Is gold such a wonderful long-term investment?
Gold price was fixed for more than 100 years at US $20.65 an ounce. Its price in 1932 was US $20.69 an ounce.
Based on a price of US $ 744.84 in 2007, the price has doubled 5.25 times in the past 75 years.
{The annual compounding rate using the rule of 72 is [(72/75) x 5.25] = 5.04 per cent (actual rate = 4.89 per cent per annum.)}
In real-money terms, the price of gold has barely kept pace with the rate of inflation. So there has been little real-money value capital appreciation in the value of gold over the past 75 years.
If you go back much further, its real-money value has deflated.
Why? Very little gold is consumed - once produced it remains in circulation as jewellery or bullion, so annual production continues to add to availability.
Wednesday 5 November 2008
Stock market as a conduit for transferring wealth
The stock market is a conduit for transferring wealth from those who confuse price with value to those who do not, and from the impatient to the patient.
An investor, armed with knowledge of what their stock is worth, will sit tight and ony buy and sell when the price created by speculative traders is most advantages. Real investors don't generate a lot of brokerage fees.
Also, if a recommendation by advisory newsletters is not accompanied by an assessment of value and the business performance that created the value, a stock can only be bought on faith and sold on ignorance.
An investor, armed with knowledge of what their stock is worth, will sit tight and ony buy and sell when the price created by speculative traders is most advantages. Real investors don't generate a lot of brokerage fees.
Also, if a recommendation by advisory newsletters is not accompanied by an assessment of value and the business performance that created the value, a stock can only be bought on faith and sold on ignorance.
Irrationality of the Efficient Market Hypothesis
Buffett gratefully acknowledges the irrationality of the efficient market hypothesis:
".....these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore, calculations of business value - and even thought itself - were of no importance in investment activities. We are enormously indebted to those academics: what could be more advantageous in an intellectual contest - whether it be bridge, chess, or stock selection - than to have opponents who have been taught that thinking is a waste of energy? .. it's like telling a bridge player that it doesn't do any good to look at the cards."
------
Although business performance is likely to be far from fixed or stable, most listed companies have an average price variation in the course of a 12-month period of about 40 to 50 percent (meaning that the difference between the 12-month high and low prices is about 40 to 50 percent of the low price). One would need to be exceedingly credulous to believe that, on average, the value of a business varies by 40 to 50 per cent every 12 months.
When a stock market falls 10 per cent or more overnight, does this mean that the value of all businesses comprising the market decclines by an average of 10 per cent while we sleep? When the Australian market fell 50 per cent in 51 days in 1987, was market pricing correct both before and after prices declined?
--------
However, one should not assume that the market is always wrong. In fairness to believers in EMH, it should be acknowledged that mispricing also results from
".....these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore, calculations of business value - and even thought itself - were of no importance in investment activities. We are enormously indebted to those academics: what could be more advantageous in an intellectual contest - whether it be bridge, chess, or stock selection - than to have opponents who have been taught that thinking is a waste of energy? .. it's like telling a bridge player that it doesn't do any good to look at the cards."
------
Although business performance is likely to be far from fixed or stable, most listed companies have an average price variation in the course of a 12-month period of about 40 to 50 percent (meaning that the difference between the 12-month high and low prices is about 40 to 50 percent of the low price). One would need to be exceedingly credulous to believe that, on average, the value of a business varies by 40 to 50 per cent every 12 months.
When a stock market falls 10 per cent or more overnight, does this mean that the value of all businesses comprising the market decclines by an average of 10 per cent while we sleep? When the Australian market fell 50 per cent in 51 days in 1987, was market pricing correct both before and after prices declined?
--------
However, one should not assume that the market is always wrong. In fairness to believers in EMH, it should be acknowledged that mispricing also results from
- accounting fraud,
- profit misrepresentation,
- a company's false or incorrect profit projections and
- recommendations of analysts that on occasion have been shown to be intentionally fraudulent.
Saturday 1 November 2008
Disparity between Price and Value
"The business performance creates the value - the price creates the opportunity."
We are taught that value is the price a willing but not anxious vendor is prepared to accept and a buyer is prepared to pay. However, such a definition applies to collectables, commodities and resources that are subject to variations in supply and demand.
Although stock prices are also generated by supply and demand, their value is not. Positive sentiment will increase demand (optimistic buyers) and reduce supply by limiting the number of willing sellers, while negative snetiment will have the opposite effect.
Although few would support the notion that the value of a financial security such as a stock is determined by the influence on prices of greed, fear, optimism and pessimism (market sentiment), reality implies the opposite.
At his breakfast meeting address to the Philanthropy Roundtable on 10th November, 2000, Charlie Munger said:
"It is an unfortunate fact that greed and foolish excess can come into prices of common stocks in the aggregate. They are valued (priced) partly like bonds, based on roughly rational projections of value in producing future cash. But they are also valued (priced) partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far. This situation, combined with big 'wealth effects', at first up and later down, can conceivably produce much mischief."
Let us try to investigate this by a 'thought experiment'. One of the big British pension funds once bought a lot of ancient art, planning to sell it ten years later, which it did at a modest profit. Suppose all pension funds purchased ancient art, and only ancient art with all their assets. Wouldn't we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences? And wouldn't this mess be bad if only half of all pension funds were invested in ancient art? And if half of all stock value became a consequence of mania, isn't the situation much like the case wherein half of pension assets are in ancient art?
One thing we know with absolute certainty is that stock prices and their value can vary hugely. If price and value were synonymous, all stocks whose future business performance was in accordance with market expectations would produce similar long-term investment returns - a notion tha is contemporaneously accepted as valid, although universally acknowedged in retrospect as false. Market commentators who fail to recognise this by referring to market prices as valuations, are by inference treating stocks as common commodities.
Althoug prices are deemed to reflect consensus, it should be remembered that prices are determined not by the majority of shareholders who are uninterested in buying or selling at the current temporary price, but by the tiny minority who are.
Following the adage that says it's impossible to be reasoned out of a belief that we were never reasoned into in the first place, if stocks are bought without reference to value, they will in turn be sold without reference to value.
Warren Buffett says:
"What could be more exhilarating than to participate in a bull market in which the reward to the owners of the business become gloriously uncoupled from the plodding performance of the business themselves? Unfortunately, however, stocks can't outperform businesses indefinitely."
