Finance Jargon

An asset is a resource that can provide positive economic value (and is expected to do so.

There are two primary types of assets:

Tangible (physical): House, land, equipment, vehicles, stocks, etc.

Intangible (non-physical): Copyright, goodwill, franchises, patents, etc.

COOL INTANGIBLE FACT:
It is estimated that the Nike swoosh alone is worth $26 BILLION dollars. And it’s intangible!

FUNNY INTANGIBLE STORY:
Nike originally paid just $35 for a student (Carolyn Davidson) to come up with this logo back in 1971. 

That’s a pretty sweet return on investment – 74 BILLION PERCENT!!

A share of COMMON STOCK is a single share of ownership in a corporation available for purchase on most trading platforms. If a company has 500 shares in total, then owning five shares would make you a 1% owner of the company.


KEY ADVANTAGES:
1. Ownership in a company so you can brag that you are part owner in Tesla.
2. Voting rights! You can tell your friends: “Well maybe that’s how Elon feels but I’m going to have a word with him. Technically, I’m his boss!”
3. Eligible for dividend payouts. Mr. Wonderful’s momma always told him to hold dividend yielding stocks.


Common stock is indeed a tangible asset as discussed yesterday.

FUN FACT!

My first time ever trading was in 2009. I saw AIG trading at $0.33 a share…I called my dad and asked him if I should put my $2,000 in AIG. He called his broker who advised him to tell me “NO”.

It jumped to to $2.10 within the hour.

Out of frustration I dumped all of the $2K in a penny stock; some bank in Arkansas. I blinked and it was worth $0.04 in total.

A share of STOCK in a corporation that comes with no voting rights but has preference in terms of dividend payments and liquidation.

KEY ADVANTAGES:
1. Dividends get paid out first (versus common). Dividend payouts are also calculated differently than common stock but this is a topic for a different time.
2. If company goes bankrupt, chances are common shareholders will get nothing. Preferred holders get priority (but bond-holders come first).
3. Preferred shares are CALLABLE. We’ll cover this later.

DISADVANTAGES:
1. No voting rights.
2. There is interest rate risk (we’ll cover this later too) on preferred stock, due to how the dividends are paid out.

I have no witty anecdote about preferred stock so I’ll leave you with this:

Q: What do you call it when Batman skips church?
A. A Christian Bail

A dividend is the distribution of some of a company’s earnings to its shareholders, as determined by the company’s board of directors.

1. Some people like div paying stocks since you’ll actually see a return on your investment, whereas non div paying stocks is a guess whether the stock prices will go up or down.

2. Dividends are usually paid out as cash but may also be paid out as stock.
3. There is a date called the “ex-div date”. As long as you own the dividend prior to that date, you’ll receive dividends at the payout date.
4. Preferred stock dividends are calculated differently than common stock dividends.


MORE BRAIN FOOD:
When a company announces an upcoming div payment the “good news” will cause the stock price to rise. When the dividend is paid out, the shares will drop a bit since the div payment is coming off the company’s balance sheet.

There is a type of trading called “div trading” which is dedicated to this (we will cover when we get to trading strategies).

Div trading is WAY more popular in UK than in the US.

Bull: A BULL is someone who purchases shares now because they believe the price will go up.
Bear: A BEAR is someone who sells shares now, hoping to buy them back in the future since they expect the prices to drop.
You might hear people say “I’m bullish on Bitcoin” or “I hear Goldman is bearish on GME”.

“Liquidity is how quickly an asset can be converted into cash.”

We say “cash” since cash is technically the most liquid of all assets – it can be used AT IT’S VALUE to purchase pretty much anything you need.

Bid: The amount of money a buyer is willing to pay for each share of a given stock.

Ask: The amount of money the seller is willing to accept for each share of a given stock.

Bid-Ask-Spread: The difference between the two.
 
Following up from #6: Stocks with very narrow spreads are quite LIQUID while stocks with very wide spreads are ILLIQUID.

Can you see why?
 
Example of BID/ASK: GME is being quoted at $100/$101
The buyer will pay the ASK price of $101.
The seller will receive the BID price of $100.
 
So where does that extra $1 go?
Why, it goes to tomorrow’s word of the day!

A Market Maker is an individual or a firm who quotes both sides of the market for securities, both bids and offers. Market Makers provide liquidity to the marketplace. MMs earn the Bid-Ask Spread diff as profit on each trade.

 
Example: ScriptUni is a Market Maker (MM).

ScriptUni is willing to purchase DATA US for $100 (200 shares in total) and willing to sell DATA US for $101 (600 shares). The number of shares for sale and purchase will fluctuate throughout the day.

The most common type of Market Maker is a brokerage house.

There is risk to MMs, this isn’t free money as the transactions (buy and sell) don’t happen at the same time. The stock price may change resulting in a loss on the transaction.

A Blue Chip Stock is stock in a company that is extremely successful, typically with market cap in the billions and an amazing reputation.

But wait, there’s more!

Blue Chip Stocks also:

1. Typically pay dividends, some have been doing so for DECADES
2. If “Blue Chip” was a bond categorization it would likely be AA+
3. Blue Chips tend to recover relatively swiftly after market downturns
4. Some popular Blue Chips: Coca-Cola, Wal-Mart, IBM, etc.

Fun Fact!

“Blue Chips” got their name from the game of Poker where the blue chips are typically worth the most.

“Long” or “being long” means you are bullish about a stock so you buy shares and hold them for a period of time, anticipating that the stock will rise in value and you will be able to sell your shares later for a profit.

What if you anticipate a stock will FALL in value? How can you profit off that?

Here is how you SHORT a stock:

1. Pick a stock you believe will fall in value.
2. Borrow the stock from an entity (usually you will pay a small fee for doing this).
3. Sell the stock to a 3rd party.
4. Wait until the stock falls.
5. Buy the stock back.
6. Return it back to the entity you borrowed it from.


Overly simplified example:

1. AAPL is currently trading at $100. Bob believes AAPL will drop in price.
2. Bob goes out and borrows 10 shares from JPMorgan (let’s assume no fee for this example).
3. Bob sells those 10 shares on the stock market for a total of $1,000.
4. AAPL falls a week later to $50 per share.
5. Bob buys 10 shares on the market for $500.
6. Bob returns the 10 shares to JPMorgan, and pockets the extra $500.

An IPO, or Initial Public Offering is the first sale or offering of a stock by a company to the public. An IPO occurs when a company decides to go public rather than remain solely owned by private or inside investors.

Why go public?


1. Allows the company to raise capital from public investors
2. Early investors, executives, and in some cases many employees get to
“cash in” on the shares of the company that they have been holding
3. Liquidity for investors is increased

Some More Tidbits:


> Usually at least one large investment bank is nominated as an underwriter
to bring the company public. It’s a pretty big honor (and paycheck) so there is
a lot of negotiating before the lead underwriter is selected
> Going public means your company is going to be under SEC scrutiny going
forward

A stock exchange is a location where stockbrokers and traders can buy and sell shares in a company. 

These companies are PUBLIC as discussed yesterday, so trading happening behind closed doors wouldn’t be very fair to other potential investors.

The five largest stock exchanges in the world are:

1. New York Stock Exchange:  $28 Trillion
2. Nasdaq:           $13 Trillion
3. Japan Stock Exchange:    $5 Trillion
4. Shanghai Stock Exchange:  $5 Trillion
5. Hong Kong Stock Exchange: $4 Trillion

There are exchanges that trade other securities as well, but for today we are discussing just stock exchanges.

