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.

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.

GROWTH STOCK DEMYSTIFIED

What is growth stock??

Basically this is a company’s stock that is expected to grow at an above average rate than other stock in the markets.

Investopedia also calls these types of stock glamor stock

So in a sense, they are all the other types of stock that we have been discussing in the past weeks, but the difference with this ones is that the company does not pay dividends for this stock. This is because they rely on capital growth and to maximize returns, profits are reinvested.

These stocks are normally found in companies that have shown high returns and it is hoped that this growth will continue. This “hope” in future gain of an investment is what is called capital growth, and we all know who fast the weather can change(theycan easily disappoint). These type of stock are mostly found in technology companies but can also occur in other industries like natural resources, transportation, fashion etc.

These definition begs the question, what are the characteristics of a good growth stock?

- there have huge markets or have a total domination of a market or niche eg xerox  was virtually unchallenged in the photocopier business for years, Microsoft(back in the day),

-increasing earnings and growth. simple logic, the higher the growth the more attractive to investors. Accelerating growth rate is caused by increased efficiency in the running of a company

- very high quality management; think of the business titans that any person that does not live in a hole knows about. These people lead their companies to high levels of growth

- there is a comparable difference in the growth stock of a company A to others in the same industry. A company like this will stand out

Here is more on growth stock characteristics that i have pulled of the net. Also cabot.net has quite a lot to say about the characteristics of growth stock that i think you should peruse through

As this blog is to demystify financial speak, i prefer not to go into details and confuse you my readers. Any questions are welcome in the comments box and will be duly answered

HAVE YOU EVER HEARD OF LOAN STOCK??

To be brutally honest, this is a type of stock that i learnt of fairly recently.

Some of this stocks seem to be related because loan stock  are common stock and/or preferred stocks that are used as collateral to get a loan from a financial institution, individual business or any other third party.

Just like with most loans, these loans have a fixed interest, and can be secured or unsecured.

In the case of unsecured loan stock. supposing that a company A issued this type of loan stock, it means that the company B receiving the stock is not entitled to any of the issuing company’s A assets in the case of the inability of A to pay back the loan- an IOU of sorts. Therefore this type of stock is issued by companies with high credit worthiness [if not understood feel free to ask in the commentary box. u will be duly answered]

Secured loan stock is also referred to as convertible loan stock. This type of loan stock can be converted into common stock under predetermined conditions with a given conversion rate. As in the company B  that was given the stock can convert(change) the loan stock into actual shares in company A and this be entitled to the dividends and cash payments from A and so the company B looses nothing

Also converible loan stock/secured loan stock can also be converted into a stated number of (ordinary) shares in a specified date and so the company B becomes a shareholder in A. This all depends on the dynamics of the agreement between the two companies A & B

Here is a slightly more in depth article on the dynamics of a convertible loan stock

Businessdictionary.com says that loan stock is an alternate term for debt security

I have found a number of definitions of convertible loan stock so that it can totally click into your minds

Have i hit the nail on the head in regard to this type of stock or is the explanation still wanting? Please leave your comments, criticisms additions, anything really concerning the topic at hand

PENNY STOCKS FOR THE SPECULATIVE INVESTOR

The previous post was about some of the dynamics of speculative stock and i mentioned that penny stocks were an example of speculative stocks

[By the way, i know i said that i would handle penny stocks yesterday but i got caught up couldnt find time to post]

Basically a penny stock is a share that trades for less than 3-5 dollars per share.

As with all speculative stock these stocks are very risky(on the down side) but have very high reward potential (on the upside)

Penny stocks are undervalued, undiscovered and there is a likelihood for them to increase in price as time goes by(just like small cap stock).

Penny stocks differ from small cap stock in that the penny stock companies have a much lower much lower market cap than small cap companies and thus of much lower value, and much higher volatility and thus higher risk.

But in essence they are both value stock depending on the company. The better the fundamentals of a company, the better chances the stocks have to appreciate in value. Like for instance stocks for companies like Xerox, General Motors, Ford, Google and many of the major companies used to be penny stocks(ancient history for some) but are now large cap companies with very high stock prices but hard for a small investor to get a sizable piece of such companies. Those initial penny stock investors are examples of how some of these stocks can make investors rich.

