Insider Buying and Management Stock Options Can Signal Opportunity

In their search for complete information on businesses, investors often overlook one very important clue. In most instances no one understands a business and its prospects better than the management. Therefore investors should be encouraged when corporate insiders invest their own money alongside that of shareholders by purchasing stock in the open market.

It is often said on Wall Street that there are many reasons why an insider might sell a stock (need for cash to pay taxes, expenses, etc.), but there is only one reason for buying. 

Investors can track insider buying and selling in any of several specialized publications, such as Vickers Stock Research.

The motivation of corporate management can be a very important force in determining the outcome of an investment. 

• Some companies provide incentives for their managements with stock-option plans and related vehicles.  Usually these plans give management the specific incentive to do what they can to boost the company's share price. 
• While management does not control a company's stock price, it can greatly influence the gap between share price and underlying value and over time can have a significant influence on value itself. 
• If the management of a company were compensated based on revenues, total assets, or even net income, it might ignore share price while focusing on those indicators of corporate performance.
• If, however, management were provided incentives to maximize share price, it would focus its attention differently. 

For example, the management of a company whose stock sold at $25 with an underlying value of $50 could almost certainly boost the market price by announcing a spinoff, recapitalization, or asset sale, with the result of narrowing the gap between share price and underlying value. The repurchase of shares on the open market at $25 would likely give a boost to the share price as well as causing the underlying value of remaining shares to increase above $50.

Obviously investors need to be alert to the motivations of managements at the companies in which they invest.

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

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

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.

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