the predictable actions of others, one can determine their effects on supply and demand thus determining price.
I do not mean to say that fundamentals are without merit. For example, if a company has more cash (minus all liabilities) than the current market value of the company, then, of course, if one has the capital - common sense dictates buying the company and turning a quick profit. But, if one cannot outright buy an undervalued company, the next best thing is to buy stock in the company. Therein lies the problem. For suppose someone buys stock in the aforementioned company and wants to wait for the market to reach efficiency (operating with the presupposition that markets do in fact reach efficiency), as the individual sits and waits, perhaps the stock goes lower for reasons that have nothing to do with the fundamentals, e.g., hedge funds and mutual funds dumping their positions for redemptions or more lucrative opportunities.
In addition to the problem of inefficiency, the fundamentals of the company could actually change while waiting for efficiency. A myriad of reasons could cause this, e.g., poor acquisition(s), taking on of too much debt relative to earnings, unexpected lawsuit(s), etc. The fundamentals once held dear are now meaningless. The more jejune trader or talking head on television may sight a time to buy or sell stocks based on fundamentals without realizing their overly simplistic approach.
A quote from Keynes regarding this issue:
"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
If one can predict the actions of others one will be able to predict price and thus profit. Many times the short term over-enthusiasm or overly-pessimistic attitudes of traders can affect price going into a predetermined event. For example, if the sentiment on the street is that XYZ Corp is going to blow away earning expectations, the sentiment many times results in action i.e. buying of aforementioned stock. Then what does it matter whether XYZ Corp does well on their earnings? As the easier and more lucrative trade is many times gauging the expectations of the masses prior to an event rather than after, for after contains the unknown and predicting sentiment to the unknown is not feasible. Another quote from Keynes is applicable here:
"Anticipating the anticipations of others is successful investing."
A put option is a contract that gives the holder the right but not the obligation to sell a certain number of shares at a set (strike) price on or before a predetermined date.
A hypothetical example will highlight conceptually a put option:
I am short an ounce of gold at the current market price of $1,000 ("short," meaning I borrowed someone else's ounce of gold, sold it to someone for $1,000, and am now obligated to return an ounce of gold to the one I borrowed it from). You also anticipate that the price of gold will decrease over the next month, so you offer me $50 to have the right to sell an ounce of gold to me for $1,000. I could use the extra $50 and do not anticipate the price of gold declining by more than $50 over the next month, so I agree to take your $50 with the stipulation that I will buy an ounce of gold from you for the agreed upon (strike) price of $1,000 if you so choose.
Now I will outline what would happen in two hypothetical scenarios:
1) Suppose in a month's time there is a glut of supply of gold, driving the price of gold down to $500 an ounce. Now it will be profitable for you to exercise the deal we had - that is - sell me an ounce of gold for $1,000 (i.e., make me buy an ounce of gold from you for $1,000). Upon exercising the put option, you will sell an ounce of gold short to me (i.e. borrow an ounce of gold from someone else to sell to me at the strike price of $1,000). You will now be looking at a net paper gain of $450 ($500 minus the $50 spent on the put contract). To lock in your gains, you can buy an ounce of gold in the open market for current prices of $500 to return to the one borrowed from.
Since I was short gold at $1,000 and was forced to buy an ounce of gold from you for $1,000, I will have effectively broken even. This was an example of selling a covered put. Had I not been short an ounce of gold and sold you that same put contract, it would have been considered as selling a naked put. In the case of a naked put, I would have suffered losses of $450 by being forced to buy an ounce of gold from you for $1000 - $500 above market price - then adding $50 for the money paid to me for the put contract.
2) Suppose in a month's time currencies crash, then uncertainty and fear cause the demand for gold to increase, driving the price of gold up to $2,000 an ounce. It obviously will not be profitable for you to sell me an ounce of gold for $1000 (i.e., make me buy an ounce of gold from you for $1,000), since the current price is $2000 an ounce. Thankfully for you, options give the holder the right but NOT the obligation to exercise. So, you will just be out the original $50 spent on the put contract. I, on the other hand, will be looking at paper losses of $950 on my gold position, since I went short at $1,000 and the price of gold is now $1,000 higher to $2,000 an ounce (i.e., $950 because I added the $50 you paid to me for the right to sell).
