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  • Volatility Trading – How To Trade Volatility Profitably?

    Volatility Trading – How To Trade Volatility Profitably?

    (Updated November 2021)

    Volatility Trading - How To Trade Volatility Profitably?
    Volatility traders do not pay attention to which direction stock prices move, they are interested in the level of volatility itself.

    Volatility trading describes trading the volatility of the price of an underlying asset. Make a note of the difference, it isn’t trading of the price itself. Or in other words, volatility trading indicates trading the assumed future volatility of the index. Hence, it is buying and selling the anticipated future volatility of the asset. Every single asset in which price changes, actually manifests price volatility. So, traders that trade volatility looks at how much change, in any direction, will happen. They don’t pay attention to the price, they don’t want to predict the price itself. Such traders just think about how much the price of some asset will move in the future, in the stock price, for example. No matter if it will go up or down. And it isn’t random trading. They have developed strategies which we’ll present to you.

    But firstly, we would like to make clear what volatility trading is.

    For example, options are a favorite tool for volatility trading. Why is that? Well, many factors can affect the value of the option but a crucial for its value is the expected future volatility of the underlying asset. Hence, options with higher expected volatility are more valuable than options on instruments with low expected volatility in the future.
    Therefore, options represent an easy way to get exposure to the volatility of the underlying instruments. Basically, that expected future volatility of the underlying instrument of an option is a very important part when traders’ valuing the option.

    Factors important to determine the volatility

    We can recognize seven factors that determine the price of an option and they are also called variables. While all of them are variable only one is an estimate and represents the most important part. The known factors are the current price of an underlying asset, strike price, also the known part is calls and puts, meaning what is the type of an option. Further, we always know what is the risk-free interest rate, and the dividends on the underlying assets. But what we don’t know is volatility. The volatility is the most important variable to determine the price of an option. So we need to know what indicates volatility. 

    First of all, it is one of the “Greeks” – Vega. 

    It is the measure of an option’s price sensitivity to shifts in the volatility of the underlying instrument. Vega outlines the value that an option’s price changes as a response to a 1% move in the expected volatility of the underlying asset. This “greek” will show the change of an option for every 1% of the change in volatility. 

    Main points related to volatility trading

    Traders should pay attention to two main points related to volatility.

    One is relative volatility. It refers to the current volatility of the stock in comparison to its volatility over a given period. For example, ABC stock options that expire in one-month historically showed expected volatility of 15%, but current volatility is 25%. Let’s compare it with XYZ stock options that had expected volatility of 25% but now grown to 30%. If we want to estimate absolute volatility it is obvious that XYZ stock has a greater. But the stock ABC gained a greater change in relative volatility. 

    The volatility of the overall market is important too. The most used is VIX ( the CBOE Volatility Index) that measures the volatility of the S&P 500. VIX is also known as the investors’  fear gauge. When the S&P 500 experiences a sharp decline, the VIX increases sharply. Every time when the S&P 500 is rising gradually, the VIX will be pacified. 

    Strategies for volatility trading

    Straddle strategy

    As we said, traders who trade volatility are not interested in the direction of the price changes. They make money on high volatility, no matter whether the price goes up or down. 

    One of the most popular strategies for volatility trading is the Straddle strategy with pending orders. This strategy provides a profit when the price goes considerably in one direction, no matter if it is up or down. The best time to use this strategy is when the traders expect an extreme increase in volatility.  

    We said it has to be used with pending orders. The pending orders are orders that were not yet executed, hence not yet becoming a trade. They’ll become market orders when certain pre-specified conditions are met.
    If you want to use this strategy, you’ll need to identify a market in consolidation before some significant market release. Further, set a buy stop pending order above the upper consolidation resistance. A sell stop pending order you should set below the lower consolidation support.  

    In Forex trading

    For example, you are trading Forex and have a currency pair that entered a consolidation stage with low volatility. Just put buy stop orders a few pips above the upper resistance,  so a sell stop order should be a few pips below the lower support. No matter in which direction the price will change, it will trigger one of these orders and when the volatility continues, the trade will end up in a profit.

    The real trigger for pending orders is volatility. Volatility occurs a bit before important reports in the market and traders usually schedule this kind of trades before them.
    In a straddle strategy, the traders write or sell a call and put at the same strike price wanting to receive the premiums on both positions. The reason behind this strategy is that the traders await expected volatility to decrease significantly by option expiry. That allows them to hold most of the premiums received on short put and short call positions.

