Flexibility: The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

Net present values (NPVs) calculated from single cash flow projections may be inadequate because they do not take into account the ability to expand or scale back.



Here is a simple example.  

A firm can scale back by eliminating a negative cash flow project after the first period.

There is a 60% probability of $20 per year forever or 40% probability of -$6 per year forever.

The discount rate is 10%.


Without an option to cancel

If the initial cost today is $100, then without an option to cancel, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/0.10) = -$4


With an option to cancel after the first year

With the option to abandon after the first year, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/1.10) = $17.82


The value of the option to cancel the project is the difference, or $21.82



Conclusion:

The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

The real-option valuation (ROV) and decision tree analysis (DTA) are the two primary methods of valuation.

• Both depend on forecasting based on contingent states of the world.
• Although ROV is often a better methodology to use than DTA, it is not the right approach in every case.

Stocks and Bonds

The balance sheet helps us understand the overall financial health of a company.

A major factor in determining financial health is the company's underlying capital structure.

What is the best way to capitalize a company?  Is it equity or debt?  The answer is that it depends, as both debt and equity have their advantages.


Debt

Debt offers the following advantages.

1.   Lenders have no direct claim on future earnings.  Debt can be issued without worries about a claim on earnings.  As long as the interest is paid, the company is fine.

2.  Interest paid on debt can be deducted for tax purposes.

3.  Most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.

4.  Debt does not dilute the owner's interest, and so an owner can issue debt and not worry about a reduced equity stake.

5.  Interest rates are usually lower than the expected return.  If they are not, a change in management can be expected soon.



Debt securities can take a number of different forms, the most common being bonds.

Bonds are obligations secured by a mortgage on company property

Bonds tend to be safer from the investors' standpoint and therefore pay lower interest.

Debentures, in contrast, are unsecured and are issued on the strength of the company's reputation, projected earnings, or growth potential.

Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.




Equity

Equity has the following advantages:

1.  Equity does not raise a company's break-even point.  A company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.

2.  Equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity.  Equity is essentially capital with unlimited life and so a company can issue equity and not have to worry about when it comes due.

3.  There is no need to pledge assets or offer by personal guarantees when equity is issued.



Equity can take a number of different forms.

A simple form of equity is common stock.

This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely.

There are no fixed terms; the stock is issued and the holder bears the stock.

Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation.

Preferred stock may have anti-dilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake.

Convertible securities are highly structured in nature and are based on certain parameters.  As the word convertible indicates, they may convert into other securities.

Among the most common are warrants and options.

Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price.

There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favourable than the current rate of return.

Beginner Strategies for Investment

Investment strategies aren't just about picking the best investments you can find, but about picking investments that are more beneficial together than they are on their own.

Here are some basic strategies to build your investments.

The most common strategy is simple diversification of investments.

For bonds, this means staggering your coupon and maturity dates not only to provide consistent income but also so that you can more readily respond to changes in the market, rather than having the entirety of your bond investments tied up at the same time.

For stocks, this means picking high-quality investments which tend to fluctuate in price in opposite directions; as one stock decreases in value in the short run, another should increase, but both should appreciate over the long run.

In the same manner, including global diversification of stock investments can reduce the impact of global trends.

Diversifying into types of investment you have can help you find an appropriate balance of potential gain and risk - maintaining a percentage of your portfolio in stocks or even high-risk investments like speculative stocks or junk bonds and the remainder of your portfolio in low-risk investments.



Options

Many options make use of a combination of stocks and derivatives.

Buying stocks as well as a put option gives you the upside potential of the stock but limits your potential losses by guaranteeing you will be able to resell the stock at the price noted in the option.  So long as your gains exceed the purchase cost of the put option, you will remain "in the black".

If you believe a stock will decrease in price, you can sell it short and then buy a call option, so that if you are wrong you can repurchase the stock at a guaranteed maximum price, putting a limit on the immense risk associated with shorting stock.

Buying both a call and a put option with the same strike price (the price at which you can exercise your option) means that you will make money regardless of which direction the stock moves, so long as the move is large enough that you earn more money than the cost of the options.  This strategy is known as a "straddle".

In a strategy known as a "collar", you buy a stock and sell a call option on the stock , so that if the price of the stock increase, the option buyer will likely exercise their option; this creates limited upside potential, but the money from the sale of the call option can be used to fund a put option, so that you eliminate the cost of the option.  The result is that you create both a "floor" and a "cap" (a maximum amount of loss and gain, respectively), functioning as a collar that limits the amount of movement in the stock price.

The strategies available to you are varied and numerous.  As you get more practice using them, you can expand to develop multi-step strategies.




[Diversification:  The act of investing in several different investments to reduce the potential value of loss if a single investment fails.

Buying a call option gives you the choice to purchase a given volume of something at a specified price, so long as you do so before the maturity date.

Buying a put option gives you the choice to sell a given volume of something at a specified price.

Regardless of what happens to the market price, the seller of the option is obligated to participate in the exchange if the buyer decides to exercise the option.]

Options - Trading mechanism

If you are optimistic about the underlying, you can buy a call option or write a put option.

If you are negative about the underlying, you can choose to buy a put option or write a call option.



