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Financial Literacy

Understanding Derivatives as investment products (2)

Options are derivatives that give the buyer the right but not the obligation to either buy or sell the underlying.

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Understanding Derivatives as investment products

In this second part, I will be talking about options.

What are options?

Options are derivatives that give the buyer the right but not the obligation to either buy or sell the underlying. When you buy a call, you buy the right to buy, and when you buy a put, you buy the right to sell. When you sell a call, you are giving someone else (the buyer) the right to buy from you, in which case, you have the obligation to sell. In the same way, when you sell a put, you give the buyer the right to sell and you are obliged to buy if he decides to sell.  Before going into more details about calls and puts, it is necessary to clarify something about option types.

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Types of Options

There are two broad types of options, American and European options. An American option is one where the buyer can exercise his right at any time until the expiration date of the option. On the other hand, with a European option, the buyer cannot exercise his right until the exercise or expiration date of the option. The rule book released by the Nigeria Stock Exchange seems to be silent on the type of options that will be on offer in Nigeria.

Note that the name American or European does not indicate or imply place of issue of the option, rather, it refers to the timing of the freedom to exercise the right conferred by the purchase of such option. My guess is that the Exchange will opt for American type options because they are more popular and usually have more value than European type options.

investments, how to measure the performance of your investments., Here are ways to ask family and friends to fund your business - PART 2 

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Calls and Puts

A call is a derivative that gives the buyer or holder the right but not the obligation to buy the underlying instrument. This implies that while the holder or buyer of a call has the right, he is free to let that right lapse if he thinks that exercising such right will not be profitable. On the other hand, a put is a derivative that gives the buyer or holder the right but not the obligation to sell the underlying instrument. So, because the exercise of the option is optional, it derives its name, option—you, the buyer, have the option to exercise the right or not.

[READ MORE: Understanding Derivatives as investment products (1)]

Characteristics of Options

To understand the features of options (Calls and Puts), let us say, for example, that Access Bank shares are selling for N6.6 per share and someone tells you that he will give you the right to buy it any time between now and December 31, 2019 (American Option), at N6.75. He tells you that to get this right, he will charge you N0.50. If you think that given the “crystal ball” you have in your pocket, that Access Bank shares will increase in prices within the period, you may like to take up the right. However, that would depend on the extent of price increase as we shall see shortly. From the above example, we can filter out the features of a call or put option as follows:

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Strike Price

Recall that the option gives you the right to buy or sell at an agreed price, this agreed price is known as the strike price. In the above case, the strike price is N6.75.

Option Premium

In finance and indeed, in life, there is no free lunch. The right that an option grants you is not free, you have to pay for it. This payment is called the option premium. In the above case, it is the N0.50 per option that you are required to pay.

Intrinsic Value

For you to exercise an option, be it American or European type option, it has to have some value to you. The value of an option is made up of two major components, intrinsic and time value. Intrinsic value of an option is the difference between the price of the underlying and the Strike price. If the difference is positive for a call, then the call has intrinsic value, otherwise, it does not. If the difference is negative for a put, then the put has intrinsic value, otherwise, it does not. In the above case, if the price of Access Bank share increases to N8.75, then the call option with a strike price of N6.75 has an intrinsic value of N2, while a put option on Access Bank with a strike price of N6.75 has no intrinsic value.

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Time Value

Because the price of the underlying changes with time, and since an option derives its livelihood from the underlying, as the price of the underlying changes, so does the value of the option. The more time the option has until expiration, the more time it has to witness changes in value. The change in the value of an option due to time to expiration (and not due to changes in the characteristics of the underlying), is the time value of an option. The difference between the option premium and the intrinsic value, if positive, is the time value of an option. Option time vale decreases as the option approaches expiration.

[READ ALSO: Here are 10 actions that can make you a successful investor]

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Moneyness of an option

When the price of the underlying is less than the strike price of a call, the call is said to be out of the money. But if the price of the underlying is more than the strike price of a call, it is said to be in the money. However, if both the strike price and the price of the underlying is the same, the option is said to be at the money. The reverse is the case for a Put, which is said to be in the money if the strike price is more than the price of the underlying and out of the money if the price of the underlying is more than the strike price. The only options worth exercising are in the money options.

 

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Patricia

Uchenna Ndimele is the President of Quantitative Financial Analytics Ltd. MutualfundsAfrica.com and mutualfundsnigeria.com (both Quantitative Financial Analytics company website) is a leader in supplying mutual fund information, analysis, and commentary on African mutual funds. We provide reliable fund data; and ratings information that will add value to fund managers, the media, individual investors and investment clubs.

1 Comment

1 Comment

  1. Jerry

    September 30, 2019 at 8:32 am

    Very insightful article.
    Thank you!

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Personal Finance

Emergency Fund: Can you raise N50,000 cash tomorrow?