    Ratio Writing

    Ratio writing is simply writing more options than are bought. Use a 2:1 ratio, just two options, sold or written for every option bought. The aim is to profit on a large fall in expected volatility before the date of expiry.

    Iron Condors in volatility trading

    In this strategy, the traders combine a bear call spread with a bull put spread of the same expiration. They hope to profit on a reversal in volatility. The result would be the stock trading in a tight range during the life of the options.
    The iron condor strategy has a low payoff, but the potential loss also has a limitation.

    Go long

    During the high volatility, traders who are bearish on the stock can buy puts on it. Keep in mind the saying “the trend is your friend.”
    “Go long” strategy or buy puts is expensive. It requires, from traders who want to lower the costs of long put positions, to buy more put out-of-the-money or, the other way is to add a short put position at a cheaper price to meet the cost of the long put position. You can find this strategy under the name a bear put spread.

    Go Short

    The other name for this strategy is “write calls”. The traders who are bearish on the stock but think the level of expected volatility for options could decrease may write naked calls to pocket a premium.
    Writing or shorting a naked call is a very risky strategy, keep that in mind. There can be an unlimited risk if the underlying stock boosts in price before the expiry date of the naked call position. In such a case, you can end up with several hundred percent of the loss. To reduce this risk, just combine the short call position with a long call position at a higher price. This strategy you can find under the name “a bear call spread.”

    Use VIX to predict the volatility 

    Yes, you can recognize market turns by using VIX. To be more specific,  you’ll recognize the bottoms. Well, the stock market regularly rises gradually and the VIX will decrease in the same manner. So very low levels can occur. The investors don’t feel they need any protection. If these periods last longer, the VIX as a sell signal can be useless. 

    But, the nature of the S&P 500 is long-biased. If index declines investors start to buy protection (simple put options) fast. That pushes up the VIX. Can you see how great the “fear barometer” VIX is? When you notice a high VIX you can be sure the investors and traders are overreacting because the market drops. The VIX during times of market drops will behave as the spike. That is a good signal to discover when selling is overdone and the market is moving higher due to bounce or even bottom for a longer-term.

    This strategy is suitable when the VIX ‘sign’ appears during a bullish trend in the S&P 500.

    Bottom line

    Volatility trading is an excellent way to get profitable trades even if you are wrong about the direction of the price. Volatility is the main interest of volatility traders. They are seeking big changes in any direction. Use the VIX index as a measurement for volatility in the stock market. A rising VIX index indicates fears in the market. But it is a good time to buy stocks. The most popular trading strategy to trade volatility is the Straddle strategy.
    Also, traders use the Short Straddle strategy when they expect a lack of volatility, for example, the prices continuing with steady change.
    No matter which of these strategies you want to use, just keep in mind that you can profit no matter what is the direction of the price movement.

  • Gross Margin How To Calculate And Why It Is Important For Investors

    Gross Margin How To Calculate And Why It Is Important For Investors

    Gross Margin How To Calculate
    The gross margin helps investors to examine a company’s potential for profitability. But investors shouldn’t rely on it as the only metric.

    Gross margin represents the companies’ net sales revenue minus the cost of goods sold or shorter COGS. Why is this so important? Gross margin is the sales revenue companies keep. To put it simply, that is the money the companies left over when they pay all cost, fixed and variable related to their production but subtracted from their net sales. Fixed and variable costs are purchasing the materials needed for production, plant overhead, labor. So, the higher gross margin means that a company retains more capital. That money company usually uses for debt payments or some other costs. 

    To calculate it we need to know two figures: net sales and cost of goods sold. Net sales is calculated if subtract returns, discounts, and allowances from the gross revenue. 

    So the formula to calculate the gross margin is expressed as

    gross margin = net sales − COGS

    This is is an important metric. It enables companies to fund investments during periods of growth and be profitable when the growth declines. Many factors add to a company’s capability to keep a high gross margin. That can be products that deliver high ROI, pricing discipline, etc. It reveals how much a company is able to invest in further development, sales, or marketing and consequently, can it be the winner in the market.

    The importance of gross margin in investing

    Every single investor would like to discover the next big player in the market and invest in the company in its early days and ride those stocks to enormous gains. For example, some of them did it in the early days of Apple, Microsoft or similar. 