When prices increase at a greater rate than can be justified by business performance, they must eventually stagnate until the value cathces up or they must retreat in the directions of the value. Only when a stock is bought at less than its value can price increases that exceed incremental increases in value be justified.
It is useful to understand some of the reasons for the disparity between price and value.
We are taught that value is the price a willing but not anxious vendor is prepared to accept and a buyer is prepared to pay. However, such a definition applies to collectables, commodities and resources that are subject to variations in supply and demand.
Although stock prices are also generated by supply and demand, their value is not. Positive sentiment will increase demand (optimistic buyers) and reduce supply by limiting the number of willing sellers, while negative snetiment will have the opposite effect.
Although few would support the notion that the value of a financial security such as a stock is determined by the influence on prices of greed, fear, optimism and pessimism (market sentiment), reality implies the opposite.
At his breakfast meeting address to the Philanthropy Roundtable on 10th November, 2000, Charlie Munger said:
"It is an unfortunate fact that greed and foolish excess can come into prices of common stocks in the aggregate. They are valued (priced) partly like bonds, based on roughly rational projections of value in producing future cash. But they are also valued (priced) partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far. This situation, combined with big 'wealth effects', at first up and later down, can conceivably produce much mischief."
Let us try to investigate this by a 'thought experiment'. One of the big British pension funds once bought a lot of ancient art, planning to sell it ten years later, which it did at a modest profit. Suppose all pension funds purchased ancient art, and only ancient art with all their assets. Wouldn't we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences? And wouldn't this mess be bad if only half of all pension funds were invested in ancient art? And if half of all stock value became a consequence of mania, isn't the situation much like the case wherein half of pension assets are in ancient art?
One thing we know with absolute certainty is that stock prices and their value can vary hugely. If price and value were synonymous, all stocks whose future business performance was in accordance with market expectations would produce similar long-term investment returns - a notion tha is contemporaneously accepted as valid, although universally acknowedged in retrospect as false. Market commentators who fail to recognise this by referring to market prices as valuations, are by inference treating stocks as common commodities.
Althoug prices are deemed to reflect consensus, it should be remembered that prices are determined not by the majority of shareholders who are uninterested in buying or selling at the current temporary price, but by the tiny minority who are.
Following the adage that says it's impossible to be reasoned out of a belief that we were never reasoned into in the first place, if stocks are bought without reference to value, they will in turn be sold without reference to value.
Warren Buffett says:
"What could be more exhilarating than to participate in a bull market in which the reward to the owners of the business become gloriously uncoupled from the plodding performance of the business themselves? Unfortunately, however, stocks can't outperform businesses indefinitely."
When prices increase at a greater rate than can be justified by business performance, they must eventually stagnate until the value cathces up or they must retreat in the directions of the value. Only when a stock is bought at less than its value can price increases that exceed incremental increases in value be justified.
It is useful to understand some of the reasons for the disparity between price and value.
Value assessment does not rely on precision
Investing is the intention to seek a required rate of return (RR) relative to risk, based on an assessement of value.
The deployment of capital in the absence of assessment of value is called speculation.
Value investing can be defined as buying a share at a price lower than its calculated value. Only investors who have the ability to calculate value can call themselves "value investors"
The very factor on which investing is based, namely value, is little understood, and therefore nearly always ignored.
Warren Buffett once said: "I'd rather be approximately right than precisely wrong."
Stock valuation is subjective in that it requires a judgement of the sustainability of past profitability and is therefore far from being an exact science. Like price, value will not increase in neat, even increments year after year, but will vary with the changing fortunes of the business.
An assessment of value is determined by making forward assumptions of a business's performance based on its historical performance. Depending on the current outlook for the business and its future prospects, the adopted performance criteria (APC) may differ from thsoe that past performance indicates. One also needs to make an assessment of the RR to compensate for many factors. The adopted assumptions are then used to calculate the value, the preciseness of which is not as important as being, as Buffett suggests, "approximately right."
As essential as valuation is in determining the margin of safety between value and price, other factors need to be considered when deciding whether a stock should be bought or sold.
The argument that value is misleading because it infers precision is as foolish as suggesting that real estate valuations are a waste of time because they too imply precision.
A recommendation may be correct, but unless it is accompanied by evidence of value, it can be considered only an unjustified expression of opinion.
Investing in stocks is not about buying scrip that will go up and down in price, but about investing long term in a sound business that represents good value at its present price.
The deployment of capital in the absence of assessment of value is called speculation.
Value investing can be defined as buying a share at a price lower than its calculated value. Only investors who have the ability to calculate value can call themselves "value investors"
The very factor on which investing is based, namely value, is little understood, and therefore nearly always ignored.
Warren Buffett once said: "I'd rather be approximately right than precisely wrong."
Stock valuation is subjective in that it requires a judgement of the sustainability of past profitability and is therefore far from being an exact science. Like price, value will not increase in neat, even increments year after year, but will vary with the changing fortunes of the business.
An assessment of value is determined by making forward assumptions of a business's performance based on its historical performance. Depending on the current outlook for the business and its future prospects, the adopted performance criteria (APC) may differ from thsoe that past performance indicates. One also needs to make an assessment of the RR to compensate for many factors. The adopted assumptions are then used to calculate the value, the preciseness of which is not as important as being, as Buffett suggests, "approximately right."
As essential as valuation is in determining the margin of safety between value and price, other factors need to be considered when deciding whether a stock should be bought or sold.
The argument that value is misleading because it infers precision is as foolish as suggesting that real estate valuations are a waste of time because they too imply precision.
A recommendation may be correct, but unless it is accompanied by evidence of value, it can be considered only an unjustified expression of opinion.
Investing in stocks is not about buying scrip that will go up and down in price, but about investing long term in a sound business that represents good value at its present price.
Friday 31 October 2008
Panic-Resilient Stocks
There are, by contrast, several groups that tend to act well in a post-panic environment, especially if the crash itself drives prices to incredible levels.
Sub-par performers in a post-crash environment
Stocks that tend to be sub-par performers in a post-crash environment are the following:
- low-priced stocks
- lower NASDAQ issues
- small total capitalization issues
- thinly traded, analyst under-covered or non-covered stocks.