Focus on building up your emergency funds before building a portfolio of assets.

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Emergency Fund

Can you raise N50,000 cash tomorrow? Yes cash, without selling any asset of yours; Can you? This is a very important question you need to ask yourself. One generally accepted lesson from the 2020 economic downturn for both corporations and individuals is to always have an emergency fund (EF). So, what is an Emergency Fund? How is it set up? How is it used? Let us explore.

What is Emergency Fund

An EF is a savings account set up to pool and hold a minimum of three months of calculated Non-Discretionary Income (NDI). The EF is advised as the first activity any investors should undertake. Specifically, before even investing a cent, set up and maintain an EF because this fund acts as an “insurance” or stop-gap for your income or investment portfolio.

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How is an Emergency Fund set up?

An EF captures a minimum of three months of Non-Discretionary Income (NDI). What is NDI? These are expenses incurred that must be settled irrespective of income. For instance, rent must be paid, groceries must be paid, we cannot simply stop paying utility bills because we lost our job and thus income.

Once we decide on an investment plan, the first thing to do is to list out all expenses we will incur and attach a cost to them per month or annual basis but corresponding to the period of payment. We do this to identify the necessary expenses which we refer to as the NDE.

List of expenses

  • Rent N1,500
  • School fees N500
  • Camping/Holiday N300
  • Go to Movies N100
  • Groceries N400
  • Cable TV N200
  • Gas for cars N200
  • Phone Bill N300
  • Eating out Dinner N200

Total expenses for the month are 3,500

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Next, decide which of the expenses listed above are Non-Discretionary. In other words, which of these expenses must be settled irrespective of income? Let us assume our client chooses the following as NDE:

  • Rent N1,500
  • School fees N500
  • Groceries N400
  • Gas for car N200
  • Phone bills N300

These expenses above come to a monthly NDE of 2,900, with a three months minimum of 8,700. This minimum sum means that should the client lose his job or suffer any other income interruption, these necessary expenses will be paid from the emergency fund, without the need to sell down investment assets at fire-sale prices just to raise income.

How is it used?

The Emergency Fund is simply a piggy bank. Once it is set up, you can increase the minimum saving from 3 to 4 and as high as you want to go. What is does is insulate your investment portfolio from losing any compounding or dissipation in principal because you must sell.  So, if there is income interruption due to job loss or you simply want to take a long holiday and write a book, you can do so and still meet your expenses from these savings.

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An EF is not only for downturns, as it is also good for opportunities. A friend of mine bought an almost brand new car from a work colleague that was emigrating abroad because he could pay cash immediately in short notice. Cash is always king when you are in a tight negotiation with a seller.

Your Emergency Fund should be kept in cash or near cash investments. Return on investment for the EF is secondary to access to those savings. Also, you want your EF in an investment class with fixed income with no variation in returns. this means in practical terms do not invest your EF portfolio in equities that pay a variable return or even any asset which may need documentation and visits before you can access your funds. I am also wary of a commodity like gold, which does hold value, but cannot easily be converted to cash. The recommended asset classes to invest your EF are:

  1. Call or Fixed Deposit in Banks
  2. Sovereign Treasury bills, they are easily discounted and converted to cash
  3. Certificates of Deposit with bank

If the asset call cannot be converted to cash in one activity should be avoided. Also, ask the institution if they charge fees for early withdrawal and what those fees are.

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What can I do tomorrow?

  1. Start an emergency fund immediately. Do the expense exercise, determine your Non-Distortionary Expenses, start to build up a savings pot.
  2. Focus on building up your emergency funds before building a portfolio of assets.

Patricia
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Investment Tips

What bad stocks have in common with bitter relationships 

The feeling you get from marrying the wrong partner is similar to that felt after buying the wrong stocks.

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I have always argued that stocks cannot be summarised into one statement for a newbie, until recently when a friend told me that it could.  

“Simply put, buying stocks can be likened to relationships, he said.  

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did not immediately agreebut over the next few minutes, he explained to me what he meant, and drew several analogies to back his claims.  

While he is no expert, I understand that he has drawn his conclusion from his experience buying stocks for himself over the past 5 years, so I took his points seriously. These points have been summarised in this article. 

READ MORE: Cocoa prices melt lower as COVID-19 weakens demand 

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When it crashes, there is no telling how far it can go  

My friend mentioned of some company’s stock he bought in 2016 in the hope of selling short-term. At the time he bought, there was a dip and he expected things to pick up within some months so he could sell-off.  

Two years later, the stock price had plummeted 50% down from the price at which he bought. Without saying, he became a long-term investor because he was not ready to sell off at a loss.  

 

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How does this liken to being in a bad relationship?

As the value plummets, you keep hoping it will rise again and then before you know it you are stuck for the long haul. Same thing can happen with a wrong partner. You remain there hoping things will be better but it gets worse. 

