Debunking Myths 1 - Savings cannot make you rich

Savings can be defined as putting aside some money every month so that consumption can be deferred to a later date. Whenever we talk about savings, it will refer to our savings accounts. Savings take many different forms and to determine whether a vehicle can be classified as savings, it must fall into the following principles.

1. Savings must be liquid or easily convertible to cash

Buying a piece of land does not qualify as savings, because it will take months to sell and convert it to cash. Similarly, by buying a house does not qualify it as savings, because due to the time lag or illiquid nature of the investment, it is either too long or difficult to get buyers before the sale can be to converted to cash. Also, by buying a house is also not safe as can be seen by the sub-prime crisis in the U.S. This will inevitably, lead us to conclude than an investment can only be considered safe when you are able to ‘get back the return OF your money instead of the return ON your money’.  

2. Savings had to be relatively safe

Investing in the commodities or futures market cannot be considered savings because it is too risky and your savings can be wipe out. Similarly, investing in the stock market cannot be considered as savings because it carries considerable amount of risk if you don’t have a plan.

Due to the high cost of living and the amount of materials goods that is available out there, it is now very difficult to save any money. After deducting our household expenses, monthly mortgages, credit cards payments, phone and utility bills, insurance and et al, we will be lucky to be able to scrape through without digging into our savings.

Another problem is instead of saving, most people spent most of their money on things that they can’t afford on credit cards and also purchase things that they don’t need. This is one of the reasons for the current credit crunch that is facing most countries around the world.

Different Savings Plan

A lot of people have the wrong misconception that savings cannot make you rich. But in reality it can make you rich and I will show you with the following tables.

Assumption : Salary and interest rates are fixed throughout the period

Table 1 :  Savings of 5 % of Annual Income and 10 % return

Salary	Monthly Savings	Value in 10 years	Value in 20 years	Value in 30 years
20,000	83.33	17,069.79	63,278.21	188,366.46
30,000	125	25,605.62	94,921.11	282,560.98
40,000	166.67	34,140.49	126,560.20	376,744.21
50,000	208.33	42,675.35	158,199.30	470,927.43
Source :	Mkvicka

Table  2 :  Savings of 10 % of Annual Income and 10 % return

Salary	Monthly Savings	Value in 10 years	Value in 20 years	Value in 30 years
20,000	166.66	34,139.46	126,566.41	376,732.91
30,000	250	51,211.24	189,842.21	565,121.97
40,000	333.33	68,280.97	253,120.41	753,488.42
50,000	416.66	85,350.71	316,398.61	941,854.87
Source :	Mkvicka

Power of Compounding

The above plan in Table 1, call for a savings of 5% of your annual income. Say if you are earning $40,000 per annum, 5% of it will be $2000. So your monthly contribution will be $2000/12, which is $166.67. This applies to the rest of the salaries. The above table shows that your savings can be generated into hugh amounts after 20 to 30 years.

A savings of $166.67 per month can gross you the total amount of $125,560.20 and $376,744.21, respectively after a 20 and 30 years period. What happen if you double your savings from 5% to 10%?

Table 2 will show you the difference. A savings of $333.33 per month can gross you the total amount of $253,120.41 and $753,488.42, or double respectively after a 20 and 30 years period.

Remember those figures are based on a fixed income of $40,000 per annum. Due to the effect of inflation, salaries tend to go up over the years. What happen if the salary revised to $60,000 after 10 years. A 10% savings of $60,000 will be $6000/12 = $500 per month and the equation will certainly be different. In the end, your nest egg will be more than 1 million dollars. Who says savings cannot make you rich?


I am sure a lot of folks will be saying this will not work because our banks only pays 3-5% interest rates. Well even on a 5% interest rate, your compounding effect will also be sizeable if you save 10% of your annual income instead of stipulated 5%. 


Another issue is that interest rates of 8-10% are achievable in emerging economies although you can hardly find such returns in developed economies nowadays. For example banks in Indonesia pays about 7-9% yield on term deposits and in Australia you probably be able to get about 7-8% returns. If you invest in money markets, you might be able to add another 1-2% more on your investments.


Banks in Singapore offers what they call the Foreign Currency accounts which caters for foreign investors and account secrecy will be assured. Ever since the increased scrutiny and pressure by the authorities in America on Swiss Banks to open up their customers portfolio, they had been an upsurge of funds flowing into Singapore. In fact private equity and wealth management is big business in Singapore. A report by the labour department reports that there will be a shortage of about 3000 private equity and wealth managers in Singapore this year.So, in a way in the next few years, Singapore will be the 'Switzerland of Asia'.