If you are positive about the underlying

If an investor wants to buy a call option, he needs to pay a premium upfront.  In case the underlying price does rise above the strike price, the investor can exercise the option to earn the difference.

If the investor chooses to write a put option, he will receive a premium.  If the underlying price climbs above the strike price, the put option will become worthless (and not exercised), leaving the premium safe in the hands of the investor.  In writing a put option, the investor is required to deposit a margin and face the risk of unlimited loss (in theory), the underlying price can drop to zero).

If you are negative about the underlying

If the investor chooses to buy a put option, he needs to pay a premium upfront.  In case the underlying price does fall below the strike price, the investor can exercise the option to earn the difference.

If the investor chooses to write a call option, and if the underlying price falls below the strike price, he will pocket the full amount of the premium.  On the other hand, if the underlying price is higher than the strike price, he will face the risk of unlimited loss (in theory, the underlying price can go up indefinitely).


Warrants versus Options

In the case of warrants, the investor can only be a buyer, and choose between call warrants or put warrants.  The seller is always the issuer.

While options offer more possibilities, the risk is also much bigger.  In contrast, warrants are only subject to limited risk exposure.

How to benefit from call options?

A call option gives the holder the right to buy 100 shares of the underlying stock at the exercise or strike price up through the date of expiration of the option.

The basic problem is that the stock would have to move up in price above the strike price before the option expires because the option is worth nothing at expiration.

Intrinsic value of call option = Market Price of the Stock - Strike Price

The option premium price fluctuates depending on two factors:( a) the underlying price of the stock, and  (b) the time left until the expiration of the option.

Should you Buy and Sell the Option or the Stock?

Stock Price $35   Option Price $0.50  Strike Price $35

Stock Price rises to $42   Option premium price increases to $7.25

Scenario Analysis

1.  Buying the Stock

Buy 100 shares of the stock at $35 per share    Total Cost  $3,500

Sell 100 shares of the stock at $42 per share     Total Proceeds $4,200

Profit = 4,200 - 3,500 = $700

Return on Investment = 700/3500 = 20%

2.  Buying and Selling the Option

Buy stock option   Total Cost $50

Sell stock option   Total Proceeds  $725

Profit = 725 - 50 = $675

Return on Investment = 675/50 = 1350%

3.  Exercise Option

Buy stock option   Cost $50

Cost to exercise option at strike price   Cost $3,500

Total Cost = 50 + 3500 = $3,550

Sell stock at $42 per share   Total Proceeds $4,200

Profit = 4,200 - 3,550 = $650

Return on Investment 650/3550 = 18.3%

1. Buying and selling the stock, in scenario 1, results in a 20% return.  
2. This is not to be sneezed at, but compared to buying and selling the option in scenario 2, buying and selling the stock comes in as a poor second to a return of 1350%.
3. Comparatively, scenario 3, buying and exercising the option, produces the smallest return of 18.3%.  
4. Moreover, this scenario 3 also requires the largest outlay of capital ($3,550 versus only $50 for the call option and $3,500 to buy the stock).  

Stock Price $35   Option Price $0.50  Strike Price $35

Stock Price falls to $30  

Scenario Analysis

1.  Buying the Stock

Buy 100 shares of the stock at $35 per share    Total Cost  $3,500

Sell 100 shares of the stock at $30 per share     Total Proceeds $3,000

Loss = 3,500 - 3,000 = $500

Return on Investment = -500/3500 = -14.28%

2.  Buying and Selling the Option

Buy stock option   Total Cost $50

Stock option expires  Total Proceeds  $0

As the strike price is above the current price, the intrinsic value of the option is zero.

Loss = cost of buying the option = $ 50 

3.  Exercise Option

Buy stock option   Cost $50

Cost to exercise option at strike price   Cost $ -

As the strike price is above the current price, so the option would not be exercised.  

Loss = cost of buying the option = $50

1. However, if the stock price declines to $30 per share, buying the stock at $35 and selling it at $30 results in a $500 loss and a 14.28% loss (= -500/3500)
2. Buying the stock option and having it expire results in a 100% loss on invested capital and a $50 loss of capital.
3. There is no third alternative; the strike price is above the current price, so the option would not be exercised.  The maximum loss is the cost of the option, $50.

Conclusion:

• Buying and selling the option not only gives the greatest return on investment but also requires the lowest capital outlay.
• By buying a call option instead of the stock, the investor invests a small fraction of the cost of the stock.
• If the stock price rises significantly above the strike price within the period before expiration, the investor can profit by selling or exercising the option.
• In the later case, the investor can then sell the stock or hold it for long-term capital appreciation.
• The most an investor can lose from buying a call option is the cost of the option.
• Thus, the downside risk is limited, as opposed to the potential loss in the case of buying the stock.
• There are many examples of high-flying stocks that have risen to abnormally high prices only to fall back into oblivion, resulting in tremendous losses for those investors who had invested when the stocks were trading at excessively high price.

How to use stock index options?

