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MENTORING - Fundamentals - Fundamentals of financial instruments (Options,…
MENTORING - Fundamentals - Fundamentals of financial instruments
Cash/spot stock
(1) It is a ownership in a company.
(2) Real money invests
primarily
in cash, and being a financial asset, it is crucial for real money to do in-depth research before entering into a cash stock.
(3) Because it is costly to enter or exit a cash stock, it is paramount for real money to do in-depth research before entering a cash stock. Once it enters, it cannot change its decision quickly.
(4) That is the reason why they will NOT exit a cash stock easily. They will exit only if the stock is removed from the top index and if the company goes bankrupt. Else, they will write off that investment.
(5) For a cash stock to be considered, real money requires the stock to be in the top benchmark indices. If not, the stock should have (6).
(6) For real money to consider a stock, it should have deep liquidity. This is the most important point. Hence, they generally (not always) consider stocks in the top benchmark index - because everyone needs to have it.
(7) Before entering a stock, real money looks at many fundamental attributes such as economic conditions, sector conditions and finally the microanalysis of the company.
(8) Real money looks at consistent cash flows from the company, which is possible if the company has
operating leverage
, It will also look at a strong
balance sheet
. Finally, it looks for a good management. (
these are what we learnt in our earlier course
)
(9) What does real money want from cash stock? (a) consistent cash flows (dividends, bonus et al), (b) capital appreciation. Then only the cash stock will become a good financial asset over the long term.
Futures
(1) It is a payment of rental for ownership in a company.
(2) Taking a future in a stock is like leasing a stock for a month (because of monthly expiry). This is the reason the contract automatically expires on the expiry date given in the contract specification.
(3) For leasing a stock through a future, we have to pay a rent, which is the leverage for the stock. But as the price of the underlying (spot) is changing, due to demand and supply forces, it is important to understand the changes in the lease rental paid for a future.
(4) That rental is called leverage. This leverage is paid through a margin in a trading account. The margin can be two types: SPAN margin and exposure margin. SPAN margin is the base margin, but exposure margin keeps changing as per the change in stock. If SPAN margin is also consumed because of an adverse movement in a stock, then either the trading account should be filled or the position will be exited by the broker automatically.
(5) Futures prices are always quoted at a premium or a discount to the cash stock (spot).
This is called basis.
This is seemingly important for a market. But this is more important in the commodity markets rather than index and stock futures. Because the basis is determined or controlled by various extraneous factors, including storage cost, which is the biggest determinant of the basis.
(6) Basis is very tough to determine in financial assets, unlike in commodity assets.
(7) Futures are broadly used for hedging and speculation. Hedging is protecting the real cash stock. Speculating is hardly done by real money. It is the job of retailers, brokers, hedge funds and other short-term players. Real money is always a long term player.
(8) One of the well-known features of futures is hedging, which is what real money uses these contracts for. However, there is one more reason why they will use futures. They will use futures as synthetics along with or without options to mimic a move in a stock.
Options
(1) Options, along with futures, are used by real money to manage risk in cash portfolios. Because futures and options are expiry contracts, they do not stay on the books for the long term.
(2) One key feature of options is that they bring rental income to a portfolio unlike futures, and regularly.
(3) Options, because of time decay and other forces, expire faster than futures. That is they are impacted by expiry every day since the contract is opened (open interest).
(4) As most of the options expire worthless, real money shorts options to bring rental income. That is how they make regular money.
(5) One advantage they have is even if an option goes against their position, they can control futures and cash to let the option expire worthless.
(6) Shorting options is called writing options. An investor or trader is writing options, if he is initiating the contract. If he is selling already bought option, he is a mere seller. So options selling is different from options writing.
(7) An option's fair value cannot be priced easily. However, Black-Scholes-Merton found an equation to value an option. That equation assumes a number of varriables, depending on which an options fair value can be arrived.
(8) The variables act like levers to control the option value. These are called greeks.
(9) We cannot track or control these greeks because they are higher dimension variables. We do not have the computing capacity to understand and control them. But one way to just follow the big boys is to learn order flow.
(10) We will try to see where maximum writing is happening in options contracts.Once we get a decent understanding of this, we can know levels where real money is focussing on.