STOCK OPTIONS; USES AND MISUSES

Yesterday, I did a post on stock options where I briefly explained what they are and how they are used. I also wanted to include their uses and misuses but I decided not to because it was getting too long (I don’t like monstrosities of posts). So in this post, I do just that.

An advantage that stock options bring a company is that it motivates the workers to work harder because they feel that they have a personal stake in that business so the harder they work, the higher the stock value climbs and thus the higher their options increase in value. If this happens everybody wins. Many companies have made thir employees into stock option millionaires and this is a major incentive for employees to work at long term success of the company e.g. Microsoft

The above merit brings another to the employee because if he/she happens to sell a stock option that has increased in value, an extra income, apart from the monthly paycheck is borne. This extra income can be re invested, saved or used in any way that the employee sees fit.

Another way that a company benefits from stock options is that they make the employees stay on and work at the company for the number of years that the options take to expiry. The reasoning behind this is that employees cannot just pick up and leave while they have their own money invested in the business. If the sale of the options proves profitable, they may decide to stay on and work at the company.

A third advantage for the company giving out stock options to the employees is that they(employees) will have a personal stake in the company without really having a say in the running of the business because as I mentioned earlier, these stock options do not offer voting rights.

For a risk aversive employee, stock options have less risk than their underlying stock. I know that in the stock options post I did, I happened to mention that if the option sale proves unprofitable, the investor loses all the money he put into It; the premium. But something that you should consider is that stock options are much cheaper than their underlying stock. Let’s say that the stock is $10, the option can be $2 and so an unprofitable trade would mean that the investor loses $2 than the stock investor who has $10 on the line. Another advantage related to the above is that the value of stock options increase faster than their underlying stocks so it goes without saying that if well used they can bring large profits to the seller.

I also mentioned that these options can be used to take advantage of markets heading in whatever direction. I happened to use put option in a bear market example (here is the link) because it is fairly easy to imagine using call options in a bull market(sell the call options at the highest price). These are mostly used by investment funds like hedge funds and private equity funds that use them as a hedge against losses. Their profit is obscenely high as compared to the employee when exercising these options because of the fact that they have a lot of disposable capital and the fact that they are very experienced in this art.

For a short term trader or a speculator these options help in decreasing the loss incurred in a losing trade. This is because it is very easy to sell stock options and if a day trader sees that a trade is going badly, he can easily sell it to minimize losses. Something that a short term stock investor would have some trouble in doing

Indiastudychannel.com has more advantages of stock options, some of which I have mentioned

Even with the myriad merits of these options, there are some not so unpleasant disadvantages like;

If the employee does not exercise his options within the time stipulated when the option was being offered (the vested period), they expire and the investor loses his invested capital (called the premium)

Also a major decline in stock price and thus option price can cause a decrease in motivation to employees because we all know how demoralized one feels when after working so hard, there is no returns visible.

But the major one is management in a company rigging them to produce better than average returns in their sale. This is done by a lot of complicated accounting hocus pocus by charging off loses in some years and using tax credit to make the company seem more profitable than it really is. This means that when the company’s financial statements are released and the high profits noted by the investing masses the company’s share prices mostly increases (which means that the stock option prices do so to). In the sale most executives make a killing. While this benefits a few, the future of the company is put at risk because when the accounting time bomb explodes stock prices tank with it and most shareholders are left high and dry. On the up side, companies have many ways to prevent this.

These are basically the advantages and disadvantages of stock options but all in all they are very beneficial to those that know how to use them.

UNDERSTANDING THE STOCK OPTION

Most of us have heard of this provision but how many know what it really is? If you don’t know, this post may enlighten you.

This is a provision that gives the holder/buyer of the stock option the right to buy or sell the stock of a company he works in at a specified price or date. When the holder is to buy the stock, it is referred to as a call option and if the holder wants to sell his stock, it is referred to as a put option.

They are also known by other names like share options, equity options or futures options.

Having this in mind, let’s get a better feel of them.