1. Stock index options allow investors to take long and short positions on the market without having to buy or sell the stocks that make up the index.
2. A stock index option is a put or call written on a market index.
3. Options are offered on most of the major stock market indices.
4. Settlement for stock index options is in cash rather than stocks.
5. If you think the market is going to decline, you can buy a put option.
6. With stock index options you can track the markets without having to buy or sell the stocks.
7. Options on stock indices are valued and trade in the same way as options on individual stocks with the notable exceptions that settlement is made in cash for the former.
8. The use of stock index options can assist individual investors with large stock portfolios to hedge against potential losses.
9. If the investor does not want to sell holdings of appreciated stocks int he portfolio, the investor can protect these gains by buying stock index put options.
10. If the market declines, the stock index puts will rise in value, which will  offset the losses on the individual stocks.
11. Instead, if the investor wrote call options on the stock index resembling the portfolio, the value of the options would decline if the market declined. 
12. The stocks in the portfolio would lose value, but this loss would be offset by the premiums received from writing the call options.

Related:

Options, rights and warrants

Should you bother with options, rights, or warrants?

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Should you bother with options, rights, or warrants?

Options

Options are relatively complicated financial instruments.  Most people lose money using options.   The obvious question is whether you should even bother with using options.

Options do have characteristics that make them unattractive to some investors:

• Options contracts have short lives, and investors could lose their entire investment if the stock price does not change in the predicted direction within the time frame.
• Investors could lose their entire investment even if the stock price moves in the predicted direction after the time frame.
• The risk of loss is not limited when selling uncovered calls or puts.

There are also a number of reasons for using options:

• Investors can profit from using options without having to invest larger amounts to buy the underlying equity.  In other words, investing in options costs a fraction of the cost of buying the stock.
• Returns on invested funds from the use of options is much greater than investing in stocks.  
• The risk of loss is limited to the cost of the premium paid on the option when buying options.
• Mini options were launched on March 18, 2013.  They represent 10 shares of stock, as opposed to regular options contracts, which represent 100 shares, with the aim of creating a broader audience for this market.

Rights and Warrants

Understanding what rights and warrants are can assist investors in determining a course of action when faced with having to make decisions about them.


Related:

Options, rights and warrants

Options, rights and warrants

Options have many uses and investors need to be aware of their ramifications in order to be able to use them.

In order to do so, investors need to familiarize themselves with knowledge about options.

Learning the Vocabulary

Options:  They are stock derivative investments.

Derivative security:  A financial security that derives its value from another security.

Options and futures:  These are stock derivatives that offer investors some of the benefits of stocks without having to own them.

Options contract:  This gives the holder the right to buy or sell shares of a particular common stock at a predetermined price (strike price) on or before a specified date (expiration date).

Option:  An option is a right, not an obligation, to buy or to sell stock at a specified price before or on an expiration date.

Strike price:  The price at which the holder of the option can buy or sell the stock.

Expiration date:  An option expires on its expiration date.

Stock Option:  This is a derivative security because its value depends on the underlying security, which is the common stock of the company.

Options market:  Chicago Board Options Exchange (CBOE), New York Stock Exchange (NYSE), the American Options Exchange (AOE), the Philadelphia Exchange (PHO), and the Pacific Exchange (PSE).  Options can also be traded in the over-the-counter market.

Options websites:  www.cboe.com, www.nyse.com/futuresoptions/nyseamex, www.amex.com, www.phlx.com.  Click on all exchanges and list all options and LEAPS.  Click on Submit, and a list of options for the stock you requested will appear.

Options contracts:  Calls and Puts

Call option:  A call option gives the option owner the right to buy shares of the underlying company at a predetermined price (strike price) before expiration.

Put option:  A put option contract gives the option owner the right to sell shares of the underlying company at the strike price before expiration.

Option holder:  Option holder has the right to convert the contract at his/her discretion.  It is not an obligation.  Holders of the option can exercise the option when it is to their advantage and let the options contract expire if it is not advantageous.

Options contract:  SIX items of note in an options contract.  1.  Name of the company whose shares can be bought or sold.  2.  The number of shares that can be bought or sold, generally 100 shares per contract.  3.  The exercise or strike price, which is the stated purchase or sale price of the shares in the contract.  4.  The expiration date, which is the date when the option to buy or sell expires.  5.  The settlement procedure.  6.  The options exercise style.

Option buyer:  The option buyer is also referred to as the option holder.

Option seller:  The seller of the original contract is referred to as the option writer.  In any contract, there are at least two parties:  buyers and sellers.

Settlement procedure:  This is stipulated for stock options, which indicates when delivery of the underlying common stock takes place after the holder exercises the option.

Options exercise style:  There are two basic exercise styles that determine when the option can be exercised, namely, American style and European style.

American style:  Options on individual stocks can be exercised ANY time before the expiration date.

European style:  Stock index options can be exercised ONLY on expiration date.

Life of the option:  The expiration date is also important, as it specifies the life of the option.

Standardized expiration dates:  The expiration dates are standardized for options contracts listed on the exchanges.  There are three cycles for listed option expirations, and each option is assigned to one of these cycles:  January cycle: January-April-July-October; February:cycle: February-May-August-November; and March cycle: March-June-September-December.