    Though, finding these stocks is the tricky part. Early-stage growth companies don’t have obvious and constant earnings. Some investors who invested in such companies usually end up in loss. Since there is no earnings yet, what do you have to look at? Simple, look at the gross margin and cash flow. For early-stage companies, but not for them only, these two metrics are most important. Well, you have to understand one important thing. Some companies will heavily spend to develop some products or expand their business during some period. So, it might be some losses over those periods that can last even a few years. But every investor is expecting that, right? Hence, the most important for you as an investor is to determine if the company is able to be profitable after all.

    For example, you are examining a fresh company in the market. It has fantastic revenue growth. Always ask yourself how capable is the management in turning sales into profits? Here is this important metric on the scene to help us. It is the best tool we have to examine a company’s potential for profitability. Use the formula above and calculate it before deciding to buy any stock. Never overlook the importance of gross margin.

    A real-life example

    Let’s assume a company you are estimating has $10 million in sales. The costs of purchasing materials and labor amount to $6 million. What will be its gross margin? Let’s use the formula.

    $10.000.000 – $6.000.000 = $4.000.000

    That is a 40% gross margin rate. This figure is important but you’ll need to estimate if a company is on the way to profitability. So, watch for increasing gross profit margins. The increasing gross profit margin will show if there is an uptrend.
    Also, increasing gross margin is connected to research and development. For example, biotech and technology companies need money to invest in these sectors. Companies with increasing gross margins always invest more cash in future operations.

    What does the gross margin tell investors?

    The gross margin is the part of the revenue that the company retains as gross profit. For instance, when a company’s quarterly gross margin is 40%, that means it retains $0.40 from each dollar of revenue produced. You can use any currency, of course. Since COGS has been already subtracted, the rest of the fund can be used for interest fees, debts, dividends payment, etc. Gross margin is very important for companies, not for investors only. By using this tool they can compare the expense of production with revenues. For instance, a company has a problem with falling gross margin. What can management do?

    They may try to cut labor costs or to find a cheaper supplier. The other solution is to increase the price of the products to increase revenue. But this isn’t always the best solution since the sales may drop due to increasing prices. Gross profit margins can be useful for investors to estimate company efficiency. Also, this measure can help investors to compare the companies with different market caps.

    How gross margin influence the profitability

    To explain the influence gross margin has on profitability, let’s examine an easy example. For example, two companies are the same, but their gross margins are different. They have the same revenue, distribution, operating costs, almost everything is the same. But, company ABC is generating double the operating profit of company XYZ. If we want to value these companies, we can conclude that company ABC should be valued more than twice the value of company XYZ.  

    But what if company XYZ has a temporary hard time making gross margin below, for example, 10%? What is this company is investing in research and development, and thus has an expense for that of about 30%? Does this make it less efficient and favorable? Maybe this company is doing something on the go-to-market side to get more customers? So, this part has to be examined also. What we want to say is that one metric isn’t good enough, you have to use several to get the full picture of the company’s performances. Even companies with low gross margins can be profitable in a long haul.

    Is it important in stock picking and investment?

    Some investors misunderstand the gross margin also called gross profit margin with profitability ratio operating margin. 

    Remember, different companies have different gross margins and that depends on the essence of business. That is the reason why you should never try to compare the gross margins of companies from different industries. Do it in the same industry. Of course, you can make comparisons for companies with different market caps.

    When you are estimating the gross margin willing to pick a stock to buy, remember that the majority of the companies are following the market cycles. When the market is booming the demand is very high, while in the dropping market the demand is low. During the bull market, period companies with a high gross margin will be a favorable investment. Hence, when the bear market starts such a company will suffer more. Well, how is that possible? The company with a high gross margin tends to grow faster, its profit and EPS grow faster, and higher EPS means higher returns for shareholders. But when the bear market occurs the profit of such a company will usually fall faster.

    Of course, the management has the possibility to reduce the costs and limit the operating margin decline.

    Bottom line

    Investors can use this metric while deciding to invest in some company but shouldn’t be relied on it as solely one. They have to use it along with other metrics to pick a stock they want to add to the portfolio. Companies with high gross margin can deliver strong returns but the other parameters should be included also. Keep in mind that some early-stage companies can be a good choice too, also if the other metrics show that.

  • The Average Daily Trading Volume How to Calculate

    (Updated October 2021)

    A stock’s daily trading volume shows the number of shares that are traded per day. Traders have to calculate if the volume is high or low.