That is the beauty of what we call positive compounding of interest rates, which can be shown by the chart below. Another advantage about using the above Savings Plan to achieve your retirement plan is that you can start at any age. You can start when you are 30,40 or even 50 years old, the only difference is the duration of the plan. If you are 30 years old, then probably you might choose a 20-30 years plan and alternatively if you are 50 years old then probably you will go for the 10-20 years plan (if you can last that long).


However compounding can work both ways, meaning it can be positive and negative compounding. You will be amaze what negative compounding can do to your investments or portfolio. Understanding the drawback of negative compounding will help you in your selection of either mutual fund or dividend yield stocks for your retirement portfolio.




On our next posting, we will be addressing the issue on how negative compounding will affect your portfolio and investments. Stay tuned.

Options Trading Part 4 - Using Options to Manipulate Stock Markets

The stock market has always been in the influence of Big Money and Insiders. Most of the trades and volumes, generated in most stock exchanges around the world, are done by either by quantitative or high frequency traders. It is estimated that more than 75% of all trades in New York, 60% of all trades in Europe and 50% of all trades in Asia are generated by Quantitative or High Frequency Traders.

However, there is one tool that escapes the attention of most traders (or rather amateurs) that professionals use, not only to reduce risk but also to influence trades in stock markets. The tool that they employ is Equity Options. How they use it to their advantage?

1. Block Trading

Block trading refers to the buying and selling of large number of shares in a particular security. It normally refers to hundreds of thousands or probably millions of shares and they are common in the security industry. That is why some brokers have a special department just to handle such trades because it is very profitable.

Take for example Broker Morgan Stanley (MS), receives an order from an investor to sell 500,000 shares of IBM at $100 a share. The investor is not interested in staggered sales or selling by small amounts, which may take up to two months to dispose. The investor wants to get it done ‘all in one shot’. So, MS needs to call up other brokers if they are interested to take up 500,000 shares in IBM at $100 a share. Getting someone to take up the offer is not easy. Say if they found someone who is interested in only buying 400,000 shares, what is MS going to do with the remaining 100,000 shares?

MS will have the following options.

1. Sell 400,000 shares to the client and 100,000 in the open market
2. Sell 400,000 shares to the client and sell a call option on IBM
3. Sell 400,000 shares to the client and buy a put option on IBM

Option A will force MS to sell 100,000 shares of IBM at $100 in the open market. By selling such a large block in the open market will tend to arouse attention among other investors and hence might push down the price of IBM shares to below $100. In this case, MS will incur a loss on itself, which is not a good strategy.

Option B will be a better strategy and MS may execute the following.

Sell 1000 IBM Aug 100 Call – Premium 5

So, what the above strategy does is, Sell 1000 IBM Call Options, which is100,000 shares (1000 x 100 shares) and in this case there is no risk because MS had already in possession of 100,000 IBM shares from the investor. By selling the 1000 options, it is in a position to receive a 5 points premium, which is amounted to (100,000 x 5 = $500,000).

But in this case, there is a downside risk associated with selling a call option. If the stock price of IBM shares were to go down to below $100 then MS will incur a loss.

Option C will be to buy a put option on IBM, which can be illustrated below.

Buy 1000 IBM Aug 100 Put – Premium 3

Say if the IBM share is now trading at $95 then you will have a profit of $5 ($100 - $95) x 100,000 shares, which is equivalent to $500,000. Therefore, the Put option will be more valuable if the Stock price is decreasing and less valuable if the Exercise price is increasing because profit is equivalent to Exercise price – Stock Price. But buying a put, MS’s profit will be lesser because it has to pay a premium of  $300,000 (1000 x 100 shares) x 3 points premium. So, MS profit will only be $200,000 but his risk in protected should IBM share price rise above $100.

But professionals are different from amateurs, they will rather take a risk and make a profit than to just receive a commission for doing the trade. So, professionals will rather go for Option B rather than the rest because it is their job to manage risk. Amateurs probably, will be better off by buying the put and pay the premium, because their risks are protected.

Similarly, block trades can be employed to facilitate large buy orders of shares in a company.


2. Acquiring large position in a company

Investors may use options to disguise their activities in the stock markets. If they are interested to acquire a large position in a company (AB) say 1 million shares, they may do so in the following methods.

1. buy all of the shares in the open market

2. buy half using call options of AB and the other half through open market

Option A. The investors will need to buy all of its 1 million shares in the open market. By purchasing such a large amount of shares, will lead to an appreciation in the price of the targeted company. Moreover, by buying such a large block in the open market, will tend to arouse attention among other investors, because it will increase its volume. Hence this will induce other investors to participate into buying the shares, and will push up the price of the shares of the targeted company. This will make this exercise very expensive and difficult and hence this is not a good strategy.


Option B will be a better strategy and the investors may execute the following.