Options Clearing Corporation (OCC):  The trading of options is greatly facilitated by the Options Clearing Corporation, which, besides maintaining a liquid marketplace, also keeps track of the options and the positions of each investor.  Buyers and writers of options do not deal directly with one another but instead with the OCC.

Contract period for stock options:  The contract period for stock options is standardized with three-, six-, and nine-month expiration dates.  Generally, two options on a stock are introduced to the market at the same time with identical terms except for the strike (exercise) price.

LEAPS (long-term equity anticipation securities):  Longer-term options contracts, called LEAPS have life spans of up to three years before expiry.  They have similar characteristics to the short-term options contracts but, because of their longer expiration periods, have higher premium prices.

Time value of an option:  An option is a wasting asset.   There is a time value to the price of an option.  The more time before the option expires, the greater is the time value of the option.  As the option moves closer to its expiration, so the time value of the option decreases in value.  Generally, options are not normally exercised until they are close to expiry because an earlier exercise means throwing away the remaining time value.  Another generalization with options (both calls and puts) is that most options are not bought with the intention of exercising them.  Instead, they are bought with the intention of selling them.

Intrinsic value of the call option:  The intrinsic value of a call option is the difference between the market price of the stock and the strike price.  Intrinsic Value of Call Option = Market Price of the Stock - Strike Price.

In the money call option:  When the market price is greater than the strike price, the call option is said to be in the money.

Out of the money call option:  A call option is said to be out of the money when the market price of the stock is less than the strike price.

At the money call option:  The market price of the option equals the strike price.

Time value of put option:  Puts are wasting assets and have no value at expiration.

Intrinsic value of put option:  The intrinsic value of the put option is determined by subtracting the market price of the stock from the strike price.  Intrinsic Value of a Put Option = Strike Price - Market Price of the Stock.

Out of the money put option:  If the put option has no intrinsic value, it is out of the money.

In the money put option:  If the put option has intrinsic value, it is in the money; and it is profitable to exercise the put option.

At the money put option:  If the strike price equals the market price of the stock, the option is at the money.

Writing options:  Investors can also write or sell options, which provide additional income from the premiums received from the buyers of the option contracts.  The upside potential to this strategy for option writers is limited, however, because the most money the writer can make is the amount of the option premium.

Writing covered option:  A covered option is an option that is written against an underlying stock that is owned, or sold short, by the writer.  The writer of the option owns the stock against which the options are written.

Writing naked option:  This is the second method of writing an option.  A naked option, is  an option written on an underlying stock that is not owned or sold short by the writer.

Writing covered calls:  A covered call limits the appreciation the writer can realize.  Therefore, it is a good idea to write covered calls on the stocks you think won't rise or fall very much in price.

Writing naked call:  Writing a naked call on a stock is more risky than writing a covered call because of the potential for unlimited losses.  A naked call is when the writer does not own the underlying stock, which would limit the losses if the stock rocketed up in the price.  Investors can profit from writing naked calls on stocks whose prices either decline or remain relatively flat below the strike price for calls.

Writing covered puts:  The writer of a covered put sells short the underlying stock and receives a premium for the covered put.  If the option is exercised, the writer would buy back the stock at the strike price and use the shares to close out his short position.

Writing naked puts:  The writer of a put option expects the stock to rise or at best not fall in price.  If the put writer does not own the underlying stock, the contract is a naked or uncovered put, which necessitates that the writer deposits an amount of money with the brokerage firm for the required margin.Without owning the underlying stocks, the potential loss is not cushioned if the price of the stock falls rapidly.

Combination of Puts and Calls:  Straddle and Spread

Straddle:  A straddle is the purchase (or sale) of a put and a call with the same strike price and the same expiration date.

Spread:  A spread is the purchase or sale of a combination of put and call options contracts with different strike prices.

Stock Index Options:  Stock index options allow investors to take long and short positions on the market without having to buy or sell short the stocks that make up the index.  A stock index option is a put or call written on a market index.  With stock index options you can track the markets without having to buy or sell the stocks.  Options on stock indices are valued and trade in the same way as options on individual stocks with the notable exceptions that settlement is made in cash for the former.

Rights:  A right, also known as a preemptive right, is an option allowing a shareholder to by additional shares of new stock of the company at a specified price within a specified time period before the shares are offered to the public.  A right allows a current shareholder to buy more common stock of the company in advance of the public at a discounted price (subscription price).  Stock rights are issued to existing shareholders on a stated date.  These rights give existing shareholders the opportunity to maintain their same proportionate ownership in the company after the new issue of common stock.  Rights, like options, can be bought for one of two reasons:  either to exercise the rights or to speculate on the rights.

Trading cum rights:  To be eligible to buy these additional shares at the subscription price, the common stock of the company must be owned as of the record date set by the board of directors.  Most rights offering have a short period of time (between two and six weeks) for existing shareholders to either subscribe to the new shares or sell the rights.  It is during this period that the stock is said to be trading cum rights, where the value of the right is included in the market price of the stock.

Trading ex-rights date:  After a specified date, known as the ex-rights date, stock transactions do not include the rights.  Theoretically, the stock price goes down after this date, when the rights trade separately.
Value of a right:  The value of a right depends on the market price of the stock, the subscription price of the right, and the number of rights necessary to buy each new share.