Top management decides to give stock options to employees so that they can gain from the company’s increased production and hence stock value. It is a nice way to increase one’s income apart from the usual salaries not to mention motivating them to work harder since having a personal stake in the company makes them feel as if they are working at their own businesses.

When offering options to the employees, management lets them buy a specified number of shares at a given time and price all decided by management. Let’s say that as the CEO of KTBN financials, a fictional company, I decide to offer my employees stock options where they could buy 100 shares of the company’s stock at $2 and with an expiry that’s one year from the offering. Since the employee can exercise his options in the course of the year, he can either sell all his shares at any increased price, let’s say $5 thereby making $300, exercise some of his options by selling part of his shares and leaving the rest for a greater profit or do nothing with the hope of future higher prices and hence more profit.

BTW options cost much less than what the real shares cost but the owners of these options are not seen as shareholders and cannot claim any of the rights that they (shareholders) enjoy. Also just like stocks, they are traded in the markets making them fluctuate in price just like stocks

Knowing this, some terms that you should incorporate into the above example are;

1- The 100 shares of the company you work for is referred to as a stock option contract

2- The $2per share that you buy the shares at is called the strike price or the exercise price or the grant price.

3- The underlying security is the company’s stock that the employee that the right to exercise

4- The expiry date is that date at which the option is nullified. If this happens before the option holder exercises them, he loses his premium (price of the option contract). This can happen for many reasons like when the underlying share price is below the strike price for the call option or if the underlying share price is above the share price in the case of the put option

5- At The Money (ATM) is when the stock’s price is about the same price as option’s strike price

6- In The Money (ITM) is when the stock’s price is less than the option’s strike price

7-Out of The money (OTM) is when the strike price is higher than the stock’s market price

Darwin’s finance has a page that expounds more on the intricacies of put buyers and sellers and the like which if I was to include in the post, we would have a book. Darwin also explains how the terms are used in everyday stock option trading.

These stock options are like a godsend for many investors and investment companies since it is possible to make money whichever direction the market is heading e.g. in a bear market you can sell put options and in a sense you would be selling stocks that you really don’t own and so you get some form of commission in the sale, no matter how small. More on this at this “how put options work” hub-page

So that is the little on the complex world that is stock options trading.

WHAT IS TAX CREDIT??

Some time back i did a post on preferred stock and why i thought  that they were not that good particularly for individual investors. According to financial samurai and tax guru, the tax angle was interesting and so i decided to do another tax post.

This will be a little about tax credit.

This is a good thing for me and people like me that don’t like paying taxes as it enables me to pay less.

While it enables the taxpayer to pay less tax, it is totally different from a tax deduction because the latter deduces the taxable income while tax credit reduces the amount of tax that is owed to the Caesar (the government).

Let me illustrate. Supposing you make $1000/month and you have to pay say 10% of this as tax i.e. $100. You can use tax deductibles like education expenses, charity contributions etc to reduce this taxable income to let’s say $800 but you will still have to pay the 10% tax. In the tax deducted figure, you will pay $20 less than the original figure. When it comes to tax credit, the $100 you owed is reduced to say $80 if you received a $20 tax credit.

As you can see from the above example, tax credit is better than a tax deduction since it does not depend on the tax rate but still reduces the amount given to the tax payer, which is not the case with tax deductions because this guy still takes the given percentage.

It is worth saying that tax credits are larger figures than the ones that I have mentioned in this example. Also tax deductions vary with tax brackets since the higher your income bracket, the higher the tax rate which is not the case with tax credits since a certain given amount of tax credit can be used by all those eligible to take advantage of it.

Since all bad ideas started as good ones, tax credits have a myriad advantages like reducing the tax paid by low income people and thus effectively increasing their income, encouraging use of alternative sources of energy by offering tax credits on the preferred type, making businesses make the environment better for everybody involved but businessmen have in the past used them to their own advantage and in misleading their shareholders. One example is doctoring the financial statements by charging off losses anticipated in the next financial year to the current year and then using the tax credit due to them to give the illusion of a profitable year when in real sense there was a loss.