Buy 5000 AB Aug 100 Calls – Premium 3

So, what the above strategy does is to buy 5000 AB Call Options, which is 500,000 shares (5000 x 100 shares) and pay a 3 points premium, which amounts to (500,000 x 3 = $1,500,000).

In this case, he can buy the shares in the stock exchange without arousing any attention to his activities. He can slowly take his time to accumulate his shares quietly in the stock market while at the same time he purchase 5000 AB Aug 100 Call options.

Since purchase of option is not reported as part of AB’s trading volume and hence other investor’s will not know of his intentions. Also, purchasing of options will not alter the daily trading volume of AB, it will be ‘easier to collect’ his required amount of shares.   

Hence, the use of options helped the investors to accumulate their required amount of shares in a particular company, without arousing much attention of other investors, which might make it difficult for them to achieve their goal.


3. Insider Trading

Company Directors, Financial Controllers and Insiders, may use options to hide their activities in the stock markets. If they are in the know that there are good news pertaining to their company such as a larger than expected profit, a Merger or Acquisition activity, a large find of mineral reserve and etc. Instead of buying or accumulating of shares of their company in the open market, they may buy call options of their company.

When the good news is reported, they can cash in their call options. But they might be under the scrutiny of the Securities Commission, as call options is also known as stock equivalents. Since call options can be converted to shares, they may be subjected to insider trading. However, they can get around it by purchasing it under someone else name such as their relatives or some sort.

Similarly, this also applies when Insiders may use options to capitalize on the bad news of their company. If they know that their company will be reporting a larger than expected loss or the canceling of a Merger and Acquisition agreement, they can buy a Put Option. So when the bad news is announced, the price of the underlying security will go down and hence the price of options. So they just exercise their put option for a profit.

4. Hostile or Management Takeover

Due to the diverse amount of shareholders, the ownership of some companies are rather thinly distributed. Sometimes, a 5-10% ownership of the company shares is considered substantial. These companies are prime target for hostile or management takeovers. If an outsider wants to gain control of the company, all they need is to quietly purchase a 10% stake in the company. They can do it through the options market without arousing the attention of the management. By the time they have accumulated enough options, they can exercise it and they will automatically become a substantial shareholder.

When they have gain control of the company, then can blackmail the current management by threatening to discharge the whole management. So in order not lose their jobs and the perks that come with it, the management had to conformed to their demand by buying back their shares at a higher price.

The SEC in trying to control such activities enacted Rule 13D, which requires any individual that owns 5% or more of a corporation stocks to file a report. Again, investors can get around it by purchasing the stake with different names.

5. Selling large Block of shares in thinly traded stocks

If an investor is holding a block of 500,000 units ABC shares, which only trades about 2000-3000 shares a day. How can he get rid of his shares within a short period of time say one week? Should he dispose the whole block of ABC shares in the open market, it will crash the share price of ABC. Say if the price of ABC shares is trading at $30. What strategy should the investor employ to sell the shares without hurting its share price?  

The answer is the following.
 
Buy 5000 ABC Aug 31 put – Premium 2

By buying the put it will cost him a 2 points premium. Always remember you will receive the premium when you sell an option and vice versa. So when August arrives, he will exercise his option and deliver his 500,000 shares at the price of $31. After subtracting the premium, he is actually getting $29 for his block of shares. It will be much better selling it in the open market because by doing so he might drive the shares price below $29 and most probably to $25.

So, finally as you can see, there are many uses of options, not only to trade but also to maneuver your trading strategies in the market. Another use of option, is to help corporations to hedge their risk in their global operations. This will require another article, which I will later address on how Multinational Corporations use Currency Options and Forward Contracts to hedge their foreign exchange exposure in international markets.

Options Trading Part 3 - Trading Strategies

There are various strategies that can be employed using options to counter different market conditions. Equity Options can be used as a hedge and also speculate on the underlying securities. For example if an investor thinks that an underlying security is getting bearish in the coming weeks. He can counter the downturn with the following moves.

1. Sell a call option
2. Buy a put option

If he is bullish on the underlying security then he may employ the following moves.

1. Buy a call option
2. Sell a put option

However there are more complex strategies that are available in trading options and it is not suitable for many investors. We shall address the strategies below.


1. Straddles
A Straddle is made up of one put and one call option on one underlying security that is having the same strike price and expiry. So in a straddle, the investor buys or sells two identical options except one is put and the other is call. The investor can either have a long or short straddle.


Long Straddle
After studying the volume accumulation of IBM and its price patterns, the investor feels that IBM is going to make a move but not sure whether up or down. What she can do is the following.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

By this, it means that she will be participating in either an upward or downward movement of IBM. Please note that the total premium she paid was 17 points, and her initial investment is $1700 (10x100 shares + 7x100 shares).

