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The Advisory Firm Newsletter:  May 2012

THIS MONTH IN PERSONAL FINANCE: Options 101 & Endowment Model / Alternative Investing

 

This month we focus on Investing, with a primer course on Options (the tradeable type) and Endowment Model / Alternative Investing.

OPTIONS 101

While many of you may be familiar with stock options from grants given by your employer, there are also "tradeable options" that are listed on the exchanges, which can be bought and sold daily. This month we will explore that a bit deeper.

What is an Option?

Commonly referred to as a "derivative", an option is a tradeable instrument which gives the owner the "right" to buy or sell a security, commodity or index at a specific price - by a specific date. Is that confusing? Let's break it down with an example:

In the graphic below you will see the June options for Coca-Cola. When I took this screen shot Coke stock was trading at $76.68 (on the graphic under the column titled "strike").

call
put

Call Option:

A Call Option gives the buyer the "right" to purchase the stock for the "strike" price before the expiration date of the Option. In this example of the June 2012 Options, a buyer wanting the right to buy Coke at $77.50 per share in June could pay $.84/share (look at the Bid / Ask columns and line up with the $77.50 strike price row) and have that right. The important thing to note is Options do expire on the 3rd Friday of each month. So if Coke was not at or above $77.50 on June 15th, the option is worthless.

Put Option:

A Put Option gives the buyer the "right" to SELL stock to someone at the "strike" price before the expiration date of the option. In the example above you could buy the right to sell Coke stock at $75 per share for approximately $.93/share. (go to Strike price column, go down to $75 and then go across that Row to the bid / ask columns for option price)

Common Uses of Options:

By now you may be wondering what is the purpose of an Option? If you want to buy or sell Coke stock, why not just trade the actual stock?

There are a couple of primary uses for Options: Speculation, Hedging and Income. So let's explore:

Speculation: If you are a trader and feel that a stock is going to move higher or move lower, you could purchase that stock (or short sell the stock). With Coke the trader would need $76,680 to buy 1000 shares if they thought it would go higher. However, they could buy 10 of the $77.50 June Calls (equivalent to 1000 shares) for $840. If the stock moved higher in the near term the trader could make his money without tying up a lot of capital. This applies the same way for a trader that thinks the stock will go lower, he can buy the PUT options and profit if that stock drops.

Hedging/Income: these sort of work the same. Hedging would be "buying" insurance on your stock portfolio by purchasing PUT options. If you were holding stock and feared it might drop in price you could buy the PUT option and hedge your account. On the flipside if you were holding stock and wanted to generate some income as you thought it would trade sideways or correct a little, you could sell a CALL Option and generate some income. You as the seller get to take in the proceeds of selling the CALL option but give the buyer the right to purchase the stock from you on or before expiration. So you always run the risk of having the stock "called" away from you at the strike price.

Without going into a lot of detail, Option prices are made up of an Intrinsic Value and Time Value. The closer you get to the monthly expiration, the more rapidly the "time value" premium of an options price drops. (In the case of Coke $77.50 CALL option above, it is all Time Value premium until the stocks actual price gets above that level) It has been estimated that up to 80% of Options expire worthless, so keep that in mind if you get the urge to speculate by trading options. You can lose money fairly quickly.

 

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ALTERNATIVE INVESTING / THE ENDOWMENT MODEL

There has been a lot of talk recently about Alternative Investing, so while we are dedicating this month's newsletter to Investing topics, let's go ahead and define what exactly Alternative Investing is: simply investing in alternatives to stocks and bonds!

Alternative Investing has been around for a long time, but began gaining some traction with the publicity of David Swensen, the Chief Investment Officer for The Yale Endowment fund. Mr. Swenson came public with his strategy after two decades of market beating performance managing the $20 billion endowment fund. His strategy included investing in many non-traditional asset classes at the time which allowed him greater diversification and less correlation to the stock market while generating more robust returns.

Investing in Alternatives Assets in the past had been extremely difficult as only the largest pension and endowment funds had the available capital to allow them access to these areas, however as with everything if there is a demand then more products will be rolled out to make it accessible to a greater number of people.

So what type of Alternative Investments are there?

Commodities, Private Equity, Hedgefunds, Venture Capital, Managed Futures, Real Estate, Timber and Derivatives to name a few. The idea behind the Endowment Model was to incorporate more of these Alternative Assets within the overall investment allocation, while still maintaining some exposure to traditional assets like Stocks and Bonds.

The biggest drawback or criticism of Alternatives is liquidity. In Mr. Swensen's model the less liquid the investment the better as it tended to generate a higher return over time. For most investors (and investment advisors) this is a very difficult tradeoff, as knowing you will be investing in something that you cannot sell or get your money out of for many years is very challenging. For the biggest endowments and pensions however this was fine as their investment timeframes span decades into the future.

Like any hot investment topic, investing in Alternatives is now being rolled out to a wider audience via ETF's and Separately Managed Accounts. You can now invest in Commodities, Managed Futures, Real Estate via ETF's / Mutual Funds or Separately Managed Accounts. Likewise there are ETF's that track Hedgefund strategies and publicly traded companies that are involved in Private Equity and Venture Capital. (these newer alternative investing products are more liquid - meaning tradeable on the exchanges, thus giving up some of the potential gains of the more illiquid strategies the endowments look for)

Caution!: Just because you can invest in something outside the traditional stock / bond universe does not mean it will automatically outperform. Many of the above asset classes have had negative years. The Endowment Model approach was to allocate a portfolio of stocks / bonds / cash and alternative investments with the idea that overall correlation to the stock market was lower and over time the total investment returns of the portfolio would outperform the S&P 500 benchmark. (note: after decades beating the S&P, The Yale Model suffered a 30% decline in 2008, so it isn't fullproof)

 

 

 

Questions?

I am always on the lookout for a topic to write about, so feel free to email me if you have a specific question or newsletter idea. (click below)

James Daniel, CFP

 

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The Advisory Firm, LLC provides fee-only financial planning services for clients throughout metro Atlanta and North Georgia including the communities
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This newsletter if for informational purposes only. The information contained within should not be considered as financial advice nor soliciation
for financial services. Consult with your financial professional if you have any questions. The Advisory Firm, LLC is a fee-only financial planning company and registered investment advisor.