I have found this site that gives a whole lot of tax credit examples which while they may not be applicable in each country, will serve to help you become more knowledgeable in this very important area.

As with tax deductions, a tax payer should do his/her research on the tax credits that she/he is eligible for because you know what they say of the taxman; if you let him, he will always take more.

A DEEPER UNDERSTANDING OF BOND INVESTING

For the past week or so, i have been concentrating mainly on bond and bond fund investing. While i have only skimmed the surface of this somewhat complicated bond market, it is better that you know some of these things because that is how education stars; first the introduction of concepts that are expounded later in an organized fashion.

I have been reading books and articles by professional investors for quite some time now and they all advice people to get into the investment world as soon as possible, so as so develop the right investor attitudes and get enough experience(a better name for mistakes).

In that same vein, i was reading an article on cnn.com that was basically addressing a question posed by a 26 year old asking for help in demystifying the complicated bond markets.

The answer explains in a very simple fashion, the inverse relationship between

-bond prices and their interest rates

-why they are called fixed income  investments and yet their interest rates fluctuate

-the risks involved in bond investing i.e. credit risk and interest rate risk. Credit risk is the risk of default and it is more common with corporate bonds than government bonds

-a little advice on the percentage to allocate to your porfolio.

I know what you guys may already be knowing these stuff but it never hurts to have a different perspective.

Here is the link

ADVANTAGES OF CONVERTIBLE BONDS TO AN INVESTOR

In a post that I did recently about convertible bonds (convertible bonds as the best of both worlds) a reader called Christian Pinnell Commented that I hadn’t really brought out the second part of the heading i.e. how they are the best of both worlds. So today’s post is dedicated to this.

To sufficiently cover this we have to look at which advantages of both stocks and bond ownership accrue to a convertible bond investor.

First of is the interest payments due to the convertible bond holder which can be seen in dividend paying stocks and all other bonds. These payments continue as long as this investment is still a bond and stops immediately after conversion into a stock at which point a different scheme is adopted.

As I said in the original post, these bonds are a very efficient way of protecting against market fluctuations while at the same time providing periodic returns. This addresses a down side of stocks which issuing companies can sometimes decide not to issue dividends for a myriad of reasons and the fact that they are less prone to the worst of market fluctuations means that the investor gets what he mostly wanted when he was investing in bonds; security from the volatility of the market, a fact that stocks have to deal with everyday.

Since companies sometimes go burst, a convertible bond holder will have a larger claim of the company’s assets than the stockholders making him at a better position when a company is undertaking bankruptcy proceedings(if he was still holding the bonds). This advantage would still be available to him but to a lesser extent if he had already converted to stocks at which point he would have enjoyed many of the advantages of common stock ownership.

Since conversion is not done haphazardly but conversion ratios are used at time frames set, this protects the convertible bond holder since he can only convert the bond into a stock when the market price of the stock goes above the calculated conversion price of the share. No convertible bond holder would convert to stocks if the market price is lower than the calculated price because this would mean a loss of cash. So as you can see there is almost no risk in conversion. It is a win-win case for all parties involved as bondholders will be happy common stock holders and the company still remains stable as their financial stability(or the lack of) is not speculated of as is normally done when a company decides to issue more shares.

As is with all bonds, when interest rates fall, their prices rise. This rise correlates to the increase in stock prices and at times this can lead to convertibles outperforming the market indices as happened in 2003 and 2004. If this doesn’t happen there is still the fact that these bonds mirror stock market indexes, kind of like index funds.

Another advantage that a convertible bond holder gains if he converts to common stock is more protection from inflation, This is because the market stock of the common stocks will rise with market prices unlike for the bonds where the interest rates are fixed. This means that bond holders bear the full blunt of inflation because his money looses value more.

Finally this website provides a more analytical basis in looking at convertible bonds and their benefits to investors.

DUAL PURPOSE FUNDS FOR THE OPTION SEEKING INVESTOR

I recently stumbled across this type of mutual funds as I was doing a little independent study and I thought of making a little post on this after a little research. This is what I found out about them.