- fundamental in industry laggards
- stocks in recession-sensitive industries
- brokerage firms' own stocks (the public will be slow to return to active investing)
- discredited groups
- stocks in panic-trigger related groups
Because of fear, nervousness and absence speculative appetite after a crash or panic, the first 6 groups (some of which will overlap for individual stocks) lack sponsorship. In addition, because market panics generate immediate scare headlines in the media, predictably there will be talk of recession (or depression) and parallels drawn with 1929. Recall the October 1987 and October 1989 bashings and the smaller one-day drubbings during the early and middle 1990s; depression talk was rampant in post 9/11 months until mid-2002.
The final 2 categories should be off your hold list for similar reasons. Sometimes there is an industry or category of stocks related to the news that triggers the panic. Even immediately after any panic itself has passed, investors and traders will have keen memories of what started the debacle, and will avoid such stocks for an extended time. The present mid-2007 trouble with sub-prime mortgage losses drives a major drop and banks will be on the defensive thereafter, even if they look cheap.
[Cyclicals such as autos, steels, chemicals, papers and capital goods producerss are not prime early choices for participating in the bounce. Similarly, vacation-related (airline, hotel and casino) and luxury stocks fare poorly early on.]
Tuition fees for painful lessons may be worthwhile!
If an investor is down to just a few core holdings anyway, he is better advised to tough it out. The very experience of playing in pain through a (temporary) crash is of enormous instructional value and thus actually worth the modest monetary cost involved.
The process of crisis thinking and the need to make wrenching decisions that prove valid in short order will serve a person well for the rest of his or her investment career.
Once an investor has successfully navigated the worst of the choppy investment seas, she will have learned survival lessons and will have internalized feelings and a vivid experience that will be of permanent psychological and instructive value.
The process of crisis thinking and the need to make wrenching decisions that prove valid in short order will serve a person well for the rest of his or her investment career.
Once an investor has successfully navigated the worst of the choppy investment seas, she will have learned survival lessons and will have internalized feelings and a vivid experience that will be of permanent psychological and instructive value.
Thursday 30 October 2008
Market remains very volatile.
The market remains very volatile. Until this volatility settles to a more reasonable level, it is extremely difficult for the market to find a bottom.
The global financial crisis and meltdown have resulted in fundamental damage to worldwide businesses and economies. Some businesses will be badly hurt and some slightly. However, a few will actually be benefitting from this crisis.
How to value these companies' businesses today? This will be difficult. The earnings for the next few quarters will need to be tracked. Past earnings are historical and due to fundamental changes in the businesses of various companies, assessing the value of these companies based on historical earnings will be unwise.
However, some companies can be anticipated to do not too badly. These are traditionally in the defensive sectors of food and beverages, gambling, healthcare and utilities.
For other companies, particularly in the industrial, plantations, tradings, construction, and housing sectors, the future earnings will be difficult to project with any degree of certainty at present. Yes, some of these companies might have been oversold in the general negative sentiment of the present market but one can only be very certain of this when the results of the next few quarters are known.
In fact, the Singapore Stock Market is now below that of the time when SARS struck in 2003. Whether it will rebound quickly after the present crisis will not be so easy to fortell. The present issues are quite different. Moreover, the financial meltdown is worldwide.
In any crisis, there will be opportunities. As this crisis continues, unfolds and deepens, more opportunities will surface. Presently, the crisis still shows little sign of abating.
Have we got over the worst yet? Will the volatilities in the market abate soon?
Well, if you do know the answers, please share here. Meanwhile, my view is there are plenty of opportunities available and you do have the time to pick the cherry/cherries at leisure, now and/or later.
The global financial crisis and meltdown have resulted in fundamental damage to worldwide businesses and economies. Some businesses will be badly hurt and some slightly. However, a few will actually be benefitting from this crisis.
How to value these companies' businesses today? This will be difficult. The earnings for the next few quarters will need to be tracked. Past earnings are historical and due to fundamental changes in the businesses of various companies, assessing the value of these companies based on historical earnings will be unwise.
However, some companies can be anticipated to do not too badly. These are traditionally in the defensive sectors of food and beverages, gambling, healthcare and utilities.
For other companies, particularly in the industrial, plantations, tradings, construction, and housing sectors, the future earnings will be difficult to project with any degree of certainty at present. Yes, some of these companies might have been oversold in the general negative sentiment of the present market but one can only be very certain of this when the results of the next few quarters are known.
In fact, the Singapore Stock Market is now below that of the time when SARS struck in 2003. Whether it will rebound quickly after the present crisis will not be so easy to fortell. The present issues are quite different. Moreover, the financial meltdown is worldwide.
In any crisis, there will be opportunities. As this crisis continues, unfolds and deepens, more opportunities will surface. Presently, the crisis still shows little sign of abating.
Have we got over the worst yet? Will the volatilities in the market abate soon?
Well, if you do know the answers, please share here. Meanwhile, my view is there are plenty of opportunities available and you do have the time to pick the cherry/cherries at leisure, now and/or later.
Warren Buffett Isn't You. Don't Listen to Him.
October 28, 2008
Warren Buffett Isn't You. Don't Listen to Him, Don't Trust Him, He is Wrong.Posted by Karen DeCoster at October 28, 2008 08:15 PM
My article from last week, Warren Buffett, Government Propagandist, drew more emails than anything I can recall in recent times. There were 200+ favorable, and only three that disagreed with me. Some web surfing this morning revealed some others who joined the fray. This article, 5 Reasons to Ignore Buffett, is eerily parallel to my piece (sometimes point-for-point), and declares Warren a "verbal interventionist." Then, here's a piece by C.S. Jefferson that states:
The difference for the average investor is that while it’s common for legendary traders of Wall Street to mock how the sheep get sheared by buying at the top and selling at the bottom, they neglect to remember that most people sell not because they want to, but because they have to make bill payments and pay for basic necessities such as food and shelter. Sound advice by professional money managers falls on deaf ears when the margin of error means being able to feed your family or not.
Warren Buffett can buy with impunity, unlike the rest of us with limited resources. Because he is rich enough that whatever decision is made to invest, he can, literally, afford to be wrong until the markets turn around and agree with him at some point or another.