So by August, IBM shares must be at 147 (130+17) for the call or 113 (130-17) for the put options, in order for it to break even. So the beauty about this strategy is that if the IBM stock goes above 147 or below 113, then it will start generating a profit. This represents an unlimited gain versus limited loss which is the premium of $1700. However, the investor seldom lose all the premium because she can cut loss in between.


Short Straddle
A short straddle is exactly the opposite. What she can do is the following.

Sell 1 IBM Aug 130 Call - Premium 10
Sell 1 IBM Aug 130 Put  - Premium  7

Instead of paying for the premium, an investor who sells an option receives the premium. So, as long as the stock price hovers between 147 (130+17) for the call or 113 (130-17), the investor will retain some of the premium as profit. However the risk and reward for the investor who sells a straddle is different from the person who buys a straddle.  This is because the maximum profit of the person who sold the above straddle is equivalent to $1700, but she will assume unlimited risk if say the stock price goes above 130.

In other words she is selling (writing in option lingo) an uncovered call in this case. So by selling a straddle, she will be exposed to limited profits but unlimited losses. 


# If you are not familiar with options, it will better limit yourself, to buying and not selling options because the risk is too high.

2. Strip

If the investor feels that the market direction is bearish for IBM, instead of buying a straddle she can buy a strip. A strip consists of 2 puts and one call. An example will be the following.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 2 IBM Aug 130 Put  - Premium  7

So if IBM were to go down, the investor will have a bigger profit. Say if IBM dropped to 110, then there will be a profit of 40 points (2 put options x 20 points). The total premium paid is 24 points (1 call x 10 + 2 puts x 7). So the net profit gained will be 40 points – 24 points premium = 16 points.

It will be a different story if the stock price rose. The investor need at least a 24 points gain in IBM stock to cover its premium so that she will be break even. In other words, IBM stock will need to rise to at least 154 so that she can exercise her call at 130 and sell the stock at 154.


3. Strap
If the investor feels that the market direction is bullish for IBM, instead of buying a straddle she can buy a strap. A strap consists of 2 calls and one put. An example will be the following.

Buy 2 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

So if IBM were to go up, the investor will have a bigger profit. The effect will be the opposite of our strip strategy earlier. These are different forms of straddle but varying the degree of puts and calls, by capitalizing on the market condition, whether it is bullish or bearish.


4. Combination
A combination will be an event where the underlying stock is the same but the strike price or the expiration date is different. An example of a straddle with a different strike price is shown below.

Buy 1 IBM Aug 135 Call - Premium 10
Buy 1 IBM Aug 130 Put  - Premium  7

As you can see, the strike price for the call is 135, whereas the put is 130. To achieve a break even, the stock price had to be at least 152 for the call option or 113 for the put option. Anything above 152 and below 113 will represent ‘additional profits’. However if the stock price is exactly at 135 or 130 then the investor will lose all of her premium of $1700. However, this is a highly unlikely scenario.

An example of a straddle with a different expiry date is shown below.

Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Sep  130 Put  - Premium  9

In this case, the strike price is the same at 130, but the expiry date is different. Call on August and Put on September. The extra month of expiry of the Put will raise the premium to 9. In this case the extra risk involved will be the extra month for the Put to expiry. If it is let uncovered, what will happen when the stock price go up to 180 in September? The investor will have to bear the losses of 50 points (180-130) x 100 shares = $5000. So the potential losses in this case will be unlimited.

5. Other Strategies

There are other more sophisticated strategies which I think should reserved for professional options traders. Some of them are dealing in more than 3 options at one time. An example will be the butterfly spreads whereby it involves buying 1 low price call option, 1 higher price call option and selling 2 call options with a price in between the buy call options.
It can be illustrated below.


Buy 1 IBM Aug 130 Call - Premium 10
Buy 1 IBM Aug 150 Call - Premium 12
Sell 2 IBM Aug 140 Call - Premium 9


In this case an investor will only make a profit if the stock price is trading in between 130 and 150. The premium paid by the investor is 10+12-(2x9) = 4 points. So if the stock price move out of this range then the maximum the investor can lose is 4 points. Other strategies includes the following.

1. Spreads which can be divided to Bull, Bear, Butterfly, Calendar and Diagonal
2. Iron Condor when an investor believes the stock will trade in a range until expiry
3. Collar is used when an investor already own a stock but looking to,
• increase return by writing call option
• minimize downside by buying put option
4. Guts used when bullish in volatility. Buy 2 calls , one with higher strike price

Alright, that basically sums up our Trading Strategies and next we will look into how Big Money and Insiders manipulate the Stock Market using Options


P/s : Part 4 will be addressing the issue of how BIG money and Insiders using Options to manipulate stock markets.