Some cool facts:

> Exchanges used to be in physical locations. Ever saw those epic videos of people shouting at each other in a crowded room holding sheets of paper? Those were physical exchanges.
> Now, trading is ALMOST all done electronically (Nasdaq was the first electronic exchange!).
> If a stock on the NYSE has an average 30 day trading price of below $1, it gets delisted from the exchange!

Pink sheets are stocks that are not listed on any public stock exchanges, they trade over-the-counter.

Pink sheets are sometimes referred to as “penny stocks” because they are so cheap, usually due to the small market cap size of the company.

Depending on the exchange requirements, usually pink sheets are not listed on an exchange because their price per share is simply too low, most often less than $3-$4.

Since there is very little regulation on pink sheets, they are very risky, but due to their volatile nature, it is possible for some PS stocks to see incredible growth in a short period of time. There are firms that have capitalized on this.

Most brokerage related movies often show scenes of brokers trying to push PS stocks to uneducated investors, claiming that due to the low prices the upside is incredible (meanwhile the brokers make a killing on fees).

Penny stocks are called “pink sheets” because the listings were originally printed on pink paper. Now they are published electronically but are still listed as “OTC PINK”.

Google Definition: Volatility is the liability to change rapidly and unpredictably, especially for the worse.

Investopedia Definition: In finance, volatility is the degree of variation of a trading price series over time, usually measured by the standard deviation of logarithmic returns.

Volatility usually measured using standard deviation, which indicates how tightly the price of a stock is clustered around the mean.

Simply put, volatility is how “jumpy” a stock is. If a stock is slow to move either up or down it’s not very volatile.

The statistics behind volatility, how it’s calculated, and how it helps technical traders is pretty vast and we will certainly not go into that here, but it is one of the most exciting measures of a stock for quant traders. 

We’ll be covering many more jargons that have the word “volatile” in them not too far in the future.

When people on the desk say “vol” this is what they are referring to, not volume!

A sector is an industry or market that shares common operating characteristics.

“Technology” is a sector.

“Health Care” is a sector.

Often you’ll find that stocks within a sector have related stock price movements.

For example, say there was an alien invasion and these aliens ate METAL for food. They started eating all the metal on Earth.

The automobile sector would likely see a significant drop in value.

In other words, most automobile stocks (Nissan, Toyota, Tesla, etc.) would see their stock price DROP significantly.

Traders would imagine that because metal is now so rare, car manufacturers will have to charge a lot more for each vehicle, which will in turn cause less cars to be sold.

This is bad for the car companies and their stock price would drop as a result.

Fun Fact:
Is TSLA an automobile company? For years many banks just weren’t sure. Some had TSLA as an Auto company while other banks had TSLA as a Tech stock. TSLA has even dabbled in the Energy sector!

Most companies are pretty straight forward, but sometimes such a revolutionary company can sometime confuse the pros!

“GICS” or Global Industry Classification Standard is an industry taxonomy developed in 1999 by MSCI and S&P for use by the global financial community. GICS consists of 11 sectors, 24 industry groups, 69 industries and 158 sub-industries.

(Thank you very much Wiki dear)

Ok, so what did all that fancy talk mean?

We discussed SECTOR yesterday. But what if Goldman calls it “Autos” and Morgan Stanley calls it “Cars”. What if Goldman has a second level breakdown under Autos called “Gas, Electric, and Self-Sustaining” while Morgan only has “Powered, and Self-Sustaining” 

Having each firm decide all levels of sector classifications can get messy very quickly, and it makes it near impossible to share data between firms.

Let’s say Citi hires DTCC to clean their trades, but DTCC returns the trades with their OWN sector classifications which don’t fit into the Citi system?

Enter GICS.

It’s universal; nearly everyone in finance is on GICS already.

FUN FACT:
When GICS decide to update their sectors it costs firms in some cases MILLIONS of dollars to do testing and updates to all of their systems and data.

All this commotion from something that sounds like an ice cream flavor…

Volume is a count of how many shares of a stock have traded during a trading period.

When talking raw volume, usually it just means how much was traded over the course of a day.

ADTV is “Average Daily Traded Volume” which is a popular metric used to see how liquid a stock has been trading over a time period.

Let’s take the most popular version of ADTV:

“ADTV22” AKA “The one month average daily trading volume”.

Let’s pretend we have a fairly illiquid stock called QZT.


If QZT traded 100 shares each day for 21 days, and then for the last day it traded 50,000 shares, what would the ADTV22 be?

((100 * 21) + (50000 * 1)) / 22 = 2,368 shares a day on average.

You can see the weakness for doing this for illiquid stocks such as this unusual case. It doesn’t tell the full story; this stock looks quite liquid but really it just had one great day!

For your average liquid stock, this metric works just fine.

An index is a method by which to measure the performance of a group of assets. Some indices are very broad such as the S&P 500 or the Dow Jones, while others are much narrower such as the S&P GSCI Energy & Metals index.

You can think of an index as a basket of securities which helps you understand how a certain sector is performing.

Most people use an index to help them track how their investment is doing “relative to an index”.

For example, if you are pretty sure that Honda is doing a great job at manufacturing new vehicles so you invest heavily, you might want to track your investment versus an auto index to see how your pick stacks up against autos in general.

Not only do indices track sectors, but there are even country-based indices!

Another great use for indices is diverse investing. If you only have a couple thousand dollars to invest, it might be trick to diversify your portfolio. Buying into funds that track popular diverse indices (such as the S&P or DJ), could be a great way to diversify at a low cost.

We’ll cover investing in indices in number 19.

An Exchange Traded Fund (ETF), is a security that is comprised of a basket of securities built to track an index, sector, commodity, bonds, or any asset
quite frankly. ETFs can be bought and sold on a stock exchange just like the underlying securities!

Big banks often construct ETFs to follow certain investment strategies (not even a specific index or sector in particular), and offer them to their PB
clients to invest in.


On of the most popular ETFs is the SPDR S&P 500 ETF which trades by the ticker SPY. This tracks the S&P 500.

ETF popularity has skyrockets in the past two decades. In 2003, worldwide ETF assets equaled $204Bn. By 2020 that number had reached $7.7Tr !!

Did you know?

People love buying ETFs because to get the same level of diversification, you would have to buy all of the underlying components individually which aside from being quite cumbersome and expensive also costs quite a lot on brokerage commissions. With ETFs it’s significantly cheaper!

Random Joke:

“What’s green, fuzzy, has four legs, and if it falls out of a tree could easily kill a full grown human?”

Arbitrage is an opportunity to make free money by taking advantage of a price discrepancy for the same asset.

A really simple example would be if XYZ stock sold on both NASDAQ and NYSE. On NASDAQ the stock was trading for $99 a share and on NYSE, $100 per share.

You could buy 100 shares on NASDAQ for $9,900 and instantly flip the shares on NYSE for $10,000 making $100 profit completely risk free.

This is known as Pure Arbitrage.

Risk Arbitrage is similar, but it’s with a bit of a gamble included so you could potentially be wrong and end up losing.

Arbitrage used to exist but in practice it is VERY difficult for regular retail investors to take advantage of these opportunities nowadays since market makers have powerful algos seeking and taking advantage of these the moment they exist, closing the gap instantly.

Arbitrage isn’t just about stocks, it could also work across multiple assets.

For example you could purchase and asset in one country and sell it in another where there is a mismatch in currency exchange rates.

