The Frog and the Roo

Recently the CBOE Volatility Index hit a record high of 80. Most of the experts have commented that they never see such a high value before. When volatility becomes high, the price of the options increases as well. I did some searching and found this the Frog and the Roo illustration in a option book easy to digest.

To understand the role of volatility and options prices, just imagine you are at carnival with a unusual game called a frog jumping game. A frog starts in the middle of a floor and it can only jump left or right. The frog jumps randomly to left or right with equal probability. At the end of one minute, the frog’s final destination is marked and you are paid $1 for every foot the frog is to the right of the starting point. If the frog happens to land on the left, you get nothing.

How much would you pay to play this game? There is no right or wrong answer but just pick a number that you think it is reasonable. Now, let’s change the game with the same set of rules except now it’s a kangaroo.

How much would you pay to play this game now? There is no right or wrong answer but just estimate how much wills this game worth to you. It should be obvious that no matter how much you choose for the previous frog game, you are willing to spend more for this kangaroo game. Why is it so? That’s because the kangaroo has the ability to jump further, and that means you could win more money and so this game worth more to you.

Notice that although the reward for both games are different, both have the same negative downside of risk. That is because for both games, you are limited to the risk of losing your $1 bet for every foot to the left of the starting point. In the other hand, your upside is the one that worth the most. Looking at the payoffs of both games, it is obvious that the kangaroo game is more valuable.

To understand how volatility affects option prices, just replace the frog and kangaroo with ATM calls on two different stocks. Which call is more valuable to you? It is the one which has the higher ability to move or in other words it is the stock with higher volatility.

Of course, there are still many reasons that affecting option prices but at least for now, I get a better understand of this unique relationship between the ‘V’ word and option pricing.

INVEST Fair'08

Remember to mark your calendar for the up coming INVEST Fair'08 on 16th - 17th August 2008, 10am - 7pm. This year event returns with a larger scale to Suntec Convention and Exhibition Centre.

According to the website, there are over 50 free seminars by financial institutions and listed companies such as keynote presentations by popular investment experts, panel discussions moderated by ChannelNewsAsia presenter Melvin Yong, lucky draw and investment games with attractive prizes.

This is a good opportunity to learn more about the latest financial products and services, understand the market outlook and hear from the experts as to how to invest in the current volatile investment climate.

I was flipping through my notes and came across interesting terms given by investment community to classify companies with different market capitalization. I listed here for easy quick reference.

Mega Cap
More than $200 billion market capitalization

Large (Big) Cap
Between $10 billion and $200 billion

Mid (Middle) Cap
Between $2 billion and $10 billion

Small Cap
Between $300 million and $2 billion

Micro Cap
Between $50 million and $300 million

Nano Cap
Less than $50 million

Before starting your journey, there are several questions you should carefully consider if you are a newbie. I came across this step by step way to develop a strategy for trading and investing in Invest magazine. The article is by Jack Wong from Optionetics. I posted the questions in my blog for your reading.

What is your business plan?
First of all, you need to have a business plan regardless of your decision to invest or trade. Your business plan should specify your goals and the milestones clearly. Your milestones could be short term, mid-term or long term. It is important to have a business plan because without one, the chances of failure will be high.

What is your time commitment?
Next, you have to be clear about your time commitment based on your personal circumstances. Traders are looking for short-term reward while investors prefer to achieve financial goal over longer period. If you are holding a full time job and works 50-60 hours a week, you really have to consider carefully whether you can become a trader who does day trading?

Which markets do you intend to participate?
The key point here is you shouldn’t get into any financial activities in a market where you absolutely have no clue. Choose to stay with the market where you are more familiar but at the same time keep an open mind and slowly extend your reach to other markets.

What instruments do you intend to use?
Most people are familiar with basic trading instrument as stock. There are alternative instruments available such as options, futures, forex and etc. You can try to keep an open mind to understand and appreciate these instruments and take time to learn how they may be used to diversify your investment.

Remember to keep a diary or journal of all your trading activities so that you may use it as a way to evaluate your past mistakes and seek to improve yourself. As a newbie, you should never stop learning.

If you have been following the stock market, you probably heard people discussing about sector rotation. I first learned about this sector rotation from Conrad Alvin Lim when I attended wealth academy investor seminar by Adam Khoo Learning Technologies Group (AKLTG).

The sector rotation model is based on Sam Stovall’s Standard & Poor’s Sector Investing. The model states that different sectors are stronger at different stages in economic cycle. This strategy involved the movement of money from one industry to another in the attempt to beat the market up down cycle.

Sam Stovall is the chief investment strategist for Standard & Poor’s Equity Research Services. His famous column, Sam Stovall’s Sector Watch appears on http://www.businessweek.com/investing.

I placed the link to an article I found in investopedia.com, Sector Rotation: The Essentials

Stockchart.com’s interactive SPDR Sector Rotation Chart is found at http://www.stockcharts.com/charts/performance/SPSectors.html

Which type of investor characters are you? Are you a bull or bear on current market?