To summarize, buying calls is bullish (anticipating the market will rise) and buying puts is bearish (anticipating the market will fall). As a side note, rarely do I actually exercise my call or put options. Since the contracts are traded in a market like stocks, you can just sell the contracts you purchased to someone else prior to expiration. It is important to note how large the spread is in the bid and ask, the avg. daily volume, daily volume, and open interest to aid in determining how liquid the market is/will be for a particular option contract. Also, strike prices are classified as "at the money," "in the money," or "out of the money" - at the money being a strike that is exactly the current market price - in the money being a strike that is below the current market price with regards to call options and a strike that is above the current market price with regards to put options - out of the money being a strike that is above the current market price with regards to call options and a strike that is below the current market price with regards to put options. ATM, ITM, OTM are used as abbreviations.
Equity options expire Saturday immediately following the third Friday of the expiration month. Options trade during the regular market hours of 8:30 a.m. to 3:00 p.m. CST.
A call optiongives the holder the right but not the obligation to buy a certain number of shares at a set (strike) price on or before a predetermined date.
A hypothetical example will highlight conceptually a call option:
I have an ounce of gold and the current market price for an ounce of gold is $1,000. However, you anticipate that the price of gold will increase over the next month. To back up your conviction you offer me $50 to have the right to buy my ounce of gold from me for $1,000 on or before a month's time. I could use the extra $50 and do not anticipate the price of gold increasing by more than $50 over the next month, so I agree to take your $50 with the stipulation that I allow you to buy my ounce of gold for $1,000 if you so choose.
1) Suppose in a month's time currencies crash - uncertainty and fear cause the demand for gold to increase, driving the price up to $2,000 an ounce. Now it will be profitable for you to exercise the deal we had, that is buy my ounce of gold from me for $1,000. After doing so, you can turn around and sell that ounce for the current market price of $2,000, thus making $950 in profit after deducting the $50 spent to arrange this deal. This is a 1,800% gain off the $50 spent buying the right to buy my gold at $1,000 an ounce versus a 100% gain had you just bought an ounce of gold. On the flipside - I will still have your original $50, but will have missed out on the gains I could have had had I never entered into this contract with you.
2) Suppose in a month's time there is a glut of supply of gold - driving the price of gold down to $500 an ounce. It will obviously not be profitable for you to exercise your right to buy my ounce of gold for $1,000, for if you did you would suffer paper losses of $550. The beauty of options is that you bought the right but NOT the obligation to buy my ounce of gold for $1,000. In this scenario, you will just be out the original $50 you spent on the contract. On the flipside - I will still have collected your original $50, but my ounce of gold will be worth the market price i.e. $500. An optimistic way for me to look at it would be as if my ounce of gold is worth $550 since after all I collected $50 from you.
A call option is actually a contract, and there is a market for these contracts. So suppose in the former scenario that the price of gold ramped up to $2,000 an ounce in only a week's time (your contract does not expire for three more weeks). Instead of exercising your contract and making $950 net profit, a possibility is to find someone else to buy the contract. If you do not expect the price of gold to continue to rise, this would be advantageous. Since there are three weeks left until the contract expires - reasonably speaking - your contract should have some added time value to it allowing you to sell it for over $1,000. In other words, your net profit will be greater by selling the contract to someone else than waiting until expiration if gold were to remain equal to or less than $2,000 an ounce.
To delve deeper, I'll explain some details in the real options market. One option contract on a particular stock represents the right to buy 100 shares of the underlying stock. If you pull up an option chain on a particular stock (this can be done through yahoo finance or through an online broker) you will notice strike prices. In our example, the strike price was coincidentally the current market price, i.e. $1,000 an ounce. However, typically there are many different strike prices to choose from, so in the example you could have bought the right to buy my ounce of gold from me at $1,050 or $950 or $500 or $2000 etc. But as the strike price changes, so does the price of the contract - the higher the strike price the cheaper the contract and the lower the strike price the more expensive the contract in regards to call options.
