How Does The Stock Market Work

Prior to electronic and internet trading, the stock market was a place where people gathered to buy and sell stocks. Stocks are certificates that certify that you own a small piece of a company. In modern times, most of all stock trading is done on the electronic exchanges via online brokerages.

When you purchase a stock you are purchasing an income producing asset (assuming the company is profitable). What this means is that you are now part owner of any cash the company earns. However, as a shareholder you have very little say about what will be done with that cash.

There are three ways a company can provide value to shareholders. First, the company can issue a dividend and pay a percentage of its profits out yearly to shareholders by sending them a check. Second, the company can buy back its own shares therefore increasing your equity stake in the share of the profits. Last and most common, the company can use the money earned and reinvest it for shareholders in order to keep growing their yearly profits and increase the company’s value.

There are companies traded in the stock market who are yet to make a profit. These companies usually trade at a value equal to what the market feels is the company’s future potential earnings. These stocks are amongst the riskiest since they usually have unproven business models.

When you place an order to purchase stock, your order is sent to the exchange by your broker with the price you are willing to pay. Once your order is listed on the exchange, it gets executed only if someone else lists shares for sale at the same or lower price. The opposite is true when you own shares and want to place a sell order, it only gets executed if the price is equal to or higher than your listed price.

In order to trade stocks you must first find their ticker symbol. A stock’s ticker is a short group of letters that identify that specific company’s stock. For example, Apple’s ticker symbol is AAPL.

Another important thing to note is that the price you see when you lookup a company’s share price, was the last price at which it traded. In reality there are three prices you should look at. The bid price is how much buyers are willing to pay. The ask price is how much sellers are willing to sell for. The last price (which is what is commonly quoted on the news) is the price at which the last transaction was executed.

If you want to learn how to get started trading stocks please see our other article on how to get started trading stocks

stock market

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Stock Market Trading Hours and Holidays

Hours

9:30 AM – 4:00 PM (Eastern Time)

Holidays

New Year’s Day (January 1)

Martin Luther King Jr. Day (January 20)

Good Friday (April 18)

Memorial Day (May 26)

Independence Day (July 4)

Labor Day (September 1)

Thanksgiving Day

Christmas Eve Day (December 24) (opened until 1:00 PM)

Christmas Day (December 25)

New Year’s Eve Day

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Writing In The Money Puts On Quality Stocks

One of our favorite strategies here at TSO is writing in the money puts on high quality dividend paying stocks. As some of our readers already know, the dividend amount is usually baked into the put option’s price as time premium. For this reason, writing in the money puts allows us to leverage the income from a stock dividend while offering us creative ways to average down if the trade goes against us.

One of the reasons why we choose in the money puts instead of at the money or out of the money puts is because we like to benefit from price appreciation. Being as most quality stocks we follow perform share buybacks to return cash to shareholders, it makes sense to expect some capital appreciation on the stocks we sell puts on.

The main reason we like this strategy so much is that even if the stock goes down one year, we can simply turn around and resell the same put for more time premium the following year. This is beneficial because it brings down our cost basis every year and allows us to sell additional puts if we feel like averaging down.

If you plan to take advantage of this simple strategy we recommend looking at blue chips with steady cash flows and shareholder friendly management. Also, only sell in the money puts on stocks that pay a dividend as this will boost the premium you can collect even with in the money puts. We usually recommend selling puts with deltas between 0.60 and 0.75 as they allow for price appreciation and have some time premium to offer some downside protection. 50% of total returns from the stock market in the last 100 years have come from dividends so it only makes sense to leverage them by writing slightly in the money puts.

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Put Option Definition

A put option is an exchanged traded contract that gives the buyer the right to sell his or her stock at a predetermined price from now until a future date. In contrast, when you sell / write a put option you take in the obligation to purchase someone’s stock from now until the future date at a predetermined price. Lets look at the standard components of a put option:

Strike Price

The strike price is the predetermined price at which you can sell the stock regardless of its current price. Eg: You own 100 shares of XYZ stock and XYZ is currently trading at $30. You also own a put contract on XYZ with a strike price of $40. Basically you can exercise your put contract and sell XYZ for $40 instead of the current price of $30.