JOTD:

Q: If you’re a NASA engineer, how do you prepare for your friend’s birthday party?

A: You planet!

We already discussed “asset” (our first jargon). There are tangible and intangible assets.

We defined stocks (common and preferred), but there are many other assets.

The official online definition of asset class is:

“An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.”

Each “type” of asset is in a class of it’s own, hence “asset class”.

Stocks are part of the EQUITY asset class.

This is because when you own a stock you own equity in a company.

Over the next week we’ll break down the other popular asset classes.


JOTD:

My financial advisor just told me, “I’m sorry to say, but all of your assets are Frozen.”

I responded: “Why did you use all of my money to buy so many of same movie?”

The important thing to know about this asset class is that it is the most liquid of all asset classes.

From a regulatory perspective this is an extremely important asset class for big banks as they might need some extra cash on hand quickly if some of their more risky trades turn sour.

Often this asset classes is also turned to when a party needs to post collateral.

So what can be liquidated quickly?

> Cash
> Govt Bonds
> Commercial Paper

From an accounting perspective, cash and cash equivalents help companies with their working capital needs since these liquid assets are used to pay off current liabilities, which are short-term debts and bills.

You’re generally not expecting amazing returns from this asset class. Unlike other asset classes it’s purpose are those mentioned above, not to earn profits.

A few items in this definition we did not cover yet, but we will shortly: Collateral, regulatory, Govt Bonds, Commercial Paper, working capital, current liabilities.


JOTD:
Why is cash called “dough”? Because we all knead it!

We already covered the major asset classes: Equity, Fixed Income, Cash or Cash Equivalent.

There are quite a few additional asset classes but most institutions don’t agree on how to categorize them.

Some institutions put them all in a catch-all bucket called “Alternative Investments”, while some institutions categorize them individually.

Since I would like to move on to new topics I’m going to bucket them here as well.

Here are a few asset classes that might fall in the alternative bucket or might stand on their own:

1. Real Estate – Land & Property
2. Commodities – Gold, Minerals, Oil, Grains, Beef, etc.
3. Cryptocurrency – Bitcoin, ETH, Dogecoin, Potcoin, etc.
4. Art – Paintings, sculptors, etc.
5. Private Equity
…and more

Most analytic-driven firms won’t bucket all of these into one “Alternatives” bucket because commodities are affected by seasonality while art is not. Bucketing like this isn’t very safe for making assumptions about investments or risks given how different these asset classes are.

Another example: Real estate is a very stable investment. Crypto is more erratic than Goofy on drugs.

A bond is a fixed income instrument. It’s a loan made by YOU the “bondholder” to a corporation or government “the issuer” to help them raise money for use in their company or government. This is paid back either slowly over time or as a lump sum, often many years later.

***Storytime***

Zapple Computing is excited to release it’s latest offering the iBalloon, a balloon which streams both party streamers AND music! Sadly, they have run out of funds for manufacturing. Already pretty diluted, they don’t want to offer up any more equity of the company (stock issuance) to raise capital, so instead they offer YOU Jane Doe a BOND in exchange for a gazillion dollars.

They then use the gazillion dollars and invest it all in their iBalloon product which is a colossal failure.

The company goes bankrupt and you never see a penny back on your gazillion dollar investment.

Sad times.

As discussed above, a bond is a loan from you (the bondholder) to an entity that gets paid back to you at some point in the future.

The simplest bond to understand both conceptually and mathematically is the zero coupon bond.

It’s simply a loan paid back in the future at a higher amount.

There are no intermediate interest payments.

Example: A $1,000 bond that expires in one year is trading for $900 today.

Essentially it’s as if you invested your $900 and earned 11% interest over the year, a very nice return on investment.

There is a pretty substantial risk to consider though. What if this bond pays out not in 1 but in 10 years.

You won’t see a penny until the expiration date, which is a long time to “hope” that the company or gov’t doesn’t go bankrupt! If they do go under, there is a chance you won’t see your money.


Fun Fact!
You DO have to pay taxes (federal, state, and local), on the money you earn on the bond (in this case a total of $100). In some cases, you’ll have to pay taxes on the interest that you have earned throughout the bond period EVEN THOUGH YOU DIDN’T GET A PAYOUT YET.

Pretty weird.

There are ways around this but we won’t get into this today.

A fixed coupon (or “fixed rate”) bond, is a bond that makes periodic payments throughout the life of the bond and then a single final payment at maturity which matches the initial principal amount.

At face value this looks pretty simple:

Time 0: You loan ABC Suppliers $100
Time 1: ABC pays you $5
Time 2: ABC pays you $5
Time 3: ABC pays you $5
Time 4: ABC pays you $5
Time 5: ABC pays you $5 + returns your $100

But if you think about this, it’s not very different at all from putting $100 in the bank at a 5% interest rate.

This has interesting implications.

Let’s say for arguments sake this bond is currently trading in the market for $100.

What would happen if interest rates would rise to 10%?

Well, people would never take this bond! Why invest $100 to get $5 a year when you could simply invest your money at a bank for $10 a year?!

Because of this, the bond price will FALL. Maybe people will only pay $80 now for this bond.

So we would say that interest rates have an inverse relationship with the price of the bond.

One final comment: This bond is SLIGHTLY less risky from a default perspective as the Zero Coupon Bond. Even if the issuer defaults a few years in the future, at least you got some payments out of it!

Companies can be strong and stable with a seemingly rock-solid future (see Amazon, Microsoft, etc.) or weak and unstable (see Radio Shack, Sears, and dare I say it, GME).

Governments are typically considered very stable but there are instances (see Greece a few years back) where they are so financially unstable they can’t pay their dues.

There are agencies that have built up a huge reputation for rating bonds of companies and governments. The most popular of these companies are Moody’s and Standard and Poor’s.

While they both rate differently, the general concept is the same:

AAA = Amazing rock solid, won’t default
C/D = “Junk”, very good chance of default

Generally when a bond is higher rates you can expect it’s interest rate to be lower. For example, government bonds tend to offer a very low coupon, but that’s because it’s more or less a guaranteed payout.

For more information on bonds, don’t forget to tune in to AbsoluteFintech this Sunday where Simon Ree will drop a AAA rated session on us!

Would you lend $100 to a friend who was extremely unreliable, rarely paid you back, but promised to pay you back this time and pay you back $200, DOUBLE what you loaned her?

That’s a Junk Bond in a nutshell.

> A corporation is borrowing money from you but it’s not a very reliable company. Typically the S&P and Moody’s ratings will be C or D.
> The coupons or payout at the end tend to be much higher than a typical bond to compensate for the riskiness
> The big risk here is that the company will DEFAULT and won’t be able to pay out it’s dues

A few other cool things to keep in mind:
> These bonds are also known as “high yield” due to the second bullet above.
> If investors are purchasing junk bonds it tells us how much risks investors are willing on taking; a nice market indicator
> If you own a Junk Bond and the companies status improves the bond price could bounce back earning you a nice return on investment!

If you loaned Billy Gates $100, what annual return would you like to see on your investment?
That’s yield. But it changes every single day.

How so?

The basic calculation for yield is COUPON / PRICE.
So if you loaned Billy G $100 for Microsoft and you were paid $5 each year on this bond, your yield is 5%
$5 / $100 = 5%

But don’t forget that last week I mentioned that interest rates and company stability both change frequently, and both impact the price of a bond.
This bond that you now own…stinks for you but the price now dropped drastically and now is only worth $50! Oh no!
If you would sell this on the market, what would the yield be listed as?
Well, the price is now $50, so 5 / 50 = 10%.
The yield went up, making it a much more attractive purchase!