In the National Post, Diane Francis writes Buffett is Wrong: Avoid Stocks and Buffett is Wrong: Avoid Stocks, Part II. In the Sunday Times, Jennifer Hill writes Capital Hill: Buffett is wrong: the market madness is still far from over.
http://www.lewrockwell.com/blog/lewrw/archives/023716.html
------
"Dear Warren Buffett"
Knoxville blogger 500Jerk has penned an open letter to HIs Greatness:
Dear Warren:
I appreciate your advice in the NYT last week, you know, where you advise being greedy when others are fearful and fearful when others are greedy. That's very helpful. And its good advice, to the extent being greedy is praiseworthy at all. But I get your drift, I truly do: buy now, because American companies are on sale. And believe me, I would like to take advantage of the deep, deep discounts currently available in the stock market, because like you, I believe these investments will result in fabulous profits years from now.
Here's the thing, though, Warren, and I know you don't have this particular problem, but maybe you can mull it over on one of those cold Nebraska nights: Like most Americans, I DON"T HAVE ANY MONEY LEFT TO INVEST IN THE STOCK MARKET. While you may have millions rolling around in your pockets, I invested my spare change. Now I've watched it devalue 25%. So although I'd like to be courageous (I like that word better, don't you?), I can't actually afford to do that. For now, I'll have to hang back and hope the stock market rebounds in fairly short order so I can recover what I've lost.
Thanks for the words of encouragement, though. Maybe I can use them in the next recession. And good luck to you shopping for bargains.
Sincerely yours,
500Jerk
http://blogs.knoxnews.com/knx/granju/2008/10/dear-warren-buffett.html
------
Comment: I have blogged on this here.
In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.
The intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong - as even the best analyses will be at least some of the time.
The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.
http://myinvestingnotes.blogspot.com/2008/10/consequences-must-dominate.html
Warren Buffett Isn't You. Don't Listen to Him, Don't Trust Him, He is Wrong.Posted by Karen DeCoster at October 28, 2008 08:15 PM
My article from last week, Warren Buffett, Government Propagandist, drew more emails than anything I can recall in recent times. There were 200+ favorable, and only three that disagreed with me. Some web surfing this morning revealed some others who joined the fray. This article, 5 Reasons to Ignore Buffett, is eerily parallel to my piece (sometimes point-for-point), and declares Warren a "verbal interventionist." Then, here's a piece by C.S. Jefferson that states:
The difference for the average investor is that while it’s common for legendary traders of Wall Street to mock how the sheep get sheared by buying at the top and selling at the bottom, they neglect to remember that most people sell not because they want to, but because they have to make bill payments and pay for basic necessities such as food and shelter. Sound advice by professional money managers falls on deaf ears when the margin of error means being able to feed your family or not.
Warren Buffett can buy with impunity, unlike the rest of us with limited resources. Because he is rich enough that whatever decision is made to invest, he can, literally, afford to be wrong until the markets turn around and agree with him at some point or another.
In the National Post, Diane Francis writes Buffett is Wrong: Avoid Stocks and Buffett is Wrong: Avoid Stocks, Part II. In the Sunday Times, Jennifer Hill writes Capital Hill: Buffett is wrong: the market madness is still far from over.
http://www.lewrockwell.com/blog/lewrw/archives/023716.html
------
"Dear Warren Buffett"
Knoxville blogger 500Jerk has penned an open letter to HIs Greatness:
Dear Warren:
I appreciate your advice in the NYT last week, you know, where you advise being greedy when others are fearful and fearful when others are greedy. That's very helpful. And its good advice, to the extent being greedy is praiseworthy at all. But I get your drift, I truly do: buy now, because American companies are on sale. And believe me, I would like to take advantage of the deep, deep discounts currently available in the stock market, because like you, I believe these investments will result in fabulous profits years from now.
Here's the thing, though, Warren, and I know you don't have this particular problem, but maybe you can mull it over on one of those cold Nebraska nights: Like most Americans, I DON"T HAVE ANY MONEY LEFT TO INVEST IN THE STOCK MARKET. While you may have millions rolling around in your pockets, I invested my spare change. Now I've watched it devalue 25%. So although I'd like to be courageous (I like that word better, don't you?), I can't actually afford to do that. For now, I'll have to hang back and hope the stock market rebounds in fairly short order so I can recover what I've lost.
Thanks for the words of encouragement, though. Maybe I can use them in the next recession. And good luck to you shopping for bargains.
Sincerely yours,
500Jerk
http://blogs.knoxnews.com/knx/granju/2008/10/dear-warren-buffett.html
------
Comment: I have blogged on this here.
In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.
The intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong - as even the best analyses will be at least some of the time.
The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.
http://myinvestingnotes.blogspot.com/2008/10/consequences-must-dominate.html
Weathering a Panic
When you are caught in a market panic, the bottom-line reality question is whether capitalism in the United States and other major Western nations will continue to function after the panic ends. If the answer is yes, then there is no reason to sell at foolish levels.
In fact, the only rational thing to do is take courage and make buys. Being gutsy enough to act on our contrarian test - refusing to sell good stocks cheap because Wall Street and Main Street have lost faith for a few days - ensures that your earlier selling at better levels, or not at all, will prove appropriate.
It will be emotionally difficult to buy in a panic. those who can do so are demonstrably rational and therefore also calm enough to sell with discipline as the prior highs approached.
-------
When appropriate selling has left an investor with only a few, high-quality stocks, he can and should hold onto those gems and play through the difficult experience of a panic or crash. He will be holding only a relatively small portfolio, so his level of pain will be no worse than moderate.
His cash holdings will give emotional comfort and provide the resources for acquiring stocks advantageously when prices get really low and buying feels scary.
A comforting perspective for those less than 50% committed to stocks is that each decline means their cash is gaining stock-buying power faster than their remaining holdings are losing cash value! Think about that.
------
Once the panic subsides, there is a lift in the market. But its effect is significantly different across various kinds of stocks. For some issues, there is a sharp snap=back rally; for others, very little improvement.
Just as it is not advisable to sell directly into the panic, it is prudent to reassess positions after the selling frenzy has subsided and an initial bounce in prices has begun.
------
Decide in real time, what to sell and what to hold.
Selling should not be urgent because pre-bear phase tactics will have raised a lot of cash, so there is no need to sell to raise cash for margin calls or for new buying.
But because the goal is always to maximize return on capital and to take advantage of the time value of money, look closely at what to hold and what to sell now that the panic's dust has cleared.
One must look forward at future prospects rather than backward at now-irrelevant old (higher) prices.
Some investors may see a contradiction in the advice to hold the remaining few gems through the worst psychological heat, because earlier they were counseled that avoid losses is the first priority and the best reason for selling.