Expiration Date:

The expiration date of a put is the last day on which you can exercise your rights as a put holder and assign your shares to the put seller in exchange for the strike price. For example, in the previous scenario if the put you own has an expiration date of January 2016 this means that you have the right to sell XYZ stock at $40 per share until January 2016.

Premium

When you buy a put option you must pay the put seller a premium to compensate them for the risk they are taking by taking on the obligation to purchase your stock at a specific price from now until a future date. The longer the expiration date, the higher the premium. What this basically means is that put sellers act more or less like an insurance company against a decline in price on the shares you own. Similar to an insurance company, the less risky the company is then the less premium you pay to insure your stocks.

Having looked at these three components of a put option, you should now have enough knowledge to start experimenting with put options. We usually recommend put selling strategies since it puts the odds in our favor. Put selling strategies basically make you an insurance underwriter on stocks. Please check out our other articles on how we utilize in the money puts as surrogate stock to achieve leveraged returns on high quality dividend paying stocks while supercharging the dividend.

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Call Option Definition

A call option is a contract sold by a shareholder to a call buyer in exchange for a premium. A call option gives the call buyer the right to purchase 100 shares at a future date at an agreed upon price. Let us look at what that exactly means  by looking at the standard components of any exchange traded call option.

Strike Price

The strike price is the price at which the call buyer can purchase the stock from the shareholder from now until the expiration date.

Expiration Date

The expiration date represents the last day on which the call buyer can exercise his right to buy the stock at the agreed upon strike price.

Premium

An option’s premium is the amount paid by the call buyer in exchange for the call contract. The premium is quoted on a per share basis so a $5 contract represents a $500 investment since each contract represents 100 shares.

Example:
Microsoft currently trades at $45/share and you believe it will go to $50 by January of 2016. You purchase a call option with a strike price of $45 for a premium of $3 for a total investment of $300. Lets look at the possible outcomes.

The formula used to calculate the price the stock needs to reach before you are profitable is:

Strike Price + Premium = Breakeven Stock Price (at expiration)

In this example the price Microsoft needs to reach before we are profitable is $48 since:

Strike Price + Premium = Breakeven Stock Price
$45 (Strike Price)
 + $3 (Premium) = $48 (Breakeven Stock Price)

  • Microsoft trades at $50/share
    If Microsoft trades at $50 a share on January 2016 and our breakeven stock price is $48 then this represents a gain of $200 or a 66% return on investment. You can calculate your total profit by subtracting the breakeven stock price from the current stock price and multiplying by 100 shares.
  • Microsoft trades at $45/share
    If Microsoft trades at exactly $45 a share on January 2016 then we have a total loss of $300 since that is what we paid for this call option. If it trades slightly above $45/share but below the breakeven stock price then its not a total loss but it is still a loss.
  • Microsoft trades under $45/share
    If Microsoft trades under $45/share on January 2016 then we still have a total loss of $300 since you can’t lose more than what you paid for the premium on a call option.

Screen Shot 2014-12-15 at 8.29.57 PM

Overall what attracts traders to call options is the incredible leverage they offer in exchange for a small time premium.  It isn’t all easy gains though, call writers usually price at the money options using the stock’s volatility making it really hard for at the money call buyers to really benefit from an up move in the stock.

Additional Information

Call Option Definition – The Options Guide
What is a call option – Investopedia

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The Best Investing Books Of All Time

Security Analysis: Sixth Edition

Security Analysis is one of the best investing books written to date. Written by Warren Buffet’s own professor, Benjamin Graham, this book can be said to have stood the test of time. This book is huge and half of the book talks about valuing bonds instead of securities; The other half however is filled with tons of useful information on stock valuation. This book will teach you what to look for in a good company so that you don’t overpay. Many investors today are too busy chasing the momentum names instead of stopping for a second to think if the company is really worth as much as they are paying. Additional chapters in this book cover things such as discounted cash flow as well as valuation ratios you should look for.