It could happen sometimes that a company’s stock market price comes crashing and it never goes back to where it was againThe factors which triggered its fall, may not even be able to return it to its starting price.  

 

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The stock price is not indicative of the company’s profitability 

For some reason, there are company stocks market prices that remain low year after year despite the billions declared in profits, and the dividends paid out to shareholders.  

Sometimes, the stock market price could still slump even when the company has positive records in its financials. Market experts are not always able to explain this, but it remains true. Some of the most profitable stocks are undervalued.  

 

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You can never take stocks at face value

That a stock has been on an upward trend in the last few months does not mean it will remain so. One must always consider several other factors before purchasing a stock.  

While it is important to look at past performance, there are other things that could point to the likely future of such stocks. 

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Say, for instance, the company has just announced a new board chairman who was implicated in some fraud cases in the past. It doesn’t matter how well the stocks have performed in the last 365 days, or the chairman’s competence, the stock prices are most likely to slump due to loss of investor confidence.  

There was a recent case where the CEO of an internet service provider company was alleged to have been involved in sexual harassment, and was eventually pressured by shareholders to resign. The pressure came not necessarily because they thought he was guilty, but because of the implications on the company.  

You have to probe to discover the real qualities.  

 

The most expensive stocks are not necessarily the best. 

If you ever heard a stock described as under-priced or over-valued, then you should understand that the price you pay is not necessarily suggestive of the value.  

Some great stocks, with good potentials, high liquidity, good company profile and adherence to corporate governance ethics, are not as expensive as they should be. While some other stocks are ridiculously overpriced, even when they do not have as much promise. Some of these overpriced stocks could still be basking in past glory or just positive media hype.  

This explains why investors must conduct due diligence before putting in their hard-earned money. Sometimes the media hype around a company’s stock might not be giving you all the information you need to make a decision, so you necessarily have to go the extra mile.  

Subscribe to newsletters from financial news websites if you need to, take courses if you have to, but ensure to learn all you can.  

Remember price is what you pay for the stock, but value is what it is really worth, and there is no law stating that one must justify the other.  

READ MORE: Global stocks records astronomical gains in Q2 2020

When you get the wrong stocks, you get stuck! 

You know that feeling when you are sure that you have made the wrong choice, but also know that there is no way out? That’s the feeling you get when you marry the wrong partner, as my friend said. And that’s the same feeling you get when you get the wrong stocks.  

You simply get stuck.  

No returns. No dividends. Probably, no way to sell either because no one else is interested in buying from you. And if you do succeed in selling off at this point, you would most likely be doing so at a loss.  

If you study trends in the stock market, you will see some dormant stocks that have remained stagnant for long periods of time. No rise in share price, no fall in share price, and no share is being traded either.  

READ ALSO: Best time to make money trading BTCs

It is not a nice position to be in, and that is why you want to be sure of the company, its management, and board members who take the decisions before you decide to buy or not, even more so when you are a long-term investor.  

And even then, with the wrong stocks, you could suddenly find that your proposed short term investment of 6 months will run into years because you keep waiting for things to pick up before you sell.  

Patricia
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MSME

130 farmers to receive seed funding of N100,000 each

The target of the programme is to adopt farmers in 774 LGAs across the country.

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The National Information Technology Development Agency has kick-started a job and wealth creation programme where 130 farmers will each receiv, e seed funding of N100,000Border Closure: Nigerian rice farmers are struggling to feed a rice-hungry nation. CBN to give Niger Delta rice farmers single-digit loan 

The National Information Technology Development Agency has kick-started a job and wealth creation programme where 130 farmers will each receive seed funding of N100,000. The programme will be supervised by the Federal Ministry of Communication and Digital Economy.

According to a statement from the agency, the National Adopted Village for Smart Agriculture (NAVSA) programme is in line with the government’s drive to lift 100 million Nigerians out of poverty, and it will start with 130 farmers in Jigawa state.

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The target of the programme is to adopt farmers in 774 LGAs across the country, open the platform to all agriculture ecosystem players with access to information, facilitate and improve productivity, reduce the cost of production, and facilitate access to local and international markets.

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READ MORE: President Buhari directs Ministries of Power, Finance, BPE to seal Siemens deal

With all of this in place, it is expected that the farmers will be able to build sustainable business models and digital business opportunities that will create not less than 6 million well-paying jobs in the next 10 years.

“NAVSA Platform is aimed at digitalising agriculture to drive Digital Economy, as part of President Buhari’s agenda to leverage on technology and innovation to revolutionise the agriculture value chain,” the statement read.

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Among other things, the farmers will be empowered with a digital platform, smart devices (tablets), connectivity for data and calls, Digital agripreneurship skills, and enrolment with telecom operators and the National Identity Management Commission (NIMC) for identification.

All of these will be given to them at the end of the programme, which will last from July 1 to July 13, 2020.

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Patricia
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