But taking a limited short-term dose of paper losses in a crash - by holding a few items of real quality - is a lesser risk than selling out during the fury and hoping to have the courage and good timing to get back in at lower prices shortly afterward.
------
Ref: It's when you sell that counts, by Donald Cassidy
In fact, the only rational thing to do is take courage and make buys. Being gutsy enough to act on our contrarian test - refusing to sell good stocks cheap because Wall Street and Main Street have lost faith for a few days - ensures that your earlier selling at better levels, or not at all, will prove appropriate.
It will be emotionally difficult to buy in a panic. those who can do so are demonstrably rational and therefore also calm enough to sell with discipline as the prior highs approached.
-------
When appropriate selling has left an investor with only a few, high-quality stocks, he can and should hold onto those gems and play through the difficult experience of a panic or crash. He will be holding only a relatively small portfolio, so his level of pain will be no worse than moderate.
His cash holdings will give emotional comfort and provide the resources for acquiring stocks advantageously when prices get really low and buying feels scary.
A comforting perspective for those less than 50% committed to stocks is that each decline means their cash is gaining stock-buying power faster than their remaining holdings are losing cash value! Think about that.
------
Once the panic subsides, there is a lift in the market. But its effect is significantly different across various kinds of stocks. For some issues, there is a sharp snap=back rally; for others, very little improvement.
Just as it is not advisable to sell directly into the panic, it is prudent to reassess positions after the selling frenzy has subsided and an initial bounce in prices has begun.
------
Decide in real time, what to sell and what to hold.
Selling should not be urgent because pre-bear phase tactics will have raised a lot of cash, so there is no need to sell to raise cash for margin calls or for new buying.
But because the goal is always to maximize return on capital and to take advantage of the time value of money, look closely at what to hold and what to sell now that the panic's dust has cleared.
One must look forward at future prospects rather than backward at now-irrelevant old (higher) prices.
Some investors may see a contradiction in the advice to hold the remaining few gems through the worst psychological heat, because earlier they were counseled that avoid losses is the first priority and the best reason for selling.
But taking a limited short-term dose of paper losses in a crash - by holding a few items of real quality - is a lesser risk than selling out during the fury and hoping to have the courage and good timing to get back in at lower prices shortly afterward.
------
Ref: It's when you sell that counts, by Donald Cassidy
Reviewing and Understanding Earlier Panics
On the way down, each temporary bottom during a bear trend is typically characterized by increases in fear and therefore in trading volume, with a bit of panicky dumping to mark each new interim low.
The final downside climax is most violent and usually sees the greatest trading volume. Selling pressure becomes so intense that it literally cannot be exceeded; it becomes exhausted as large numbers of the previously brave finally capitulate and sell even at obvious bargain levels.
As a large crowd jumps overboard simultaneously, the moment they are finished is why and when prices hit a bottom. This is the long-repeated profile of a final bottom, that is, the culmination of a selling frenzy and the end of a sharp downward movement in prices.
Minyanville founder, Todd Harrison, a wise commentator, says that all markets (up and down) go through 3 stages in sequence:
The final downside climax is most violent and usually sees the greatest trading volume. Selling pressure becomes so intense that it literally cannot be exceeded; it becomes exhausted as large numbers of the previously brave finally capitulate and sell even at obvious bargain levels.
As a large crowd jumps overboard simultaneously, the moment they are finished is why and when prices hit a bottom. This is the long-repeated profile of a final bottom, that is, the culmination of a selling frenzy and the end of a sharp downward movement in prices.
Minyanville founder, Todd Harrison, a wise commentator, says that all markets (up and down) go through 3 stages in sequence:
- disbelief,
- migration and
- panic.
The panic stage is usually followed on lower volume by timid bargain-hunting. When that process runs its course and the bulls run out of guts and/or ammunition, the initial base-building or rally falters. Such failure to hold ground leads to renewed fear, which builds in a minor crescendo to a new, sometimes lower, cascade-shaped bottom on moderately high volume. The key to note here is the less dramatic price drop and volume rise than those seen earlier; the difference proves that the prior low was one of psychological exhaustion or washout.
Major market bottoms often produce a W shape on the charts over two or three months; the two bottom points need not be at exactly the same level.
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Recall the chaotic pace of trading on Oct 19, 1987, when the Dow lost 508 points (23%) and made its bottom for the move on then-record volume.
A more recent is the aftermath of the Sept 11, 2001 terrorist attacks. The US market actually closed for the rest of the week. After its re-opening on Monday, Sept 17, several trading sessions were required for the emotions and new thinking of the post 9/11 world to be worked out before the selling was all exhausted.
Re-reading reports and looking at newspaper stock-price tables from that time will provide a vivid flavour of the fear psychology that defines a market crash. If there has not been a major crash lately when you read this, the instructive value will be all the greater.
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Important bottoms are typically referred to as selling climaxes because they consist of prices falling in a cascade or waterfall shape (when plotted on a graph against time), accompanied by a sharp concentration of heavy trading volume as investor emotions widely take control and completely trample logic.
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My comments: While the bottom of the market is yet to be certain, many stocks have been sold down hugely. Studying the charts of these stocks reveal many of these stocks are already trading at their bottom for some time, even though the market continues to slip down further.
Ref: It's when you sell that counts, by Donald Cassidy
Managing Investment Risk
Risk equals the potential that actual returns will differ from expected returns.
1. The best way to manage risk is to allow yourself ample time. Start investing now rather than later. When you have time on your side, more of your money can be invested in stocks rather than in bonds and money market instruments because you would have a larger capacity to ride the ups and downs of the stock market.
2. Secondly, you can manage risk by diversifying your money into stocks, bonds and money market investments. This is called asset allocation.
3. Finally, the way you divided your investments depends on your specific situation and your goals. Spend some time thinking about the best way to divide your money based on your needs and the type of risk you can take. This exercise will make a big difference to your investment success.
Ref: Make Your Money Work for You, by Keon Chee & Ben Fok
1. The best way to manage risk is to allow yourself ample time. Start investing now rather than later. When you have time on your side, more of your money can be invested in stocks rather than in bonds and money market instruments because you would have a larger capacity to ride the ups and downs of the stock market.
2. Secondly, you can manage risk by diversifying your money into stocks, bonds and money market investments. This is called asset allocation.