The Intelligent Investor

Another Warren Buffet favorite, The Intelligent Investor will walk you through the basics of value investing as well as show you what a good stable business looks like. Benjamin Graham was the person that introduced Buffet to value investing as well as the core concepts that have made Buffet such a successful investor. Learn to invest for the long term with this amazing book as you learn how dividends affect total long term return. Also covered are how to read balance sheets, income statements, and cash-flow statements; Three useful documents allowing investors to assess a company’s financial health.

The Bible of Options Strategies

While an options book seems out of place for an article on long-term investing, this specific book teaches option techniques that can be applied to long-term investing. For example, most investors would park cash until a stock they have their eye on pulls back to a more reasonable price. Naked put selling as taught in this book, allows you to benefit if the stock moves up or even a little bit down. If you want to know how options can be part of an investor’s toolbox check out our other article on naked put selling. As many people now know, the reason why Buffet has managed to achieve such great results over the years by investing in large caps has been partly due to leverage. Options will give the small time investor the leverage he or she needs to compete if used with caution.

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Fundamental Analysis of Intel (INTC)

Intel (INTC) has been breaking into new 52 week highs lately, so I figured it would be appropriate to write up some of the fundamentals that are supporting the price action.

Free Cash-Flow

In the last fiscal year total free cash-flow came in at a little bit over $10 billion or $2.80 per share showing the cash generating ability of the chip maker. Current earnings yield (free cash-flow per share / current price) currently sits at around 7% annually, money the shareholder friendly management has been returning to shareholders through stock buybacks and dividends (the current payout ratio is hovering around 50%).

Stock Buybacks

Intel’s management has shown competency in buying back their own shares by buying less in the last couple of years as the stock price has soared and more during times when the price has been depressed. The average sits at around $4B in buybacks yearly during the last 4 years. With another $4B going into dividends yearly, management has managed to effectively return most of its earnings directly and indirectly back to shareholders while still retaining enough to invest in growth.

Dividends

As stated above, Intel’s management has pretty much a 50/50 split between dividend payments and share buybacks making it easy for the company to keep growing its dividends without requiring aggressive growth. Dividend growth as well as the continued stock buybacks during times when the stock price is depressed should continue to fuel the stock higher and increasing the investor’s Yield on Cost year after year.
In my personal opinion Intel is a quality company with a strong moat as the leading chip maker. If you share this opinion then the previous reasons should be enough to get you to consider an investment into intel. As always we recommend playing intel’s rise by selling in the money puts with enough time premium in them to cover any short term pullbacks in the stock.

 

Intel logo

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Cash Secured Put Selling

Cash secured put selling is the practice of selling put options on your favorite stocks in order to lower your cost basis. When you sell a put on a stock you are taking on the obligation to purchase the stock at an agreed upon price (the strike price) in exchange for a premium which can work to lower your cost basis.

There are numerous put selling strategies available to options investors. Some of these strategies sell puts out of the money, at the money, or in the money. Here at TSO we mainly focus on selling in the money put options with a delta of around 0.70 on large caps with shareholder friendly management (share buybacks / growing dividends). We focus on selling in the money puts due to the fact that they provide a fair amount of time premium as well as capital appreciation.

One thing that is attractive about naked put selling is the fact that you can roll unprofitable positions indefinitely at the same strike price while still possibly collecting a small amount of time premium year after year. One reason we choose stocks that pay a dividend vs those that don’t is because the dividend is part of the options pricing model (Black-Scholes). This works out great for the long term investor since every year you can likely collect the dividend payment through the time premium available for the next year’s put therefore consistently lowering your cost basis (year after year). Eg: If Coca-Cola (KO) is trading at $45 today you could sell the $50 strike next year put with $5 intrinsic value and a few dollars of time premium baked into the option. If next year Coca-Cola is still below $50 a share you can simply buy back your naked put when the time premium has almost completely decayed and sell the same $50 strike price for the following year once again collecting a few dollars worth of time premium. Done year after year your cost basis will surely go down over time until you are finally ready to have the stock put to you and collect an above average Yield-On-Cost via dividends.

The reason we choose large cap dividend paying stocks is because these companies tend to have a much lower risk of bankruptcy than their competitors as well as lower historical volatility vs the market. This allows us to use some of the leverage afforded by naked puts to get better risk adjusted returns vs the general market.