Cum Rights Value:  The formula to determine the value of the rights before they trade independently of the stock is as follows:  Cum Rights Value = (Market Price of Stock - Subscription Price) / (Number of Rights to Buy a Share + 1)

Ex-rights Value:  After the stock trades ex-rights, its price declines by the value of the right, because rights trade separately from the stock.  Investors who want to buy the rights can purchase them on the market in the same way they can purchase the stock.  The ex-rights value is calculated as follows;  Ex-rights Value = (Market Price of Stock - Subscription Price) / (Number of Rights Needed to Buy a Share)

Warrants:  A warrant is a security that allows its owner to purchase a stated number of shares of common stock at a specified price within a specified time period.  A warrant is similar to a long-term option in that it gives the owner the right to by a stated number of shares of the underlying company's stock at a specific price within a specific period of time.  The differences between warrants and options are that with warrants the specified price can be fixed or it can rise at certain intervals, such as every five years, and the company can extend the expiration date.  Warrants have longer lives than options.  An option can have a life of nine months or less; warrants extend for years, and some companies have issued perpetual warrants.  Generally, there is a waiting period before warrants can be exercised.  Corporations issue warrants as sweeteners with other securities issued by the company.  Warrants can be attached to bonds or preferred stocks.  In some cases, warrants have been distributed to shareholders in place of stock or cash dividends.   The major advantage of warrants over options is that warrants have longer lives.  Warrants do well when stock prices are rising, but investors should still be selective about the warrants they buy.  If the stock never goes up in price, there is little to no opportunity to profit from buying the warrants.  Generally, as with options, warrants should be bought to trade and not to exercise.

Value of a warrant:  When a company issues warrants, the purchase price of the stock is generally fixed at a higher price than the market price of the stock at issue.  Value of a warrant = (Market price of stock - Exercise price ) x (Number of shares purchased with the warrant).

Premium of a warrant:  Premium = Market price of the warrant - Value of the warrant.  If the market price of the stock never rises to the strike price of the warrant during its life, the warrant is not exercised and expires.



Related:
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A look at the Options table

Let's take a look at the Options table:

Column 1: Strike Price. This is 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. When you exercise a call option, this is the value for which you purchase the shares. Option strike prices typically move in increments of $2.50 or $5. In the example above, the strike price moves in $2 increments.

Column 2: Expiry Date. This shows the end of the life of an options contract. Options expire on the third Friday of the expiry month.

Column 3: Call or Put. This column refers to whether the option is a call or a put. A call is the option to purchase, whereas a put is the option to sell.

Column 4: Volume. This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table.

Column 5: Bid. The price someone is willing to pay for the options contract. To get the cost of one contract you need to multiply the price by 100.

Column 6: Ask. The price for which someone is willing to sell an options contract. To get the cost of one contract you need to multiply the price by 100.

Column 7: Open Interest. Open interest is the number of options contracts that are open. These are contracts that have not expired or have not been exercised.

Read more: http://www.investopedia.com/university/tables/tables6.asp#ixzz28JFzYsK6

Basic Options Concepts: Intrinsic Value and Time Value

Intrinsic value and time value are two of the primary determinants of an option's price.

Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time. 

The following equations will allow you to calculate the intrinsic value of call and put options:

Call Options: Intrinsic value = Underlying Stock's Current Price - Call Strike Price Time Value = Call Premium - Intrinsic Value
Put Options: Intrinsic value = Put Strike Price - Underlying Stock's Current Price Time Value = Put Premium - Intrinsic Value

ATM and OTM options don't have any intrinsic value because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration.

The intrinsic value of an option is not dependent on the time left until expiration. It is simply an option's minimum value; it tells you the minimum amount an option is worth.

Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time. In other words, the time value of an option is directly related to how much time an option has until expiration. 

• The more time an option has until expiration, the greater the option's chance of ending up in-the-money. 
• Time value has a snowball effect. 
• If you have ever bought options, you may have noticed that at a certain point close to expiration, the market seems to stop moving anywhere. 
• That's because option prices are exponential-the closer you get to expiration, the more money you're going to lose if the market doesn't move. 

On the expiration day, all an option is worth is its intrinsic value. It's either in-the-money, or it isn't.



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How is Option Priced?

There are 6 factors that affect option's price.  Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors.  Most of the time, for each level of strike price, an option's price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

Since option's buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.  

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option's position.

Example:  

Increase in Implied Volatility (IV) would increase option's price (both calls & puts), assuming other factors unchanged.  Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

http://optionstradingbeginner.blogspot.com/2007/05/option-pricing-how-is-option-priced_22.html

Margin of Safety Concept in Conventional and Unconventional Investments

 Extension of the Concept of Investment

To complete our discussion of the margin-of-safety principle we must now make a further distinction between conventional and unconventional investments. 

Conventional investments are appropriate for the typical portfolio. 

• Under this heading have always come United States government issues and high-grade, dividend paying common stocks. 
• We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features. 
• Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States savings bonds.

Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. 

• The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two-thirds or less of their indicated value. 
• Besides these, there is often a wide choice of medium-grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value. 
• In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first quality rating is synonymous with a lack of investment merit.