3. Finally, the way you divided your investments depends on your specific situation and your goals. Spend some time thinking about the best way to divide your money based on your needs and the type of risk you can take. This exercise will make a big difference to your investment success.
Ref: Make Your Money Work for You, by Keon Chee & Ben Fok
Wednesday 29 October 2008
More on risk
We defined risk as the chance of losing money when you sell your investment. We need to make 2 refinements to this working definition.
1. In investments, risk is defined more broadly as the chance of receiving a return that is different from the return we expected to make.
Risk, in fact, includes not only bad outcomes such as lower than expected returns, but also good outcomes like higher than expected returns.
Thus, if the expected returns of an investment is 5%, the risk that you will earn a 10% return or 0% is exactly the same. In other words, using standard deviation, you do not distinguish between downside risk and upside risk.
For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk.
They may go for:
2. There are also investments whose expected return is known ahead of time.
For example, when you buy a bond that pays a fixed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be.
1. In investments, risk is defined more broadly as the chance of receiving a return that is different from the return we expected to make.
Risk, in fact, includes not only bad outcomes such as lower than expected returns, but also good outcomes like higher than expected returns.
Thus, if the expected returns of an investment is 5%, the risk that you will earn a 10% return or 0% is exactly the same. In other words, using standard deviation, you do not distinguish between downside risk and upside risk.
For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk.
They may go for:
- a measurement called the semi-variance where only returns that fall below the expected return are considered.
- they may go for simpler yet common-sensical proxies for risk. For example, it makes sense that stocks of technology companies are riskier than those of food companies. Others prefer to create ranking categories. (For example, ranking money market instruments as lower risk and technology stocks at higher risk.)
2. There are also investments whose expected return is known ahead of time.
For example, when you buy a bond that pays a fixed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be.
Anatomy of a Crisis
The urge to panic in the wake of a crisis is understandable and this is one of the greatest fears that many investors face.
One of the best ways to confront our fears is to understand them.
(Basically, we are faced with the following fears: Fear of failure, fear of loss and fear of the unknown.)
In this section, we look at what generally happens in a crisis and some of the questions you should ask when a crisis hits. We will also look back in history and feature some events to draw out important lessons for the future. From this, you can figure out what actions are more likely to be productive and what actions are more likely to be counter-productive.
When a crisis hits
Take 9-11, for example. Now, imagine that it is the day after the destruction of the Twin Towers. Profound shock waves will be felt in New York and beyond, and this will send ripples through to the world economy for some time.
On the morning after, it is near impossible to know exactly how events will play out over the next few weeks or months. But there is a set pattern to how financial markets react to a crisis, historically, and there are a few things worth noting.
Firstly, the inital reaction will be shock. Financial markets hate uncertainty, and nothing creates more uncertainty than a sudden, shattering crisis. The result of the shock is typically a "flight of safety", as investors dump stocks in favour of bonds and cash. Stock prices will, therefore, almost always fall.
At this point, the greatest danger to investors is not shock or that prices are falling, but the urge to panic. When investors panic, they sell at low prices and end up buying back the same stocks later at much higher prices. This knee-jerk effect comes at a high cost for investors, who buy high and sell low.
The second reaction, which usually happens immediately, is increased volatility in the commodity markets. Will the terrorists bomb oilfields and stem supply? Will grain shipments be interrupted? Will demand for gold rise sharply? Uncertainties that affect basic commodities usually cause spasms in the markets.
A third reaction is over-compensation. The first shock wave of selling is often broad and steep. Then, when uncertainty dissipates, investors usually overreact in the opposite direction, sending prices back up to pre-crisis levels.
Things never seem the way they are during a crisis. What you should remember is that the impact of a crisis itself is typically a short-term matter. After a few weeks, calm usually returns. This is not to say that crises are inconsequential or insignificant. The tsunami disascter (26 December 2004) which caused tremendous destruction in Indonesia will require billions of dollars and many years of restoration work. Certain markets may stay depressed for longer.
Historically, what effect a crisis has on the financial markets depends on whether the crisis creates a long-term change in the fundamental nature of an economy. And in most cases (even in the case of the tsunami disaster), the fundamental structures of the affected were not subjected to drastic modifications.
To sum up, the typical pattern following a major crisis is this:
So, should you find yourself in the midst of a crisis in the future, remember:
Make sure your overall portfolio is designed to limit your potential losses during a substantial market decline. This is where you need to invest in many different things.
Ref: Make your Money work for you, by Keon Chee & Ben Fok
One of the best ways to confront our fears is to understand them.
(Basically, we are faced with the following fears: Fear of failure, fear of loss and fear of the unknown.)
In this section, we look at what generally happens in a crisis and some of the questions you should ask when a crisis hits. We will also look back in history and feature some events to draw out important lessons for the future. From this, you can figure out what actions are more likely to be productive and what actions are more likely to be counter-productive.
When a crisis hits
Take 9-11, for example. Now, imagine that it is the day after the destruction of the Twin Towers. Profound shock waves will be felt in New York and beyond, and this will send ripples through to the world economy for some time.
On the morning after, it is near impossible to know exactly how events will play out over the next few weeks or months. But there is a set pattern to how financial markets react to a crisis, historically, and there are a few things worth noting.
Firstly, the inital reaction will be shock. Financial markets hate uncertainty, and nothing creates more uncertainty than a sudden, shattering crisis. The result of the shock is typically a "flight of safety", as investors dump stocks in favour of bonds and cash. Stock prices will, therefore, almost always fall.
At this point, the greatest danger to investors is not shock or that prices are falling, but the urge to panic. When investors panic, they sell at low prices and end up buying back the same stocks later at much higher prices. This knee-jerk effect comes at a high cost for investors, who buy high and sell low.
The second reaction, which usually happens immediately, is increased volatility in the commodity markets. Will the terrorists bomb oilfields and stem supply? Will grain shipments be interrupted? Will demand for gold rise sharply? Uncertainties that affect basic commodities usually cause spasms in the markets.
A third reaction is over-compensation. The first shock wave of selling is often broad and steep. Then, when uncertainty dissipates, investors usually overreact in the opposite direction, sending prices back up to pre-crisis levels.