    The average daily trading volume represents an average number of stocks or other assets and securities traded in one single day. Also, it is an average number of stocks traded over a particular time frame. 

    To calculate this you will need to know the number of shares traded over a particular time, for example, 20 days. The calculation is quite simple, just divide the number of shares by the number of trading in a specified period. Daily volume is the total number of shares traded in one day. 

    Trading activity is connected to a stock’s liquidity. When we say the average daily trading volume of a stock is high, that means the stock is easy to trade and has very high liquidity. Hence, the average daily trading volume has a great impact on the stock price. For example, if trading volume is low, the stock is cheaper because there are not too many traders or investors ready to buy it. Some traders and investors favor higher average daily trading volume because the higher volume provides them to easily enter the position. When the stock has a low average trading volume it is more difficult to enter or exit the position at the price you want.

    How to calculate the average daily trading volume

    As you expected, it is quite simple. All you have to do is to add up trading volumes during the past days for a particular period and divide that number by the number of days you observe. It is usual to calculate ADTV (Average Daily Trading Volume) for 20 or 30 days but you can calculate it for any period if you like. For example, sum the average daily trading volumes for the last 30 days and divide it by 30. The number you will get is a 30-day average daily trading volume.

    Since the average daily trading volume has a great impact on the stock price it is important to know how many transactions were on a particular share. The same share can be traded many times, back and forth and the volume is counted on each trade, each transaction. For example, let’s say that 100 shares of a hypothetical company were purchased, and sold after a while, and re-purchased, and re-sold. What is the volume? We had 4 transactions on 100 shares, right? So, the volume in this particular case would be expressed as 400 shares, not 800 or 100. This is just a hypothetical example even though the same 100 shares could be traded many more times.

    How to find the volume on a chart?

    Thanks to existing trading platforms it is easy since each will display it. Just look at the bottom of the price chart and you’ll notice a vertical bar. That bar indicates a positive or negative change in quantity over the charting time period. That is the trading volume.
    For example (if you don’t like too much noise in your charts), you will use 10-minutes charts. Hence, the vertical bar will display you the trading volume for every 10-minutes interval. 

    Also, you will notice that these bars are displayed in two colors, red and green. Red will show you net selling volume, and green bars will let you know the net buying volume.
    You can measure the volume with a moving average, also. It will show you when the volume is approximately thin or heavy.

    Average Daily Trading Volume

    What is an average daily trading volume for a great stock?

    Are you looking for the $2 stock with an average daily volume of 90,000 shares per day? It won’t be easy. Sorry!

    The stocks that traded thinly are very risky and changeable. To put this simple, we have a limited number of shares in the market. Any large buying might influence the stock price skyrocketing. The same happens when traders and investors start to sell, the stock price will fall. Both scenarios are not beneficial for investors. So, you must be extremely careful when trading stocks with daily trading volume below 400.000 shares. You can be sure it is a thinly traded stock even if it is cheap as much as $2. The stocks with low prices carry higher risks. For example, penny stocks.

    Here we came to the dollar volume. While the daily trading volume shows how many shares traded per day, the dollar volume shows the value of the shares traded. To calculate this you have to multiply the daily trading volume by the price per share.

    For example, if our hypothetical company has a total trading volume of 300.000 shares at $2, what would be the dollar volume? The dollar volume would be $600.000. This is a good metric to uncover if some stock has sufficient liquidity to support a position.

    To decrease the risks, it is better to trade stocks with a minimum dollar volume in the range from $20 million to $25 million. Look at the institutional traders, they prefer a stock with daily dollar volume in the millions.

    Understanding Average Daily Trading Volume

    Average daily trading volume can rise or drop enormously. These changes explain how traders value the stock. When the average daily trading is low you have to look at that stock as extremely volatile. But, the opposite is with higher volume. Such stock is better to trade because it has smaller spreads and it is less volatile. To repeat, the stock with higher trading volume is less volatile because traders have to make many and many trades to influence the price. Also, when the average trading volume is high, trades are executed easily.

    This is a helpful tool if you want to analyze the price movement of any liquid stock. Increasing volume can verify the breakout. Hence, a decrease in volume means the breakout is going to fail.

    The trading volume is a very important measure.