It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification. 

• For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment. 
• Our favorite supporting illustration is taken from the field of real-estate bonds. 
• In the 1920s, billions of dollars’ worth of these issues were sold at par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character. 
• In the depression of the 1930s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some cases below 10 cents on the dollar. 
• At that stage the same advisers who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type. 
• But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe—for the true values behind them were four or five times the market quotation.*

The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. 

• The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment. 
• They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. 
• Thus the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.†

The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid.  Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation.

To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of  “commonstock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.)* 

• The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. 
• At the moment they have no exercisable value. 
• Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. 
• Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss. 
• If that is so, there is a safety margin present even in this unprepossessing security form. 
• A sufficiently enterprising investor could then include an option-warrant operation in his miscellany of unconventional investments.1

* Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough. 

† The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.

* Graham uses “common-stock option warrant” as a synonym for “warrant,” a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)

Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment



Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

Rule No. 1: Do Not Lose Money. How Warren Buffett avoids yearly losses in his entire portfolio?

Avoiding losses is probably the most important tool for long-term success in investing. No investor, even Buffett, can avoid periodic losses on individual stocks. Even, if you resigned yourself to buying only at incredibly cheap prices, occasional mistakes will still occur. What differentiates Buffett from nearly all other investors is his ability to avoid yearly losses in his entire portfolio.






How Warren Buffett avoids yearly losses in his entire portfolio?


Warren Buffett would rather not place his faith in the hands of investors and traders. The methods he uses to lock in yearly gains take the market out of the equation.

He reckons that if he can guarantee himself returns, even in poor markets, he will ultimately be way ahead of the game. 
To learn more, we should focus on how Buffett best avoids losses.

These include:

Timing the market. He is not concerned about the day-to-day fluctuations in the stock market. However, Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.

Convertibles. Some of Buffett's most lucrative investments in the late 1980s and early 1990s involved convertibles, which are hybrid securities that possess features of a stock and an income-producing security such as a bond or preferred stock.

Options. On a number of occsions, Buffett has expressed his disdain for derivative securities such as futures and options contracts. Because these securities are bets on shorter-term price movements within a market, they fall under the definition of "gambling" rather than of "investing." If Warren Buffett does dabble in options, and few doubt he could dabble successfully, he does so quietly. He once acknowledged writing put options on Coca-Cola's stock; at the time he was thinking of adding to his stake in the soft-drink company.

#Arbitrage. Not only did Buffett continue to beat the major market averages, but he suffered few single-year declines along the way. That second accomplishment is, by far, the more remarkable. Buffett's scorecard shows that he has increased the book value of Berkshire Hathaway's stock 35 consecutive years. In only 4 years, did the S&P 500 Index beat the growth of Berkshire's equity. Right from the start of his investment management career, Buffett resorted extensively to takeover arbitrage (the trading of securities involved in mergers) to keep his portfolio results positive. In poor market years, arbitrage activities have greatly enhanced Buffett's performance and keep returns positive. In strong markets, Buffett has exploited the profit opportunities of mergers to exceed the returns of the indexes.Benjamin Graham, Buffett's mentor, had made arbitrage one of the keystones of his teachings and money management activities at Graham-Newman between 1926 and 1956. Graham's clients were informed that some of their money would be deployed in shorter term situations to exploit irrational price discrepancies. These situations included reorganizations, liquidations, hedges involving convertible bonds and preferred stocks, and takeovers.


----

There are only 3 ways an investor can attain a long-term, loss-free track record:

1. Buy short-term Treasury bills and bonds and hold them to maturity, thereby locking in 4 to 6 percent average annual gains.

2. Concentrate on private-market investments by buying properties that consistently generate higher profits and that can sell for greater prices each year.

3. Own publicly traded securities and minimise your exposure to price fluctuations by devoting some of the portfolio to unconventional "sure things (arbitrages).# "




Also read:

Focus on how Buffett best avoids losses

http://myinvestingnotes.blogspot.com/2009/09/list-your-top-5-rules-for-success-in.html

5 "New" Rules for Safe Investing

1. Buy and Hold
History has repeatedly proved the market's ability to recover. The markets came back after the bear market of 2000-2002. They came back after the bear market of 1990, and the crash of 1987. The markets even came back after the Great Depression, just as they have after every market downturn in history, regardless of its severity.

Assuming you have a solid portfolio, waiting for recovery can be well worth your time. A down market may even present an excellent opportunity to add holdings to your positions, and accelerate your recovery through dollar-cost averaging Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/buy-and-hold.aspx#ixzz1ZC8MiDKw


2. Know Your Risk Appetite
The aftermath of a recession is a good time to re-evaluate your appetite for risk. Ask yourself this: When the markets crashed, did you buy, hold or sell your stocks and lock in losses? Your behavior says more about your tolerance for risk than any "advice" you received from that risk quiz you took when you enrolled in your 401(k) plan at work.

Once you're over the shock of the market decline, it's time to assess the damage, take at look what you have left, and figure out how long you will need to continue investing to achieve your goals. Is it time to take on more risk to make up for lost ground? Or should you rethink your goals? Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/risk-appetite.aspx#ixzz1ZC8qhVwu

3. Diversify
Diversification is dead … or is it? While markets generally moved in one direction, they didn't all make moves of similar magnitude. So, while a diversified portfolio may not have staved off losses altogether, it could have helped reduce the damage.