These are in the closed end mutual fund category broadly meaning that they have a fixed number of shareholders unlike their open ended counterparts.

Another name for them that I found out is dual fund, leveraged investment company.

The dual purpose function stems from the fact that they offer two types of stocks one that offers capital gains to its holders from the fund’s underlying assets i.e. common shares and the other that offers income to its holders  which is received from the funds underlying assets i.e preferred shares.

This means that common shareholders get what is referred to as capital shares and preferred shareholders receive what is referred to as income shares. [If confused re-read]

Another thing that sets makes fund unique is that apart from being closed ended, this mutual fund also has a set liquidation date in that after a set time the fund is dissolved. According to investopedia.com during this liquidation, the preferred shareholders are paid out first(at the par value of their shares) followed by the common shareholders. I guess this trend is universal is it not??

But strangely, it is not all the time that these dual purpose funds are liquidated and done away with. The shareholders can decide that after the period it was stipulated to live, instead of liquidation, it can be changed into an open ended fund at which point an unlimited number of investors can join the fund.

Finally cashbazar.com has a nice way of putting this explanation for an investor seriously planning on investing on these funds

I find this fund more versatile than most of the funds that I have covered of late in that they seem to cater more to investor preferences and the investors seem to have more of a say than in the other funds.

What do you think?

THE TRUST FUND EXPLAINED

We have all heard of this much media hyped financial arrangement and we have all wished at a certain point in time to be one of those enviable trust fund babies. But what are these trust funds and who exactly do they work? In this post, I will try to explain this in as few words as possible

This arrangement is also called a trust property, so you have no reason to be confused.

Basically it is a financial arrangement by a financially well off individual to provide sustained monetary assistance to another party after the benefactor (also called the grantor or trustor) dies. This can be rich parents setting up a trust fund for their children, or well to do people setting these up for their favorite charity or church or whatever.

The benefits in these trust funds can include a myriad of investments like stocks, real estate money, bonds or whatever other financial instrument or investment that the benefactor wants given out.

What happens is that a trustee is appointed and he/she is responsible for distribution of the resources to the beneficiaries (also called the trustee) according to the rules stated when the fund was being set up. The main reason that people would like to set this fund up is to make sure that their kids or charities or whatever will not undergo sudden financial hardships once the grantor dies(but they can be set up in such a way that beneficiaries get the cash will the grantor is still alive). He might also set up the provision that the beneficiary will not be allowed to access this trust fund until he reaches a certain age. Obviously a provision like this is to make sure that the kids are at an age where they are financially responsible with the money left to them.

It is important here that I add that there are two types of trust funds. The first is the living trusts that is set up in such a way that the trustee is allowed access to the cash or otherwise while the trustee is still alive. The second type is the after death trust that means that the trustee(s) will only have access to the money after the death of the trustor.

Another reason that a person would like to set up a trust fund is to protect his assets/estate from unscrupulous persons that can take advantage of there being no arrangement as to where the funds will be directed and thus by manipulation steal the funds. We have all heard of cases like this.

Also a well set up trust fund will prevent excessive taxation to the beneficiaries eg in the case of excessive real estate taxes that can be organized in such a way that tax breaks are in the mix.

Apart from these advantages, these trust funds are also a type of investment since they earn interest over time.

In a nutshell, a person willing to set up a trust fund must first do his research, make sure that he knows the beneficiaries, the time through with this people will have no right to touch any of the cash, which assets will be assigned to which beneficiary, the amount of cash the beneficiaries will get per year or whatever period etc. Basically, the grantor has to think of everything.

Finally these are very good arrangements, in some ways better than wills and they show a form of prudence by the (rich) individual.

CONVERTIBLE BONDS- THE BEST OF BOTH WORLDS??

As the name suggests, this is a corporate issued bond that can be converted into some other investment vehicle in this case, it can be converted into common stocks . This is done at only certain times and at a fixed conversion ratio.