According to wikipedia, these types of stocks have too much risk(in my opinion), not only in the stock prices but also in penny stock fraud and internet spam

Here is a motley fool feature on penny stock that has delved deeper than this blog post

Finally as with all high risk investments, one must not invest in penny stocks with money that he/she is not prepared to loose so do not go and sell everything  just because of the potential of stock prices to skyrocket.

A LITTLE ABOUT SPECULATIVE STOCK

Speculative stock is basically a stock that an investor, banking on gut feeling, invests in with the hope that the stock value will appreciate. This conclusion is normally not backed by detailed analysis.

The end result is that these types of stocks have a very high risk compared to any profit that they MIGHT generate in future. Personally, i think that a speculative stock investor is a gambler because i am more for familiarizing oneself with the fundamentals of a company before investing hard earned cash in it

This conclusion of mine is strengthened by investopedia.com because they say that “Investors in these types of stock may be overly optimistic about the probability of earning above average gains, or the lure of the above average gains may be enticing enough for them to make a purchase “

On the upside, as with some gambles, the stock pick might really pay off and stock price skyrocket. This is mostly in internet companies but these overvalued companies can occur in other companies as well like in biotechnology etc.

Companies speculative stocks are those whose stock prices are generally expected to rise and have no track record of such a trend.

This means that they are more volatile than most of the other stocks because they are subject to every market shakeup no matter how small. It goes without saying that speculative stock investors need to have a high affinity for risk and must be able to remain calm as the stock value jump up and down sometimes in a daily basis and they must be on their toes to be ready to sell when the time is “right”

The only example of a type of speculative stock that i could find is penny stock that i will cover in the next post tomorrow.

Here is an article about some companies whose stock is being speculated on. Skim through and get a glimpse of the speculative investor mindset.

I have tried to make the explanation as easy(and short) as possible and i would like a feedback from readers is it has been understood or still wanting. Any critisms or additions are welcome.

SMALL COMPARISON BETWEEN THE NSE AND WALL STREET

In  the previous post, a list of the most successful east african public companies, i briefly delved into the fact that the Nairobi Stock Exchange is the most developed in East Africa and is a major contender in the African Stock Markets.

I have been reading a little about Wall Street and i found the most fascinating article about the high tech way that business is conducted in the home of the New York Stock Exchange and i was completely blown away.

So this time i have decided to compare the NSE in the past article and the NYSE in this new article. Those wall street gunslingers are making truckloads of money at mind bogling speeds with the use of software that i believe very few people have heard of.

If you thought that the NSE was ahead, you will love the way that wall street dwarfs most of the other financial markets in the world.

Tell me what you think about both articles, Do you think that African stock markets and others in less developed countries can ever match to the level of development and efficiency of Wall Street, or are they going to always lead the pack? I need your comments

YOU SHOULD INVEST IN VALUE STOCK!!

First we begin by introducing what value stock is.

Basically a value stock is a stock that is considered good value for money. ‘Therefore this value stock can be any other of the company’s stocks

This brings the question on how to value the stock of a company. This is where financial literacy comes in like being able to read a financial statement and balance sheet and being able to analyze the fundamentals of a company. There is more of this here

Generally if in the analysis you find that the earnings of a stock are relatively low compared to its fundamentals(these include management, dividends sales) then this is a good value stock

Also one has to be able to analyze the PE of the value stock. The price per earnings of a stock is the ratio of the current price of a stock to what the company earned per share in the past year.  This is covered in this forbes article i found

This focus on the fundamentals of a company is what many top investors like Warren Buffett capitalise in so as to get the best value stock

In looking for this good bargains in value stock there are a few thing that you can look into

-the complexity of the company. it may be that a company’s stock id undervalued because investors generally dont understand it. [if you dont understand an investment dont invest in it]

-a company is just emerging from bankruptcy and investors had steered clear of it, since it is recovering and reorganized and debt free it has a very good chance of being a good investment

-there is a general bad attitude towards a particular industry like for instance investors may steer away from insurance related stock and also automotive related stock because many companies in this industries declared bankruptcy

-there are no analysts following the stock and letting the public know about its developments

-other reasons that a stock may be undervalued are in this blyth fund document

Your additions and/or corrections are appreciated

THE HISTORY OF THE STOCK MARKET

Have you ever wondered how the stock market came to be? Personally, i have and luckily i found someone else how had and written a comprehensive post on the history of the stock market (here is the article)

Apparently it did not begin as the super complex investment destination that very few people totally comprehend but was started by a few people minding their own business.

For much more read the history of the stock market here