Things never seem the way they are during a crisis. What you should remember is that the impact of a crisis itself is typically a short-term matter. After a few weeks, calm usually returns. This is not to say that crises are inconsequential or insignificant. The tsunami disascter (26 December 2004) which caused tremendous destruction in Indonesia will require billions of dollars and many years of restoration work. Certain markets may stay depressed for longer.
Historically, what effect a crisis has on the financial markets depends on whether the crisis creates a long-term change in the fundamental nature of an economy. And in most cases (even in the case of the tsunami disaster), the fundamental structures of the affected were not subjected to drastic modifications.
To sum up, the typical pattern following a major crisis is this:
- first, there will be a wave of panic selling when the news breaks.
- Then, there will be a short period of instability,
- followed by an upward sweep once investors realise the crisis itself is not likely to have a long-term effect on the economy.
So, should you find yourself in the midst of a crisis in the future, remember:
- Do not engage in panic selling.
- Sit tight and stick to your strategy.
- If you are a long-term, buy-and-hold investor, do hold on.
- If you are an adventurous investor, follow your strategy to buy on dips.
Make sure your overall portfolio is designed to limit your potential losses during a substantial market decline. This is where you need to invest in many different things.
Ref: Make your Money work for you, by Keon Chee & Ben Fok
Investing in the market or in the movements of the market
How do you react to the present market crisis? Would you sell or stay put?
Uncertainty often clouds judgement, sending even the best of us into panic and gloom. But history shows that negative events do not necessarily spell doom for investors.
Historical evidence suggests that most investors can benefit by staying put in a severely sold down market.
Some investors are skilled at anticipating market movements. They would buy on ups and sell on downs. But how many people can do that consistently? (Observe investing here and make your own conclusions: http://fusioninvestor.blogspot.com/ )
The big question for many of us is whether it makes sense to stay invested regardless of market fluctuations. According to a study by Ibbotson & Associates, the anwer is "yes".
They found that a dollar invested in the S&P 500 in 1925 grew to $1371 in 1996. That's a compound annual return of 10.6%. But when the best 35 months (less than 4% of total time invested) were removed from the analysis, the same dollar grew to only $12.50, a compounded annual return of only 3.6%.
$ invested in S&P 500
$1 invested in 1925
Value in 1996 (stay put throughout) $1,371.00
Value in 1996 (minus 35 best months $12.50
So, unless you are confident of accurately predicting the best and worst months for your investment dollar, stay put.
Uncertainty often clouds judgement, sending even the best of us into panic and gloom. But history shows that negative events do not necessarily spell doom for investors.
Historical evidence suggests that most investors can benefit by staying put in a severely sold down market.
Some investors are skilled at anticipating market movements. They would buy on ups and sell on downs. But how many people can do that consistently? (Observe investing here and make your own conclusions: http://fusioninvestor.blogspot.com/ )
The big question for many of us is whether it makes sense to stay invested regardless of market fluctuations. According to a study by Ibbotson & Associates, the anwer is "yes".
They found that a dollar invested in the S&P 500 in 1925 grew to $1371 in 1996. That's a compound annual return of 10.6%. But when the best 35 months (less than 4% of total time invested) were removed from the analysis, the same dollar grew to only $12.50, a compounded annual return of only 3.6%.
$ invested in S&P 500
$1 invested in 1925
Value in 1996 (stay put throughout) $1,371.00
Value in 1996 (minus 35 best months $12.50
So, unless you are confident of accurately predicting the best and worst months for your investment dollar, stay put.
Options versus Futures
Differences.
The purchaser of a futures contract is obligated to buy the underlying asset at the specified price (and the seller of a futures contract is obligated to sell).
The owner of a call option is not obligated to buy unless he wishes to do so; he has the right, but not the obligation.
The buyer of an option has a limited downside, but the buyer of a futures contract doesn't.
Similarities.
Options and futures contracts also share some common features. Both have standardised features that allow them to be traded quickly and "cheaply" on organized exchanges.
Ref: Make Your Money work for you, by Keon Chee & Ben Fok
The purchaser of a futures contract is obligated to buy the underlying asset at the specified price (and the seller of a futures contract is obligated to sell).
The owner of a call option is not obligated to buy unless he wishes to do so; he has the right, but not the obligation.
The buyer of an option has a limited downside, but the buyer of a futures contract doesn't.
Similarities.
Options and futures contracts also share some common features. Both have standardised features that allow them to be traded quickly and "cheaply" on organized exchanges.
Ref: Make Your Money work for you, by Keon Chee & Ben Fok
Tuesday 28 October 2008
Returns on buying and selling futures
Participants in futures are either hedgers or speculators.
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Hedgers seek to reduce price uncertainty over some future period.
For example, by purchasing a coffee contract, the coffeeshop owner can hedge and lock in a specific buying price for coffee and be protected from any price increases.
Similarly, sellers can protect themselves from downward price movements too.
The coffee farmer might sell a coffee future contract to hedge against a fall in coffee prices.
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Speculators, on the other hand, seek to profit from the uncertainty that will occur in the future.
If they expect prices to rise, contracts will be purchased, and if they expected prices to fall, they would sell contracts.
Ref: Make Your Money Work For You, by Keon Chee & Ben Fok
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Hedgers seek to reduce price uncertainty over some future period.
For example, by purchasing a coffee contract, the coffeeshop owner can hedge and lock in a specific buying price for coffee and be protected from any price increases.
Similarly, sellers can protect themselves from downward price movements too.
The coffee farmer might sell a coffee future contract to hedge against a fall in coffee prices.
----------
Speculators, on the other hand, seek to profit from the uncertainty that will occur in the future.
If they expect prices to rise, contracts will be purchased, and if they expected prices to fall, they would sell contracts.
Ref: Make Your Money Work For You, by Keon Chee & Ben Fok
Option returns
When you buy a call option, you are essentially betting that the price of the underlying common stock will rise, making the call option more valuable.
Conversely, put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.
Returns are only in the form of capital gains.
Since you do not own the stock but only the right, dividends paid on the underlying stock do not benefit you.
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The seller receives a fee called an option premium for selling you a call or put.
Once an option is created and the seller receives the premium from the buyer, it can be traded in the secondary market.
The premium is the market price of the derivative, and the price will fluctuate along with changes in the underlying common stock.
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Put and calls allow both buyers and sellers to speculate on the short-term movements of common stocks.
Buyers obtain an option on the common stock for a small, known premium.
This known premium is the maximum that the buyer can lose.