But the conversion is not as straightforward as it may seem. Let me illustrate. At the time of issue (when the company is offering these bonds to the public for the first time), a few things are spelt out. They include;

-the conversion ratio i.e. the number of bonds that can be converted into stocks

-the time period through which conversion has to occur

-the common stock price at which conversion will occur

Let’s bring arbitrary figures into this to make it more understood.

Supposing a convertible bond (or CVs as they are more commonly referred to) has a conversion ratio of 100:1. This means that one bond can be converted into 100 common stocks per say every $1000 of bonds you own. This then means that every new common stock will be worth $10 [1000/100=10]. This $10 is called the conversion price and it is normally higher than the current stock price in the markets.

This means that if at the time of conversion the current stock price was lower than the conversion price, then the involved parties will have to wait until the stock price reaches the conversion price before the conversion can occur. If the current stock price was higher than the conversion price, then a different arrangement is brought up. Let’s say that the current common stock was worth $20 (against the calculated $10), then to keep the conversion ratio at 100:1, it means that the conversion would occur for every $2000 of bonds you own i.e. $2000/20=100

I know it seems a little difficult to get your head around these figures, but just study them a little more carefully and all will be revealed. [Hopefully my bounce rate will also reduce in the process ]. Teenanalyst.com has a similar example on this figures that you can read more of

The most significant advantages are:

-In the case of the issuer, the stock dilution brought about by so many common stocks for every bond means that they pay less dividends because the earnings per share is reduced.

-Also these convertible bonds generally have a lower coupon rate than normal bonds and this means less money that will have to be paid out be the company.

-they are also used by issuers to avoid misinterpretations by investors i.e. if a company chooses to issue more stock investors might think that the stock is overvalued and this might bring other problems like investors doubting the soundness of the stock. So to prevent this, the company issues these convertible bonds since there is a high likelihood that bondholders will convert them into common stock because these stock have many advantages over bonds.

-Since the yield of these convertibles is normally lower than those of other corporate bonds, means that they are more attractive. There is a rule that the lower the   interest the more valuable the bond since it means that there is a lower risk of default by the company.

-these convertible bonds also follow the market share price of the issuer’s stock. When the share price rises, the convertible bond price also rises and vice versa but not at the same levels. Convertible bond price goes up two thirds the rate at which the stock rises and less than ½ the decrease in stock prices.

-these bonds also earn interest when the stock is going up or down and it makes it attractive to investors since who wouldn’t want a check whether the markets are going up or down? This is because issuers are required to give fixed interest income to convertible bond investors before conversion.

-these convertibles are also good to protecting against market fluctuations while at the same time providing periodic gains.

These advantages are why I think that they offer the best of both worlds between stocks and bonds.

Finally, this is the second investment that can be converted to another that I have covered. The previous one was convertible stock

WHAT IS (OR WERE) BEARER BONDS??

These are just like normal bonds (corporate or government-) but the major difference is that they are unregistered i.e. when you invest in any other type of bonds, you go into the records as a registered owner and the paper you hold has proof of your ownership of the said bonds but with the bearer bonds, there is no such registration. The person who holds the certificate owns the bond. It’s just like having money in your hands. There is really no way of tracking a previous owner once it exchanges hands.

Bearer bonds also have a stated maturity date and a fixed interest rate but can be called in by the issuers for a myriad of reasons like if interest rates are too high, they might recall them to reduce the cost of paying interest to the holders.

Each bond certificate has a single coupon that the holder is supposed to submit to the issuer. The current holder of the bonds submits the coupon, which is by the way attached to the bond, to the paying agent either annually or semi-annually and they get paid. No identification of any kind is required.

It is worth mentioning that it is the holder’s responsibility to submit the coupons for interest payment- not like other types of bonds where the issuer has the obligation of paying the bond investors interest at given times.

Although they are distinctively different from other bonds, there are some things that the current bond holder is supposed to honor. But all these are set up at the time of purchase.

These include honoring the payment periods set at the purchase of the bonds, when to cash in the coupons and the number to cash in at a time (some allow that you cash in more than one coupon at a time).