Note: If interest rates were in the 10% range that might have been the cause of the bond price changing by itself.
We’ll discuss a couple of terms associated with this price change tomorrow.


Bond Joke:
I’m often referred to as a secret agent when I play League of Legends. My Kills/Assists/Deaths is often 0/0/7.
Oh wait…

What if you just want to answer this question: Is purchasing this bond a good idea? Is it a good long term investment for me?


Yesterday we discussed bond yield and defined it as COUPON / PRICE

But the thing is, that’s coupon / current price. That yield will absolutely change.

There is a better, more “long term” yield that is used to accurately answer the question: “If I purchase this bond today and hold it until it matures, what is my yield?”

The answer: Yield to Maturity (AKA Book Yield or Redemption Yield)

YTM is the rate of return the bondholder can expect if she:

> Holds the bond until maturity
> All payments are made as scheduled
> All payments are immediately reinvested at that same rate

While YTM is a far better metric to determine if a bond is a good investment, I will not be sharing the formula here as it is pretty darn scary looking.

Look it up at your own risk!

Face Value:
When the bond matures, what will be the payout amount?

Coupons:
Periodic cash payouts (like interest payments) to the bondholder

Coupon Rate:
The % of the Face Value that will be paid out periodically

Coupon Dates:
When the coupons will get paid

Frequency:
How often coupons are paid (Annually, Semi-Annual, Quarterly)

Maturity Date:
The day that the bond expires and the Face Value is paid out

Issue Price:
The original price the bond was sold for (remember bond prices fluctuate a lot after they are initially sold)

If you were to loan the US government $1,000 for 1 year and loan $1,000 again, this time for 10 years, would expect the same annual interest rate on both loans? 

For the past few jargons we have been discussing Bond Yield.

A Yield Curve is a line that plots the interest rates (yield) paid out on bonds where the credit quality is exactly the same, but the bonds have different maturity dates.

The image attached is that of a US Yield Curve. That is, purchasing bonds from the US Government at different maturities, what yields you can expect.

(P.S. I made up the numbers in the graph, just for illustration)

The image attached is known as a NORMAL yield curve since the rate you receive is larger per anum for the longer bonds (this makes sense intuitively, because the longer hold a bond, the bigger chance their is that the issuer will default and you’ll never get your money back).

An Inverted yield curve is when it slopes DOWN instead of up. 

When would this happen?

Well if a recession was anticipated, it would be more desirable to lock in longer rates now. Let’s say we expect a recession in 5 years. You would be better off locking in a 10 year bond today, since when the recession hits interest rates fall hard. So the risk of rates dropping is so bad that it is even more desirable to take the potential default risk rather than risk the recession causing rates to go down.

There are also flat curves where the yield is pretty constant.

Normal yield curves are by far the most common.


When purchasing a bond you might ask yourself:
“How many years will it be until I have received back my initial investment on this bond given the interest payments?”

Let’s say you have a 10 year bond which has very high coupon payments and it wasn’t too expensive.

Fantastic! The duration will probably be pretty low.

That is, it might be only a few years before you receive back your entire initial investment just by the coupon payments alone (unrealistic, but for illustration purposes).

Your friend Barbara also has a 10 year bond from the same company, but her coupons are smaller (she bought at a different time).

It will take her LONGER to earn back her initial principal payment since her coupon payments received are low. So her duration is a bigger number.

The amount of years it takes to get paid back your principal is DURATION.

Duration is also thought of as metric that measures a bond price’s sensitivity to interest rate movements.

We’ll go through a few examples of different types of durations in the coming days to clarify this.

Scenario: You will need $50,000 to send your daughter to college in 18 years.

How much money will you need to invest today in a guaranteed 5% interest account to end up with $50,000 in 18 years exactly”

The method by which you calculate this is called DISCOUNTING.

Hold up! Mark, aren’t we supposed to be talking about Bonds?

Yes. Yes we are.

But for the next few terms, we will need to know what discounting is, so brief bond intermission!

Discounting is the mathematical method in which you look at a future payment of cash and determine the answer the question “what would I pay TODAY to receive that in the future?”.

For our scenario described above, we start with $50,000 and then discount it back using the interest rate (5%) and the amount of time periods (18) to end up with what we need to invest today.

This value we need to invest today is called the PRESENT VALUE.

The answer to this particular question (making some basic assumptions we won’t touch on today) is:

$20,776.03

In lieu of your next 14 years of daily Starbucks Venti Caffe Lattes, you can send your child to college!

~ Stop drinking and start thinking ~

AKA MacD.

Nope, we’re not talking about cheeseburgers.

MacD is short for Macaulay Duration and it’s the most popular version of Bond Duration.

MacD answers the question of: How long will it take an investor to recover her initial investment through coupons and principal payments?

From a strictly non-mathematical sense you won’t until the maturity date.

Let’s say your bond pays $50 a year and then $1,000 + $50 at year 5.

If you paid $900 for this bond you won’t see your $900 back until maturity when you get the $1,000 cash + $50.

Well, if you take the “weighted average present value” of each cashflow, you’ll see that mathematically, you will be receiving back your $900 investment at some point during the 4th year, not at the very end.

This has implications for one primary reason:

Bonds with lower durations are less price sensitive to interest rate moves in the market.


Is this confusing to you?

It was to me as well when I first learned it.

Well, good news.

This coming Sunday I’m teaching Bond Pricing 101. If you join this lecture, then in three weeks we will be covering MacD in Excel. When that Sunday arrives I will be covering MacD and nothing but MacD so you can be sure I will break this down very slowly and carefully answering the following questions:

1. What is MacD used for?
2. How is it calculated?
3. Walk through an example in Excel
…and end off with Q&A

I look forward to seeing you in the coming sessions.

Go to the AbsoluteFintech site to register for free today!

Bonds are one of the simplest financial instruments. You give a loan to a company, and you get back periodic interest payments until your money is returned.

It’s interesting though.

Pre-college when someone owed you money you never thought of it as you “owning” a loan.

Well, that’s exactly what it was.

Because it’s something you OWN it has a value.

This value changes on a daily basis.

Yesterday we discussed Macaulay Duration, which (complex formula aside) simply answers the question: “How long will it take an investor to recover her initial investment through coupons and principal payments?”

Modified Duration actually uses the MacD number and accounts for changes in Yield to Maturity (Jargon #32).

The math is exactly the MacD formula with a bit of YTM sprinkled in.

YES, I will cover both of these in detail in a few Sundays on AbsoluteFintech.

So what does ModD tell us?

“Modified Duration is the change in a bonds duration (and price) for each percentage change in Yield to Maturity”

It’s super confusing and often frustrating to try to understand so rather than try to simplify it here I will just demonstrate it in Excel in a few Sundays.

Please make sure you attend this Sunday’s free class on Bond Pricing.

It will be super elementary and easy to grasp.

All future fixed income lectures will build off of it!

As we have discussed previously, duration measures a bond price’s sensitivity to interest rate changes.

The problem is, duration is a linear measure. That is, if you were to graph duration against price and interest rates, it would be a straight line.

But the risk is not straight. 

Convexity measures how fast a bond’s price changes as interest rate increases or decreases (for us math nerds, we call this a second derivative).