If the buyer is correct about the price movements of the common stock, capital gains are magnified because only a small investment is committed.
-----------
There are two particularly important types of derivatives - options and futures.
Many other types exist, but they can usually be created from these two basic building blocks, possibly by combining them with all sorts of other investment assets including stocka and bonds, stock indexes, gold and commodities such as wheat and corn.
Ref: Make your money work for you, by Keon Chee & Ben Fok
Conversely, put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.
Returns are only in the form of capital gains.
Since you do not own the stock but only the right, dividends paid on the underlying stock do not benefit you.
-----
The seller receives a fee called an option premium for selling you a call or put.
Once an option is created and the seller receives the premium from the buyer, it can be traded in the secondary market.
The premium is the market price of the derivative, and the price will fluctuate along with changes in the underlying common stock.
-----
Put and calls allow both buyers and sellers to speculate on the short-term movements of common stocks.
Buyers obtain an option on the common stock for a small, known premium.
This known premium is the maximum that the buyer can lose.
If the buyer is correct about the price movements of the common stock, capital gains are magnified because only a small investment is committed.
-----------
There are two particularly important types of derivatives - options and futures.
Many other types exist, but they can usually be created from these two basic building blocks, possibly by combining them with all sorts of other investment assets including stocka and bonds, stock indexes, gold and commodities such as wheat and corn.
Ref: Make your money work for you, by Keon Chee & Ben Fok
Derivatives - options and futures
Stocks and bonds are financial assets.
A derivative is also a financial asset but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.
------------
Options
Options are one of the most common types of derivative.
There are 2 main types of options - calls and puts.
A call option gives the buyer the right but not the obligation, to purchase a specified number of shares of a particular stock at a particular price (called the exercise price) within a specified time frame.
A put option does the reverse - it gives the buyer the right but not the obligation, to sell a specified number of shares of a particular stock at a specified price within a specified time frame.
A definite advantage for the buyer of an option - whether a call or a put option - is that there is no obligation to exercise the option.
A simple example of a call option.
Suppose that you want to own 1,000 Microsoft shares at $30 each.
If you are fortunate enough to have this large amount of money ($30,000) at hand, you can pay up right away and own the shares.
But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000 shares at $30,000 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In effect, your roommate has sold you a call option.
If you buy the call option, the value of your investment now depends on the underlying asset - the share price of Microsoft.
If the price of Microsoft goes up, so does the value your call option.
If the price of Microsoft goes down, your derivative falls in value.
When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30,000.
If you change your mind because you found a better deal elsewhere, you can just walk away. You will only lose $1,500, which is called the option premium.
--------------
Futures
Suppose a coffeeshop owner wants to buy 5 metric tons (mt) of Robusta coffee in six months, and he worries that the price of coffee might increase threefold by that time.
One thing he can do now is to strike a deal today with a farmer whereby he promises to pay, say, $1,000 per mt in 6 months' time for 5 mt of coffee. In other words, the coffeeshop owner and the farmer agree that 6 months from now, the coffeeshop owner will exchange $5,000 for 5 mt of coffee.
The agreement that they have created is a futures contract.
With the futures contract, both the coffeeshop owner and the farmer have locked in the price of coffee six months from now.
Suppose that coffee is selling for $1,500 per mt in 6 months' time. If this happens, then the coffeeshop owner would have benefited from having entered into the futures contract.
However, if the coffee sells for only $700 per mt then, he would have made a loss of $1,500, because he is forced by contract to pay $1,000 per mt.
A futures contract is therefore a bet on the future price of whatever is being bought or sold.
An important feature of traded futures contracts is that they are standardised, meaning each contract calls for the purchase of a specific quantity of a particular underlying asset.
The contract specifies in detail what the underlying asset is and where it is to be delivered.
For example, with a Robusta coffee contract, the contrct would specify that a specified quantity of a particular type of coffee will be delivered at one of a few approved locations on a particular date in exchange for the agreed-upon futures price.
A derivative is also a financial asset but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.
------------
Options
Options are one of the most common types of derivative.
There are 2 main types of options - calls and puts.
A call option gives the buyer the right but not the obligation, to purchase a specified number of shares of a particular stock at a particular price (called the exercise price) within a specified time frame.
A put option does the reverse - it gives the buyer the right but not the obligation, to sell a specified number of shares of a particular stock at a specified price within a specified time frame.
A definite advantage for the buyer of an option - whether a call or a put option - is that there is no obligation to exercise the option.
A simple example of a call option.
Suppose that you want to own 1,000 Microsoft shares at $30 each.
If you are fortunate enough to have this large amount of money ($30,000) at hand, you can pay up right away and own the shares.
But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000 shares at $30,000 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In effect, your roommate has sold you a call option.
If you buy the call option, the value of your investment now depends on the underlying asset - the share price of Microsoft.
If the price of Microsoft goes up, so does the value your call option.
If the price of Microsoft goes down, your derivative falls in value.
When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30,000.
If you change your mind because you found a better deal elsewhere, you can just walk away. You will only lose $1,500, which is called the option premium.
--------------
Futures
Suppose a coffeeshop owner wants to buy 5 metric tons (mt) of Robusta coffee in six months, and he worries that the price of coffee might increase threefold by that time.
One thing he can do now is to strike a deal today with a farmer whereby he promises to pay, say, $1,000 per mt in 6 months' time for 5 mt of coffee. In other words, the coffeeshop owner and the farmer agree that 6 months from now, the coffeeshop owner will exchange $5,000 for 5 mt of coffee.
The agreement that they have created is a futures contract.
With the futures contract, both the coffeeshop owner and the farmer have locked in the price of coffee six months from now.
Suppose that coffee is selling for $1,500 per mt in 6 months' time. If this happens, then the coffeeshop owner would have benefited from having entered into the futures contract.
However, if the coffee sells for only $700 per mt then, he would have made a loss of $1,500, because he is forced by contract to pay $1,000 per mt.
A futures contract is therefore a bet on the future price of whatever is being bought or sold.
An important feature of traded futures contracts is that they are standardised, meaning each contract calls for the purchase of a specific quantity of a particular underlying asset.
The contract specifies in detail what the underlying asset is and where it is to be delivered.
For example, with a Robusta coffee contract, the contrct would specify that a specified quantity of a particular type of coffee will be delivered at one of a few approved locations on a particular date in exchange for the agreed-upon futures price.
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