Holding a bit of cash, a few certificates of deposit or a fixed annuity along with equities can help take the traditional strategic asset allocation diversification models a step further.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/diversify.aspx#ixzz1ZC921poy

4. Know When to Sell
Indefinite growth is not a realistic expectation, yet investors often expect rising stocks to gain forever. Putting a price on the upside and the downside can provide solid guidelines for getting out while the getting is good. Similarly, if a company or an industry appears to be headed for trouble, it may be time to take your gains off of the table. There's no harm in walking away when you are ahead of the game. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/know-when-to-sell.aspx#ixzz1ZC9IVW7b

5. Use Caution When Using Leverage
As the banks learned, making massive financial bets with money you don't have, buying and selling complex investments that you don't fully understand and making loans to people who can't afford to repay them are bad ideas.

On the other hand, leverage isn't all bad if it's used to maximize returns, while avoiding potentially catastrophic losses. This is where options come into the picture. If used wisely as a hedging strategy and not as speculation, options can provide protection. Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/leverage.aspx#ixzz1ZC9XvuWx

Everything Old Is New Again
In hindsight, not one of these concepts is new. They just make a lot more sense now that they've been put in a real-world context.

In 2009, the global economy fell into recession and international markets fell in lockstep. Diversification couldn't provide adequate downside protection. Once again, the "experts" proclaim that the old rules of investing have failed. "It's different this time," they say. Maybe … but don't bet on it. These tried and true principles of wealth creation have withstood the test of time.
Read: 5 "New" Rules For Safe Investing

Read more: http://www.investopedia.com/slide-show/5-new-rules/old-is-new.aspx#ixzz1ZC9pYbAD

Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a disciplined approach and using diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing rewarding - even in the worst of times.

Read more: http://www.investopedia.com/slide-show/5-tips-for-diversifying-your-portfolio/conclusion.aspx#ixzz1ZCCNZVfl

Options Usage in Equity Portfolio Management

Options are a financial instrument that can be considered whenever equity fund managers seek to:

•  Generate extra returns: by writing options and collecting premium income when your market view is that you are happy to cap upside
• Reduce risk: by buying put options as insurance, or by writing premium income which cushions downside price moves
• Reduce transactions costs: by gaining exposure to stocks or an index using options, rather than paying full stock transactions costs
• Reduce market impact costs of acquiring stock: by accumulating exposure via options, and then selling those options when the required stock weight has been reached. 
• Capital gains implications: because you can effectively sell stock by selling call options, capital gains implications can be managed.

The diagram bellow demonstrates how equity portfolio managers can expand the range of portfolio outcomes by using various options strategies. 

The yellow (centre) choices of neutral, long or short stock can be augmented by a range of strategies that enhance yield (blue circles) and that protect the portfolio (red circles).

http://www.asx.com.au/products/indices/types/buy_write/options_portfolio_mgmt.htm

Strategies to Make Money in The Stock Market

One great way to grow your money is to invest into the stock market. But deciding how to invest into it can be a bit tricky. Everyone is different, but there are 5 strategies that all traders use to make money in the market.

1. Buying and Holding for the Long Term

Everybody knows what buy and hold is. In fact the vast majority of market participants buy stocks and hold onto them for the long term. And it does make sense, stocks do go up over the long term, so buying and holding can be a passive way to grow your money.

2. Trading The Trend

One other strategy is called trend trading. It involves buying stocks that are going up and selling stocks that are not going up. While it might sound like it was invented by a 5 year old it really can work if you get the hang of it. Sometime the simplest answer is the best.

3. Swing Trade

Swing traders use technical indicators to buy and sell stocks in the short term in order to make profit when all is said and done. Any trade that takes over 1 day and has a profit target as well as a stop loss can be considered to be a swing trade.

4. Options

Stock options give investors a way to leverage their money and to make huge returns from the stock market. There is only one problem; they can also give traders huge losses. For that reason it is best to only consider options after you are already profitable trading stocks.

5. Day Trading Stocks

Day trading is exactly what the name suggests. You buy and sell stock within one day in order to make money on the small moves that occur throughout the day. Day traders are not always profitable, but over the long term it can be a great way to make money.

Every strategy has its ups and downs. But it is up to the individual trader to determine which one fits them the best. Learning the basics of each and experimenting with them can help you determine how you want to approach the market.

http://www.freefinancialtoday.com/2010/03/20/strategies-to-make-money-in-the-stock-market/

An Introduction to Stock Options

An Introduction to Stock Options

Stock options provide advanced investors with additional opportunities for potentially rewarding returns. But stock options do possess risks that require an in-depth understanding of how they work. This article provides a basic overview of stock options.

Before You Start
Pull out all paperwork describing your workplace benefits coverage to learn whether your employer grants stock options to employees.
Review the expiration dates on any stock options you currently own.
Review the buy/sell prices for your stock options.