BTW they are also called coupon bonds.

They have a large number of advantages like convenience in that a large amount of cash can be carried around in a few of these bonds, anonymity in that current bond holders are not asked awkward questions when they go to cash in these bonds, tax avoidance in the case that tax collectors couldn’t trace a paper trail for them as they exchanged hands etc.

Their major disadvantages which in most cases cloud out all their merits is the fact that in the case of accidental damage, destruction they become totally useless. Also they are totally impossible to trace when stolen. Also in they are easily used in bank fraud which to some extent discredits the issuers.

But their features are the main reason why many investors are veering away from these unregistered bearer bonds to the more secure registered counterparts. There have been many cases of criminal use of bearer bonds but the most infamous was the case of the $134 billion in bearer bonds found by Japanese travelers crossing into Switzerland from Italy.

I also read that they were made illegal in the US in the 1980s but the ones issued before that are still in circulation. There are also fewer institutions that will cash in these bonds.

Finally some legit bond holders may or have lost their invested capital since issuers may have recalled them without the holder knowing. In a case like this, it becomes really hard to get invested cash back.

That is just about all I could get about the bearer bonds (which I am sure that most of you have heard of on tv).

Any additions are very much welcome.

PREFERRED STOCKS MAY NOT BE BETTER AFTER ALL

Some time back I did a post about preferred stocks where I concentrated on the advantages that they had for conservative investors.

A small  run-through is that;

1- In the unfortunate event of liquidation or in profit sharing preferred stock holders are paid before common stock holders.

2- The cumulative nature that preferred stock dividends have in that unpaid dividends are forwarded to the next financial year. This ultimately means a higher payday because of compounding interest.

3- The non fluctuating dividend payment that is paid to preferred stock holders make it even more attractive mostly to people that live on regular income from their investments and the conservative investor looking for the security of regular checks in the mail.

4- The occasional voting rights that the preferred shareholder has during important times in the company like election of new directors makes this investor feel like he has a part to play in the business.

But be that as it may, aggressive investors tend to shy away from this type of stock, while favoring common stock because of the following reasons;

1- The preferred shareholder is dependent on the desire of the company to pay dividends on its common stocks. Once common stocks are omitted, this shareholder finds himself in a bit of a problem since directors have no obligation to pay him any dividends. Like for instance very successful companies do not pay dividends to their commons shareholders e.g. Microsoft and others, means that a preferred stockholders should not expect much in the way of periodic checks in the mail from such companies.

2- Since we above that the dividends(when paid) are fixed, this means that in highly profitable times this shareholder will not be entitled to more that his fixed share(the given percentage due to him). So he must never get excited when a company declares major profits in a certain year.

3- Preferred stocks lack the legal claim of a bond holder (e.g. in times of liquidation, the preferred shareholder has a higher chance of losing his invested capital than the bondholders-who are creditors of the business) or the common shareholders who are more like partners in a company because of their obvious advantages. This weakness is mainly seen in bad economic times like recessions and depressions when the risk of default comes a knocking.

4- Finally they have better tax advantages for corporations than individual buyers. Corporations  pay taxes on part of the dividends rather than the full amount. Let me illustrate. Supposing by law the corporation is to pay taxes on 20% of the dividends that they get in a year and the corporate tax is 40%. And assuming that the dividend is $200[all these are hypothetical figures]. The corporation will pay corporate tax* taxable income* dividend i.e. 0.2*0.4*200=$16. Whereas the individual preferred stock holder has no tax break and has to pay tax on the share of the dividend received i.e. tax* dividend= $200*0.4=$80. This shows that they are really not that attractive to an aggressive shareholder and there is a disservice to the conservative preferred shareholder.

BTW the hypothetical numbers I have used change with time and country but the same logic is used

If not for the corporations, the only time to but the preferred stock is during periods of economic adversity when they are at a major bargain i.e. they are selling at a price well below par.

So preferred stock may not be better that common stock but it all depends on one’s point of view. Your opinions on this new perspective are welcome.