Higher coupon bonds usually have lower convexity, since, for example, a 5% bond is more sensitive to interest rate changes than a 10% bond.

Zero coupon bonds have the highest convexity, more than fixed coupon bonds.

Can you see why?

Do you own a house? Are you planning on purchasing a property? Then you are an investor!

I didn’t describe Real Estate as it’s own asset class earlier (I bucketed it with Alternative Investments) but there is so much history around the impact of real estate on the financial markets that I decided it deserves it’s own class.

Over the next few jargons I’ll focus on some RE terms that have shook all of finance to the core over the past few decades.

Let’s get started.

There are two ways to think about real estate investing.

PRIVATE:

You purchase property. Private RE investing is usually broken up into two sub categories, residential (personal) and commercial (for businesses).

PUBLIC:

In the coming days I will describe in detail how to do real estate investing on the public stage. There are financial instruments that allow you to invest more broadly in RE.

I’m excited. Fun stuff ahead. But not for Bear Stearns.


Did you hear about the last apartment available in our building? It was last but not leased.

Did you ever want to be part of a really fun and exciting investment opportunity but it was just too far out of your reach?

Securitization is a the act of pooling similar assets (usually loans) into one massive new security. 

There are many financial benefits to this, and many new risks introduced as well.

In truth, this isn’t a Real Estate term per se but as you will see in the coming days, this technique had (and has) massive implications on the health of the financial markets.

From a practical standpoint, securitization is healthy for both the originators of the underlying deals as well as investors.

The originators get to sell off all their original deals which leaves them with a nice pile of cash to make NEW deals with, and the investors get to sink their teeth into investments that they wouldn’t normally have access to creating liquidity in an area that is usually illiquid.

As we’ll see in the not-so-distant-future there is a massive risk with securitization.

Transparency becomes an issue.

If these were just individual loans being sold on the market it would be obvious if there was an unhealthy loan, but now that it’s just a bucket of loans, it’s just taken at a rating and assumed to be pretty safe (whooopsie!).

If it looks like a bond and it acts like a bond but it’s a real estate investment, it’s probably an MBS.

An investor can invest in an MBS and receive coupon payments just like a bond.

Additionally, an investor can choose their risk tolerance. They can choose to invest in a more risky MBS (think junk bonds) and receive higher coupon payments to compensate for the additional risk.

So what exactly is an MBS?

A bank might grant mortgages to 100 customers, 50 of them being strong, and 50 in the high-risk category.

The bank will then “bundle” the mortgages into an instrument that aggregates the monthly cash-flows (customers making their monthly mortgage payments), and pays out coupons to investors in the MBS.

The 50 strong mortgages might be an A-rated MBS, while the riskier ones might be C-rated.

Why would a bank go through all of this trouble?

1. With the bank selling off all of these mortgages in a bundle, they get a huge injection of cash, and now they can go out and offer more mortgages.
2. Since the bank sold these off, all the risk associated with these mortgages now lies with the investors. The bank just eliminated all of its risk.


~ Fun Fact ~
Next time you purchase a house, along with the 2,000 other papers you will sign, there will almost certainly be a document authorizing the bank providing your mortgage with the right to sell off your mortgage to an outside investor. When this happens and as you are signing that paper, ask your loan officer: “Am I contributing to the next Wall Street meltdown?” Watch as she laughs sheepishly and quickly stuffs that document back in the pile.

Your name is Bill. You are standing at Bank QQQ’s headquarters.

You decide you want to get in on all of the action and start investing in an MBS. You would like to get monthly cashflows as part of the more secure mortgages in this pool.

You have one concern though.

What happens if Bank QQQ goes bankrupt? Will other creditors start dipping into your MBS and clean out all remaining $$$ before you can get paid?

You understand that an MBS is as risky as the mortgages it contains but isn’t Bank QQQ’s financial stability also a cause for concern?

The answer, is today’s Jargon:

Finance Jargon #43 – Special Purpose Vehicle (SPV)

A Special Purpose Vehicle (SPV) is a separate legal entity created by an organization. The SPV, in both legal and financial terms has no ties to its originator. Firms primarily create SPVs to minimize risk. In the case of MBS, they are created to address Bill’s concerns.

Bank QQQ sets up an SPV and funnels all of the underlying loans into it. The SPV then makes monthly payments out to its investors.

If Bank QQQ goes bankrupt, the SPV doesn’t care; the MBS will live on.

Sweet stuff!

Today’s finance lesson is also a French lesson!
Tranche means “slice” according to Google translate.

An SPV can split up the underlying mortgages into tranches (A, B, C, etc.).

These tranches are organized by riskiness as well as maturity dates.

This allows investors to choose which tranche they want to invest in giving them the opportunity to take on additional risk in return for a larger rate or return.

Tranches can also be split up by other features as well such as geography.

Tranche A would be first to receive cashflow from the mortgage payouts and carry the lowest risk, while (if it exists), tranche Z would likely get no cash payouts at all until all of the other tranches are paid out.

Credit Rating Agencies might label tranches.

In 2007, many tranches were miscategorized, and despite containing essentially Junk Bonds (below grade mortgages), were given extremely high ratings.

There are books written on how this ever allowed to take place or what prompted this in the first place, but the outcome was catastrophic…

Have you ever told someone who borrowed money from you: “No, I don’t want you to pay me back early!” ?

With all of the other assets we discussed there are risks associated with investing in them:

Interest rates can move, borrowers can default and won’t be able to payback, not enough liquidity…

But we never discussed prepayment, something that sounds more like a benefit than a risk.

In fact, it seems like the OPPOSITE of defaulting!

I mean who DOESN’T want to be paid back sooner than expected!?

The answer: People who invest in mortgage securities.

They want a steady stream of cash at an agreed upon interest rate.

If you have a mortgage at 5% interest, an individual would love to invest in that mortgage and start collecting your monthly principal + 5% interest payments.

Once you pay down the principal though, the borrower has no more interest obligations!

So what would make a borrower pay down a mortgage faster?

From a savvy investor perspective there really is one underlying cause: Interest rates.

Let’s say at the time of the mortgage interest rates were 5%, so your deal was in-line with the market.

Now interest rates drop to 2%.

The homeowner will go to a different bank, take out a new mortgage at 2% and that new bank will instantly pay down your entire loan. No more 5% interest payments! :SAD FACE:


BRAIN FOOD:

So it seems like falling interest rates are bad for an MBS investor. But what about rising rates? Those seem bad too!

If an investor could go out to the market and purchase a 7% interest bond, why would they want to hold on to this 5% mortgage investment??

So…I lied a bit.

All of that tranche and risk talk really belonged here, not in the MBS topic.

MBS are really just a pool of mortgages bundled together.

CMOs are where they get fun.

A CMO organizes the bundled mortgages by risk and maturity tranches and then issues bonds out to investors who will receive recurring payments on those bonds.

Since these bonds are backed by the mortgages, they are called “Collateralized Mortgage Obligations”.

Investors do not purchase CMOs, they buy bonds on the CMO, and they get to choose which type of bond they want to purchase based on the trance (level of riskiness).

The main distinction between ABS and MBS is that an ABS is not backed by mortgages, but by pools of other assets such as student loans or auto loans.

Prepayment Risk: It exists for ABS as well but is much more pronounced for MBS.

Refinancing: Really only something that happens with mortgages (and to some extent student loans). Autos depreciate so quickly that it’s rarely worth it to refinance.

One thing that ABS has that MBS doesn’t: Credit risk.
The tranching for ABS are designed around this, with the more risky tranches paying out higher yields to compensate for the credit risk.