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Topics
An Introduction to Stock Options
The Basics of Stock Options
Components of an Option's Value
Employee Stock Options
Consider Option Strategies Carefully

1 An Introduction to Stock Options
Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options

• to hedge against a price decline,
• to lock in a future purchase price, or
• to speculate on the future price of a stock.

Employees may also receive stock options through an employee compensation plan. For employees, stock options represent the potential for growth in value and the possibility that the increase in value will be taxed at a favorable capital-gains tax rate.Back to top

2 The Basics of Stock Options
A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike or exercise price. The right to exercise lasts for a stated period of time, which may be months or years, until the expiration date. If not exercised on or before the expiration date, the option expires.
Options come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock. For example, if a stock is trading at $100 per share and you hold a call option entitling you to buy the stock at $72 per share, your option has an immediate value to you of $100 - $72 = $28, before taking into account any tax consequences or transaction fees.
A put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with a strike price of $90 and the stock price moves to $80, you may choose to exercise the option and sell the underlying stock at $90 for an immediate unrealized per share gain of $90 - $80 = $10.
With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk -- if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received. Back to top

3 Components of an Option's Value
Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The price of an option at any given time is based on several factors, including the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.
Intrinsic value -- the intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive.
Volatility -- part of an option's value reflects the volatility of the underlying security. If a stock price is highly volatile, there is a relatively greater chance that the option will be "in the money" at expiration, and therefore, the option will carry a higher premium than an option on a less a volatile stock.
Time value -- the more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the value of the option. Time value diminishes as the expiration date of the option approaches.
Interest rates -- the option premium is a cash payment that can be invested by the option seller to generate interest income. Higher interest rates present opportunities for potentially greater earnings on the option premium.
Intrinsic value, volatility, and time value can significantly affect an option's market value. An option with an exercise price above the current market value of the underlying security may still have considerable potential value.
For example, if you hold a call option with an exercise price of $72 and the current share price is $65, your option would generate a loss if it were exercised today. However, as stated above, option contracts typically are valid for months or years, until the stated expiration date. The time value of the call option is the potential that the share price will rise over time and eventually exceed the option exercise price. Back to top

4 Employee Stock Options
Employee stock options are call options granted by an employer as part of an employee compensation plan. There are two main types of employee stock options: incentive stock options and nonqualified stock options. Incentive stock options offer special income tax benefits to the employee.
An incentive stock option (ISO) must meet a number of criteria to qualify for favorable tax treatment. As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. The tax is applied at the sale of the stock. If you don't meet the one-year holding-period requirement, the transaction is considered a "disqualifying disposition" and your gains are taxed as ordinary income.
A nonqualified stock option (NSO) is an option that doesn't meet the ISO criteria. Gains on NSOs are taxed as ordinary income at the time of exercise.

OPTION TERMINOLOGY
Call option
An option that gives the option buyer the right to purchase the underlying security.
Exercise date
The date by which the option must be exercised.
Expiration date
The date that the option will expire (same as the exercise date).
Intrinsic value
The difference between the strike price and the current price of the underlying security.
Premium
An upfront fee paid by the option buyer to the option seller.
Put option
An option that gives the option buyer the right to sell the underlying security.
Strike price
The stated price at which the underlying security can be purchased or sold (also called the exercise price).
Time value
The component of an option's price that reflects the time left to expiration.
Volatility
The tendency of the underlying security to fluctuate in price.Back to top

5 Consider Option Strategies Carefully
Options are leveraged investments that can offer significant potential advantages and risks. As part of an overall investment strategy, put and call options may offer opportunities to temporarily alter the risk/return characteristics of a portfolio. Before investing in options, it is important to thoroughly understand the potential risks and benefits. You should consult a qualified tax advisor as to how option transactions may affect your tax situation. If you are an employee and have received stock options as employee compensation, you will want to carefully consider how exercise of your options may affect your cash flow and tax liability.Back to top

Summary
An option is a contract entitling the option purchaser to buy or sell the underlying stock at the stated exercise price. A call option gives the holder the right to buy the underlying stock; a put option gives the holder the right to sell the underlying stock.
The option purchaser's risk on the option is limited to the premium paid; the option seller's risk on the option is potentially unlimited.
A call option is valuable to the extent that the exercise price is below the market value of the underlying stock at the time you choose to exercise the option by buying shares. The time value of the option is the potential that the share price will rise over time and eventually exceed the option exercise price.
Employee stock options may be tax-qualified incentive stock options (ISOs) or nonqualified stock options (NSOs). If shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. If you don't meet the one-year holding-period requirement, the transaction is considered a disqualifying disposition and your gains are taxed as ordinary income.
Before implementing an investment strategy using options or before entering into any equity arrangements with an employer, consult your tax advisor.

Checklist
Check the current share prices of the stocks associated with your stock options.
Confirm that you've met holding-period requirements before using employee stock options in order to qualify for more favorable tax treatment.
Conduct a comprehensive investment portfolio review to make sure that your options are part of a well-diversified overall asset allocation.
Consider meeting with a tax advisor or financial professional to understand how your options could affect your tax and investment strategies.

http://finance.yahoo.com/how-to-guide/career-work/12827;_ylt=Apv84a87_jfeohFOdDH4hya7YWsA#c1