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Naked put selling on large caps

Amongst one of my favorite and most profitable strategies is selling in the money naked puts on large cap stocks. Many people are misinformed by their brokers as well as their friends about the risks associated with naked put selling. Naked put selling high quality dividend paying stocks that you would love to own pretty much reduces most of the risks related to naked put selling.

First, when you sell a naked put you are basically taking on an obligation to buy the stock at a set price from now until the expiration date (or until the position is closed). In exchange for taking on this obligation you collect a premium. In essence you are acting as an insurance company, insuring people against a drop in price on the given stock.

People find naked put selling risky because of the leverage afforded by naked put selling (approximately 5 to 1). This makes it possible to wipe out your entire account if you are not careful. By writing cash secured naked puts on high quality dividend paying stocks we are 1) making sure we have enough money to buy the stock. 2) lowering our cost basis when we are assigned.

Let us take a look at what makes this strategy so successful.

Reducing our cost basis (while maintaining capital appreciation)

When you sell an in the money naked put you are getting the benefit of moderate capital appreciation as well as lowering our cost basis on the stock by receiving a premium. For this reason we maintain that you should only sell naked puts on stocks you would love to own. For example, Coca Cola (KO) is currently trading around $45, right now you can sell a January 2016 $50 put for around $7.20. If Coca Cola reaches $50 by next year you get to keep the full premium ($5 intrinsic value + $2.20 in time premium received). In the case that Coca Cola instead declines to $40 by next year you can simply roll forward the $50 put to January 2017 while also collecting some additional time premium in the process. You can do this indefinitely until the stock rises again while lowering your cost basis each and every year. If the stock does decline to a price where the valuation seems cheaper though, I would recommend selling additional naked puts at a lower (but still in the money) strike price to further decrease your cost basis.

It is important to remember that each time you reduce your cost basis by selling naked puts you are essentially increasing the yield on cost when you are finally assigned and start collecting dividends.

Moderate Leverage

One of the riskiest parts of naked put selling is the leverage possible. By using moderate leverage however we can generate market beating returns with very little additional risk. One of the reasons we use large cap value stocks with this strategy is that they are often the least volatile vs the market with betas often below 1. By utilizing a little bit of leverage we can write additional naked puts on our losing positions in order to further reduce our cost basis. One thing we find often with large cap dividend stocks is that the dividend is already baked into the naked put in the form of time premium. By using moderate leverage we can increase our returns by leveraging the INCOME rather than the PRICE of the stock. In essence this is the same as buying a house using a mortgage and renting it out, your down payment might be just 20% which leads to outsized returns on your capital from the rental income.

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How Your Spouse Helps Your Taxes

With marriage come a lot of wonderful things. You have someone to spend your life with. You have someone to raise a family with. You also have someone that will come in handy when it comes to your taxes! Of course this is not a good reason to get married in itself, but if you are going to take the plunge you may as well take advantage of all the perks marriage has to offer!

If you are married, you can use your spouses earned income to help fund your IRA. In order to contribute to an IRA you have to show taxable compensation. But, if you are married an exception can be made if you are filing your year-end taxes as married filing jointly. The spouse with the taxable compensation can make a contribution to your IRA if you do not have any taxable income. As long as one spouse is working then it does not matter who puts the money into the IRA.

While your spouse shelters you from harm, they can also serve as a tax shelter. If there is one spouse who is losing money they can take advantage of certain deductions such as those dealing with your home. This is true when it comes to medical expenses as well. Being married can also shelter your estate. If you have a good deal of money you can leave as much of it as you wish to your spouse without having to deal with estate taxes. This exemption will protect the living spouse until the time that they pass on as well.

The law puts a limit on the amount of charitable contributions one can use as deductions each year. When you are married that limit goes up so if one partner makes one big contribution to their charity of choice but does not have double the amount in income, the excess contribution is deducted the next tax year. Just be sure to save all your filing documents in case there are any discrepancies when you go for the carry over. In addition to these things you also may have a chance at getting back more money from the EIC when you file. So, if you are newly married make sure you tell your tax preparer this so they can get you everything  possible!

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