(There are some forms of MBS that do have credit risk, will cover in a future post)

Agency MBS are created by a Ginnie Mae, Fannie Mae, or Freddie Mac.

Ginnie Mae MBS are essentially free of default risk and are completely backed by the US government.

Fannie Mae and Freddie Mac MBS were created by the government but are now owned by shareholders, as such they are not US-backed. Still, they do have very low risk of default.


When a private entity such as a bank issues an MBS, that has no ties to the US government and is referred to as a non-agency MBS.

These contain credit risk as mentioned yesterday, and the lower the tranche (typically) the higher risk of an event occurring.

A CLO is very similar to a CMO except the underlying assets are loans, typically from businesses borrowing money from a bank.

The loans are bucketed by maturity and riskiness, similar to CMOs as well.

An investor is exposed to credit risk based on the risk profile of the businesses that are underlying the tranche they have invested in.

Fun Fact:

Even though these CLOs sound a lot like a typical corporate bond (just in bulk), historically, CLOs have much lower default rates than corporate bonds.

Note: This 100% real story occurred between two farmers. It took place this past winter.  

Farmer Joe thinks the corn season is going to be downright STINKY this summer. Farmer Frank thinks that on the contrary, corn is going to be bloomin’.
Currently, a cob of corn is selling for $1 a piece.
Joe decides he’s going to capitalize on Frank’s ignorance.
He walks up to Frank and says:

” Hey Frankie ol’ pal, if you are so sure corn is going to be bloomin’, there shouldn’t be any price issue this summer. In fact the price should DROP since supply will be so high.

I’ll make a deal with you now that on August 1st I can buy 100 cobs of corn from you for $1.10 per cob. 

Frank thinks:
” What a loser! With corn bloomin’ the price will go DOWN not up!! 

Frank agrees to the deal.

Sad times.
All the corn dries up and there are only a few farms that are successful in growing corn. The price rockets to $2 per cob.
Frank must fulfill his obligation. Joe buys 100 cobs from Frank for $110, and immediately flips them on the open market for $200.
Joe leaves a happy and very very rich man, earning an easy $90!

VEGAS, HERE COMES JOE!  

That’s a forward contract.
Two parties agree to exchange any asset that they choose for a predetermined price at a set date in the future. 


Note: Forward Contracts are usually not used for the case I described above (profit speculation), usually they are used for HEDGING, but given that I haven’t covered hedging yet, I didn’t focus on that use case.

Yesterday we discussed Farmer Joe and Farmer Frank. They had a agreed upon a forward contract.

Today we’ll talk about Mr. Forward Contracts’s twin sister, the Futures Contract.

A futures contract while very similar, can’t be quite customized like yesterday’s corn example.
Futures contracts have standardized terms, are traded on an exchange, and the prices are settled on a daily basis (until the contract expires).
This is unlike forwards which are “over-the-counter” and can’t be found on an exchange. Because forwards are traded OTC, you can customize them.

A good thing to think about is while with forwards you have serious counterparty risk (Frank gets upset about losing the bet and flees the country…or he just dies), this just doesn’t exist on the futures market since a clearing house guarantees the transaction.

Apple stock is trading at $100 today. I believe the price will RISE.
I make the following deal with you:

“In two years, I’ll pay you $105,000 for 1,000 shares of Apple stock ($105 per share)”

You, believing Apple shares will DROP not RISE agree to the deal. Usually there is a premium involved, I will not discuss this today.

Scenario #1:
In two years, Apple shares drop to $50.
I can pay you $105 per share, but why would I? They are only worth $50 a share now, I would be losing $55 each share? In this case, I let the option EXPIRE, and the option we agreed on becomes worthless, worth $0.

Scenario #2:
In two years, Apple shares rise to $300 per share.
I pay you $105 for each share, and turn around and sell them instantly on the open market for $300, making a $195 profit for each share!

Here is some options terminology:
K: STRIKE PRICE: $105
T: EXPIRATION:  2 Years
S: SPOT:     Current market price for a single share

The formula for calculating what this call option is worth at expiration (in 2 years) is the following:

Max(S – K, 0)

S – K simply means, SPOT – STRIKE.
As in, you pay the strike price for each share (so it’s negative because you’re losing that money), but people on the market (spot) will PAY you, so the S number is positive.

The fancy MAX function and the “,0” simply mean:
If this won’t be a positive trade for us, like in scenario #1, I’ll simply let this option expire, so it’s worth $0. In other words, while the payoff might technically be a negative number, it will never be less than 0 since I will just let it expire.

I’ve plotted a bunch of scenarios in a picture for your viewing pleasure.

People in finance love calling this chart a “reverse hockey stick”.


Apple stock is trading at $100 today. I believe the price will FALL.
I make the following deal with you:

“In two years, I’ll sell you 1,000 shares of Apple stock for $105,000 ($105 per share)”

You, believing Apple shares will RISE agree to the deal. Usually there is a premium involved, I will not discuss this today.

Scenario #1:
In two years, Apple shares drop to $50.
I can sell you (force you to buy) $105 per share, and I certainly will. I’ll earn $55 profit on each share if I sell them on the market right away. Yummy!

Scenario #2:
In two years, Apple shares rise to $300 per share.
I can sell you Apple shares for $105 for each share, but why would I? I would end up losing $195 for each share!

Here is some options terminology:
K: STRIKE PRICE: $105
T: EXPIRATION: 2 Years
S: SPOT:   Current market price for a single share

The formula for calculating what this put option is worth at expiration (in 2 years) is the following:

Max(K – S, 0)

K – S simply means, STRIKE – SPOT.
As in, you’ll pay me K for each share, and then I will go sell them on the market, earning S for each share.

The fancy MAX function and the “,0” simply mean:
If this won’t be a positive trade for us, like in scenario #2, I’ll simply let this option expire, so it’s worth $0. In other words, while the payoff might technically be a negative number, it will never be less than 0 since I will just let it expire.

I’ve plotted a bunch of scenarios in a picture for your viewing pleasure.

People in finance love calling this chart a “hockey stick”.

And before you go accusing me of copy-pasting my post from yesterday and just changing some of the numbers around, yes, that’s exactly what I did. I asked the author and he was OK with me plagiarizing from him.


Intrinsic Value is the value of an asset or company which is arrived at using concrete analytic methods, either fundamental or analytical.

For options, Intrinsic Value is quite simple:

Strike – Current Stock Price

Let’s say an option has a strike of $105 and the underlying security is currently trading at $120, the intrinsic value of this option is $15.

As in, all else equal, this is a deal to be able to purchase something at $105 that is currently worth $120.

That has a $15 intrinsic value.

Call Option:
An In-The-Money call option is one where at this point in time, the strike price is lower than the current market price of the underlying security.

If the strike price was $100 and the underlying security is currently trading at $150, option holders can force the seller of this option to hand over the underlying security at $100 per share, even though it is currently trading at $150. The fact that this option has a positive value to it is why it is called “In-The-Money”.

If however, the strike was $200 and it is currently trading at $150, the option holder wouldn’t want to pay $200 per share, so that option doesn’t have value, so it is called “Out-Of-The-Money”.


Put Option:
An In-The-Money put option is one where at this point in time, the strike price is higher than the current market price of the underlying security.

If the strike price was $200 and the underlying security is currently trading at $150, put option holders can force the seller of this option BUY the underlying security at $200 per share, even though it is currently trading at $150. The fact that this option has a positive value to it is why it is called “In-The-Money”.