The Bull
They are the buyers who always buy at low price and sell at higher price in an up-trending trade. They believe that the market will rise. They profit on upward movements and are often optimistic. Their risk is limited to the total amount of their investment and their profit is unlimited. They are the exact opposite of the bears who are pessimistic and believe the price will decline.

The Bear
They are the sellers always sell at high price and buy back at a lower price in a down trending trade. They believe that the market will fall. They profit on downward movement and are often pessimistic. Their risk is unlimited and their profit is limited to the total amount of their investment.

The Turtle
This is nickname given to those who are unskilled or ungifted investors that learn and grow in the market to become great investors. This started from experiment done by Richard Dennis and Bill Eckhardt. Dennis believed that a person could be trained while Eckhardt thought it was an innate skill.

The Pig
These are the investors who have high expectations that forget their investment plan and go for unrealistic future gains. Pigs tend to be greedy and often never know when to sell their position to realize the gain.

The Ostrich
These are the investors who are ignorant of market factors and news. The reason behind type of action could be attributed to risk aversion and bias. Ostriches will ignore the market even when it is not advantageous to them, like the actual bird that sticks its head in the ground in response to stress and danger.

The Lemming
These are the investors that follow the crowd and often end up in disaster. This is in reference to the rodent with a habit of mass migrations that end up in drowning.

The Sheep
This refers to those investors that lacks a focused trading plan and invests on the suggestions of others, including friends and financial gurus. Their behavior is like the animal that relies on its shepherd for guidance. They are famous for investing on emotion without consideration to their financial viability. They are often the last to get in on a major market move and are most likely to suffer investment losses because they have no clear investment strategy.

The Barefoot Pilgrim
This is the slang given to investor who has lost everything in the stock market. They are often the result of taking on more risk than necessary or affordable, or taking on investments carelessly without proper research and planning.

Effective Memory Strategy

Do you have a good memory? Most people would say ‘no’ immediately if you ask them. If you forget things easily, it is not because you lack of ability to remember, it just you haven’t master the memory strategy. I just learned an effective memory strategy from the book ‘Master Your Mind Design Your Destiny’ by Adam Khoo. Let’s do an exercise taken from this book now!

Take a look at the list below and do your best to remember it in sequence. Give yourself a minute to do so.
1. Eggs
2. Cow
3. Fork
4. Bikini
5. Banana
6. Fan
7. Hair
8. Glucose
9. Policeman
10. Zoo
11. Michael Jackson
12. Ear rings
13. Frisbee
14. Planet
15. Rainbow
16. Numbers
17. Crown
18. Fish balls
19. Clocks
20. Claws

Now do your best to write down as many words as you can remember. So, how many words did you manage to recall in sequence? Most people properly get 7 to 10 words correctly.

Let’s try something new, using your imagination, make a visual image of each word and associate it to the next word in a humorous way. At the same time, say the word out loud!

Use your mind and visualize an egg. Now, imagine that egg cracks and out pops a cow’s head. See that cow has forks on its head. Imagine that the fork is wearing a pink bikini. Suddenly, the bikini drops and bananas are exposed. Imagine that the skin of the banana peels off and becomes fan. The fan blows all your hair away. Your hairs flies and gets glued to a ghost (sound like ‘glucose’). The glue ghost (glucose) chases a policeman into the zoo. Inside the zoo, imagine seeing Michael Jackson wearing ear rings. He then takes the ear rings and throws it like a Frisbee. See the Frisbee spinning around the planet. A rainbow appears. Then see that there are numbers dancing on the rainbows. These numbers then join to make a crown. On the crown you see fish balls which contain small clocks. On the hand of the clock are claws.

Now, do your best to write down as many words as you can remember. If you followed the strategy above, you would able to write down all 20 words in sequence without any problem. This is because you used the strategy people with exceptional memories use whereby they make an image of the word in their mind and then associate the images together in an emotionally outstanding way.

Today I attended a seminar on the topic of investment warrants by Macquarie. This is introduction to investment warrants for me.

There are differences between trading warrants and investment warrants. Investment warrants are long dated up to 1 year plus and they are issued deep in-the-money. They have comparatively lower gearing & premium. You can choose cash or physical delivery of share at expiry for investment warrants and you also entitle to net ordinary dividend equivalent payments announced by underlying stock. These investment warrants are suitable for longer term investment.

Trading warrants are typically short dated, less than 3 months and they are generally issued out-of-the-money. Trading warrants have comparatively higher gearing & premium and only allow cash settlement at expiry date.

Investment warrants is identified with the warrant code of ‘i’ in front of usual Call or Put Warrant code (e.g. SingTelMBLiCW090703).

You can check out Macquarie Warrants website for live pricing and upcoming hotshot contest in July (simulated real-time trading contest).