On an option chain, the prices you see represent what it would cost to buy the right to buy one share of the underlying stock. However, generally speaking one contract gives you the right to buy 100 shares, so it is important to remember you will actually be paying the price you see multiplied by one-hundred per option contract.
In concept, to sell short is to borrow and then sell someone else's shares at market prices with the obligation that you must return the same number of shares to the one borrowed from. The short seller could theoretically suffer losses up to infinity as there are no limitations on how high stocks can go, but could also profit if the market price declines. Suppose I allow you to borrow an ounce of gold from me at current market prices of $1,000 an ounce - you in turn sell that ounce of gold to someone else at market prices of $1,000 an ounce. (You now hold $1,000 in cash with the obligation to buy an ounce to return me - buying cheaper than $1,000 will result in profits for you and higher will result in losses for you.)
Now to outline two hypothetical scenarios:
1) The market price of gold declines to $500 an ounce. Now it is profitable for you to buy an ounce of gold at market prices of $500 and return an ounce of gold to me at just that - the market price (since you borrowed the ounce from me, I theoretically still held a long position and would have suffered paper losses anyway). In this scenario you will have made $500, since you sold an ounce for $1,000. You collected $1,000 cash, then spent $500 of that to buy an ounce to return to me. This creates a net gain of $500 - equal to the amount of the decline in the price of gold.
2) The market price of gold advances to $1,500 an ounce. In this scenario, it has not worked out too well for you. For simplicity's sake, let's say you think the price of gold will continue higher - so to not suffer further losses you buy an ounce of gold in the open market for $1,500 to return to me at just that, the market price of $1,500. You will have suffered losses of $500 since you had to pay an out-of-pocket additional $500 after including the $1,000 originally collected. This creates a net loss of $500 - equal to the amount of the advance in the price of gold.
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And so the game continues ad infinitum. By rationally navigating through the pitfalls and perils of a predictably irrational market, consistent alpha finds way to the Keynesian way. He would also say, "In the long run, we're all dead." Thus, we have no time to wait for market efficiency. We must capitalize upon market inefficiency, and thus profit from the fear and greed that plagues the street. We seek financial gain day in and day out in the lucrative realm of the stock market. Join Today.
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John Tepichin talking stocks and options
John Tepichin, a professional day-trader, holds a Bachelor's Degree in Economics from Southern Methodist University. He has been a guest speaker at Paul Quinn College's Economics Department in topics ranging from Money and Banking to Labor Economics. He has also been featured on CNBC numerous times, accurately predicting stock prices on national television after winning 1st place out of four-hundred thousand entrants and a $10,000 cash prize in the CNBC Challenge. John has also been interviewed by Jim Cramer's www.thestreet.com after showing a 54% return in just a few weeks trading in their competition.
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Trading Stock and Options, Exxon Chart
What are options? Here at TEPICHIN capital, you will find promising option trades that typically consist of making directional trades via calls or puts. As you can see in the chart above (click to expand), Exxon increased in price by 3.9% over a 3-day period. However, by playing the options the same move in the stock yielded a 280% return.
Click to view upcomingCATALYSTS
SEP 6, 2010 - SEP 8, 2010 (Data from CNBC)
TUESDAY
Earnings: BEFORE - Caseys General ; AFTER - Navistar, Pep Boys
Other: 3 Yr. Note Auction, Treasury STRIPS
WEDNESDAY
Earnings: BEFORE - Smithfield Foods, United Natural Foods ; AFTER - Shanda Games, Mens Wearhouse
Other: Crude Inventories, Feds Beige Book, Consumer Credit, Bank Reserve Settlement, ICSC Goldman Store Sales, Redbook, Quarterly Services Survey, 10 Yr. Note Auction, Beige Book
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