If however, the strike was $100 and it is currently trading at $150, the option holder wouldn’t want to receive $100 per share (can get more for each share on the open market), so that option doesn’t have value, so it is called “Out-Of-The-Money”.

Simply put (wow I can’t believe I actually just chuckled. I’m such a nerd.), an option premium is what an investor (buyer) pays for a call or a put option.

So what exactly IS an option worth?

Well, we already discussed Intrinsic Value (Jargon 53) last week. For options, the intrinsic value is the difference between the Strike Price and the Current Stock Price.

There is also an element of “Time Value” as the option isn’t exercising right now. If the option was to exercise immediately, then the total premium would just equal the intrinsic value.

Why is there time value?

Well, since options are not mandatory to execute, by holding it you could in the future see additional value if say the stock price increases (make loads of cash), or just choose to let the option expire should the price fall so you won’t lose too much.

The fact that the future gives you this flexibility gives it a “time value”.

As you get really close to expiration, this benefit fades, so eventually you’ll be at the point mentioned above where the option’s value is only the difference between the Current Stock Price and the Strike Price.

European options are actually exactly what we have been discussing. You agree with another party on a strike price at a predetermined date in the future.

Once that date arrives you then have the choice to exercise the option, or let it expire worthless.

American options are the same conceptually, but with the possibility to exercise BEFORE the expiration date as well.

So, if the stock is doing incredibly well and you have invested in a call option, you might want to exercise early, so you can lock in your guaranteed profits.

From a pricing perspective this is by far the largest difference between there two style options.

There are a few other key differences:

> Which instruments typically trade American vs European
> Americans usually trade on exchanges while European typically trade OTC
> When the options stop trading
> Settlement price

I won’t go into detail of the above differences, but just know that usually you can’t choose which type of option you want to invest in for a security. It’s either trading as Euros or American.

Put-call parity is arguably the most popular and important options relationship, and certainly an interview favorite.

Let’s put together two portfolios both using these parameters:
Stock: AMZN
Strike: $3,500
Expiration: 3/1/2022

PORTFOLIO A:
Buy 1 European Call Option
Sell 1 European Put Option

PORTFOLIO B:
Buy 1 Forward Contract


Now for the magic trick!

Portfolio A = Portfolio B

Every. Single. Time.

It’s actually pretty straightforward if you break it down.

Scenario 1 – Amazon hits $3,600.

PORTFOLIO A:
You will exercise your call option, and make $100 profit.
The buyer will not exercise the put option, it is worth $0.

PORTFOLIO B:
You own a forward contract, you make $100 profit.

100 = 100


Scenario 2 – Amazon hits $3,300.

PORTFOLIO A:
You will not exercise your call option, it expires worthless.
The buyer forces you to sell AMZN to her for $3,500, making you lose $200.

PORTFOLIO B:
It’s a forward contract, you MUST buy the share of AMZN for $3,500, you lose $200.

-200 = -200


This has some really cool implications in quant finance, especially around the topic of arbitrage, none of which I will go into because we need to keep these jargons “light”.

If you have heard of options, you undoubtable have heard of the Greeks.

The Greeks are values that help understand how sensitive an option is to a quantifiable factor.

Let’s say for every Tesla bought, the price of gasoline decreases by $0.01.  We could call this measure “TELTLA”. It would directly show us the relationship between TSLA sales and the price of gasoline.

The Greeks work in a similar way for options.

It’s also good to note that Greeks are risk measures; they are used by traders to hedge risk and to understand how their portfolios will react to rate, price, and other market movements.

The most popular Greeks are:
Delta
Theta
Gamma
Vega
Rho

Delta tells us what impact a $1 swing in the underlying asset price will have on the options price.

For a call option, delta will range from 0 to 1. For a put option, it will range from 0 to -1.

EXAMPLE A:
Call option on DATA US has a delta of 0.5
If DATA US stock increases by $3, then the option price will rise by $1.50

EXAMPLE B:
Put option on DATA US has a delta of -0.25
If DATA US stock increases by $2, then the option price will fall by $0.50

EXAMPLE C:
Call option on DATA US has a delta of 0
If DATA US stock increases by $1, then the option price will not change at all

NOTE: The inverse reactions hold for each of the above examples.

We’re going to discuss some very fun topics with delta after we go over the basics of the Greeks.

QUESTION TIME!
If someone was to walk over to you randomly and shout “DELTA!”
What would you think of first:

1. An airline
2. A virus
3. Jargon 59
4. The Greek alphabet
5. Math or physics

We mentioned last week that as an option approaches maturity we lose the benefit of time, which has a negative impact on the option price.

Options consist of both intrinsic value and time value.

This is where Theta comes in.

Theta measures what impact a single day passing will have on an option price.

EXAMPLE:

Option value: $1,000
Theta: 25

In one day assuming nothing else changes, the option value will decline to $975. In two days, the option will be worth $950.

As options get close and close to maturity, a greater percentage of the option value disappears as a result of this time decay.

Theta works against option buyers (long) and in favor of option sellers (short).

Funny Business:
In 2011 I had the option to watch Margin Call in the movie theta but I chose not to go.

Rho is a popular interview topic which I find interesting because of the last sentence of this post.

“If interest rates rise by 1%, what will happen to the value of your call option?”

I was asked this question when chatting with an MD at BNP. I had invited him out to a casual coffee…turned out I was about to get grilled on Options. Always treat a networking opportunity as an interview…anyhow, I digress.

Call options have positive Rho, while put options have negative Rho.


Scenario 1:
Call option Price: $1.00
Rho: 0.05
Interest rates rise by 1%.
Call option price will rise to $1.05


Scenario 2:
Put Option price: $1.00
Rho: -0.10
Interest rates fall by 1%.
Put option price will rise to $1.10


Changes in interest rates usually don’t have a tremendous impact in option pricing, and for that reason Rho is usually considered one of the least important Greeks.

Did you ever take calculus?

A derivative is something that changes based on something else. As Google says “something that is based on another source”.

In calculus you’ve learned about a “second derivative”. A derivative of a derivative.

Welcome to Gamma :-).

Gamma is the first Greek that we are going to discuss where we aren’t looking at how the option price changes, but rather how the option’s delta changes based on a single point move of the underlying asset’s price.

Scenario:
Call option price: $5
Call option that has a delta of 0.25
Stock price: $50

If the stock price rises to $51, the call option will rise to $5.25. But option price isn’t the only thing that changes. Once there is a shift, the actual DELTA changes as well (this makes sense if you think about it for a minute).

New Delta: .30
The Gamma is approximately .05 (how much the delta increased). 

This isn’t an exact math, as the gamma calculation is actually much more complex.

Before we get into Implied Volatility let’s make sure we understand the basics:

Volatility is the likelihood for rapid and unpredictable change; in finance we call this “degree of variation”.

Realized (or historical) volatility is when you look back at a stock and you can tell historically how frequently the stock moved; and by how much.

Think of it this way: Historical volatility is a STATISTICAL measure of past stock movements, while Implied Volatility is thinking more from a probabilistic sense.

Implied Volatility is the market’s view on how volatile a stock will be in the future. 

This is especially important in option pricing since more volatile stocks fetch higher premiums.

IV is lower when the markets are bullish and rise when the markets turn bearish.

Great news! Apple had a great quarter, and the stock price will surely increase. As Apple is about to report on their earnings, AAPL option prices will experience price changes since the news will obviously move AAPL stock prices.

AAPL Scenario:
Call option = $10
Implied Volatility = 20%
Vega = .25

As AAPL approaches earnings, the IV of AAPL stock rises by 1% to 21%.

New call option price: $10.25

Options that have a longer time to expiry will usually have a higher Vega.

Before we get into the next few definitions we need to understand what a portfolio is and why it’s important.

If you hear that Bitcoin is a great investment and you put all of your savings into BTC (hint: don’t do this), then 100% of your personal portfolio is Bitcoin.

You might have $100,000 to invest and invest in a rental property with $50K and buy stocks with the other $50K. In this case your portfolio would consist of 50% equities and 50% real estate.

You might instead break down your investments into TWO portfolios.

In one you might have a few real estate investments, and in the other multiple fixed income instruments.

Portfolios are usually not constructed randomly.

A portfolio is any collection of financial investments (across all asset classes).

Usually there is a core strategy you incorporate when building a portfolio, such as you believe in the rebuilding of bankrupt companies so your portfolio might consist of many distressed companies.

You also need to think about risk when building your portfolio, and set up your investments to consider risk accordingly.

Tomorrow we’ll cover one of the most important concepts in building a portfolio before returning to Greeks.

You love amusement parks, and you think the whole WORLD loves them. You’re so confident in this that you invest all of your life savings in amusement parks around the world.

You might be right.

But what if you’re wrong?

Or what if a nasty virus creeps into your country from across the globe forcing all parks to shut down for a full year?

Your balance goes to $0. The end.

Diversification is a risk management tool that prevents you from “risking it all” on a single strategy.

The general principal is that you keep your portfolio well rounded.

This is an example of a VERY diverse portfolio:

1. US Healthcare Equity
2. Government Bond
3. Japansese Ice Cream Company
4. Chinese Video Games
5. Face Masks & Hand Sanitizer

Well…yeah this is super-diverse. But the problem is, there is no strategy at all here.

The magic of successful hedge funds and asset managers is that they manager to maintain a clear defined strategy while still maintaining a diverse portfolio.

There are plenty of other risk measures we will cover but this is by far the simplest to understand and to employ.

If you have $1,000 to invest and you’re good at poker, believe dogecoin will go to the moon, and want to invest in Amazon, don’t put the full $1,000 in any single one.

An even split is definitely a safer option.

Quick Review
Delta: The impact a single dollar move in the underlying security has on an option.
Portfolio: A bundle of assets used to act on a strategy.

Scenario:
You have a few positions in your portfolio of which the combination of their deltas is 120. The underlying stock moves up by $1. Now the portfolio value will be worth an additional $120.

But what if you DON’T want your portfolio to move when the stock moves, either up or down? For reasons we’ll get into later, let’s say you want a portfolio with a delta of 0. This would mean that you now need to add some new positions to your portfolio that have a total combined delta of -120.

This way all of that delta cancels out: 120 + (-120) = 0

And now when the stock moves $1, your portfolio value won’t change at all.

Tomorrow I’ll describe exactly how to set this up.

An even split is definitely a safer option.

You have an existing agreement that you will go long 50 shares of Apple stock (AAPL US).

The problem is, you don’t want to be exposed to Apple stock movement.

To eliminate this risk you decide to purchase 2 AAPL PUT contracts. Recall that each option contract covers 100 shares of underlying stock.

The portfolio setup is in the image below.

Stock has a delta of 1 always, and in this case, the AAPL puts have a delta of -0.25 (x100 means -25 per contract).

In this case longing two put contracts would neutralize your exposure to Apple stock movement.

In general, you can create a delta neutral setup by buying or selling positions with opposite sign delta to your current exposure, totaling the same delta amount. This can be done using long stock, short stock, puts and calls.

table

We discussed delta-hedging last time, where our goal was to set up our portfolio in a way that if the underlying asset price moved, it would have no impact on the overall portfolio value.

While a delta-hedge is used to reduce an option (or portfolio’s) exposure to a small move in the underlying’s price, a gamma-hedge is aimed towards larger movements.

This strategy is often used when the option is close to expiration, where underlying’s price has a critical effect in the option’s value.

A gamma-neutral position is accomplished by setting up a portfolio whose delta’s rate of change is close to zero, even as the underlying security rises or falls.

I recall in my master’s program we wrote a program in C++ that would delta & gamma neutralize a portfolio in conjunction with one another.

I will not go through a gamma-hedging example here in theme with the Jargon’s motto of “keep it light”.

Feel free to peruse the web for some riveting gamma-hedging examples.

One small note: Not always it the goal to completely neutralize delta, sometimes the goal is to keep a constant positive delta!

ANYHOW…
What’s big and green, and loves portfolios that don’t react to underlying price movements? Bruce Banner!

Option pricing is NOT an exact science. There is no one truth as to what the value of an option is. The intrinsic value is easy enough to calculate, but calculating a fair option price is far more complex, mainly because it makes ASSUMPTIONS.

What option pricing is trying to accomplish is essentially answer the question of: “Will this option be in-the-money at expiration?”.

Once we know the probability of the outcomes occurring, we can evaluate the fair value of the option.

Here are some inputs that go into an option pricing engine:

1. Current Stock Price (of the underlying instrument)
2. Strike Price
3. Interest Rate
4. Volatility
5. Time left until the option expires

There are quite a few option pricing models. We’ll cover a few of them in the next few posts.

The first method for pricing options you might learn in school is the Binomial Asset Pricing Model, BAPM. This is a bit detailed so I will break it down into two digestible posts.

Part I: 

Let’s use an AAPL stock call option for example.

To start we need to answer this: Every time the stock moves up, (or down), how much does it move?

For this example I’m going to give the specific numbers, but there are formulas that solve for this.

U, UpMove: 1.07327066
D, DownMove: 0.93173142

In other words, if my stock is trading at $100 and it moves up once we do this:

100 * 1.07327066 = $107.327066

CALL OPTION DETAILS:
S, AAPL STOCK @ Time 0 (origination of deal): $150
K, STRIKE PRICE: $160
V, VOLATILITY: 5%
R, INTEREST RATE: 6%

Look at the attached graphic. This is what we call an “Option Payoff Tree”. There are different limbs, or paths that the stock price could go.

In our overly simple example we only go out two time periods. So we start at time 0, when the option originates, and go out twice.

For an option to move up twice we would simply multiple the “UP” number by the stock value twice. In mathematical terms:

S * U^2 = 150 * 1.07327066 * 1.07327066 = 173

Or let’s say AAPL goes up the first period and then drops by “D” the second time period:

S * U * D = 150 * 1.07327066 * 0.93173142 = 150

Interesting, right?

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In our very limited world, we see three possible outcomes from AAPL stock:

$173, $150, and $130

Our STRIKE price is $160, so what would be the option worth at expiry?

If you recall from our call option Jargon:
Max(S – K, 0)

Max(173 – 160, 0) = Max(13, 0) = 13
Max(150 – 160, 0) = Max(-10, 0) = 0
Max(130 – 160, 0) = Max(-30, 0) = 0

So of our three outcomes, two of them are worthless, and one becomes worth $13.

Just to get a rough sense of what this should be worth today, think of this as if someone told you:

Hey, in the future I’ll either give you $13, $0, or $0. How much would you pay for this deal?

Considering discounting (time value of money) as well as the ratios, maybe $3 ?

So let’s see what this is worth.

Well there is one more detai