    It will rise along with the stock price’s rise. So, you can use it to confirm the stock price changes, no matter if it goes up or down. When we notice that some stock is rising in volume but there are not enough traders to support that rise and push it more, the price will pullback. 

    Pullback with low volume may support the price finally move in the trend direction. How does it work? Let’s say the stock price is in the uptrend. So, it is normal the volume to rise along with a strong rising price. But if traders are not interested in that stock, the volume is low and the stock will pullback. In case the price begins to rise again, the volume will follow that rise. For smart traders, it is a good time to enter the position because they have confirmation of the uptrend from the price and the volume both. But be careful and do smart trading. If the volume goes a lot over average, that can unveil the maximum of the price progress. That usually means there will be no further rise in price. All interested in that stock already made as many trades as they wanted and there is no one more willing to push the stock price to go up further. That often causes price reversal. 

    Bottom line

    The average daily trading volume shows the entire amount of stocks that change hands during one trading day. This can be applied to shares, options contracts, indexes or the whole stock market. Daily volume is related to the period of time. It is very important to understand that when counting volume per day or any other period each transaction has to be counted once, meaning each buy/sell execution. To clarify this, if we have a situation in which one trader is selling 500 shares and the other one is buying them, we cannot say the volume is 1.000, it is 500. Anyway, this is an important metric that will show you if some stock is easy or difficult to trade.

  • Share Turnover Ratio – What Is It and How to Calculate?

    Share Turnover Ratio – What Is It and How to Calculate?

    Share Turnover Ratio - What Is It and How to Calculate?
    The share turnover ratio isn’t the most important measure you have to take into consideration when picking a stock but it is important to know will you need a lot of time to sell off the stock.

    Share turnover ratio shows how difficult or easy, is to buy or sell shares of some stock on the market. Share turnover ratio compares the number of shares traded during some period with the total volume of shares that available for trade during the given period. Investors often avoid the shares of a company with low share turnover. 

    Share turnover is a measure of stock liquidity. When we want to measure it we have to divide the total number of shares traded during the given period by the average number of shares available for sale. For example, if the 1 million shares are traded during the year, and the average volume of shares for sale was 100.000 then we can say that turnover was 10 times. Shares can have higher or lower turnover. The higher share turnover shows that the company has more liquid shares.

    So, we can say that the share turnover compares the number of traded shares to the number of outstanding shares. When we see a high level of share turnover, this means investors can easier and smoother buy and sell the shares.

    They often believe that smaller companies have less share turnover because they are, as investors think, less liquid than big companies. But that might be a great mistake. It isn’t rare that smaller companies have a greater amount of share turnover compared to big companies. 

    How is this possible?

    Very often the reason is the price per share. Big company’s price per share can be several hundreds of dollars and only rich investors are buying them. Yes, large companies have huge floats, thousands of shares might trade daily. But what percentage do they have? The real percentage of their total outstanding shares is small. 

    On the other side, a small company’s share is significantly cheaper and such is traded more frequently. So, they may have a higher daily trading volume.

    Possibilities of share turnover ratio

    The share turnover ratio compares sellers versus buyers of stock. To calculate it we will need two numbers to know. One is the daily trading volume of stock and the other is the number of shares available for sale. This second number is actually a daily float of stock, the total number of outstanding shares. The result is expressed in percentages. And you will see, every time when we get as a result, the high share turnover ratio we can be sure that there is a high daily volume and low float. Also, a low daily volume and the high float will always give us, as a result, a low share turnover ratio. 

    But these figures are so relative. The real share turnover ratio depends on the company and the sector it belongs to. For example, you can see from time to time that some stocks have a high turnover ratio but it can be periodically. When the demand for some stock rises, the turnover ratio will grow at the same time. So, this ratio isn’t able to show how the company is healthy. 

    The limitations of share turnover ratio

    The share turnover ratio can show how easy investors can buy or sell their shares of some stock. Literally, this ratio isn’t able to tell us anything about the company’s performance. Let’s assume you are examining a large company’s stock. You know that the company has, let’s say, 4 billion shares outstanding. It is a really large company. Also, the known fact for you is the averaged trading volume. It is, for example, 40 million per month. So, this company’s share turnover ratio is 1%. What does this number tell us? The stock is illiquid. Would you avoid this stock? Remember, it is a big, well-known company, with great history, with a permanent rise, good management, great prospect. Of course, you wouldn’t. Contrary, everyone would like to buy that stock. That is a case with Apple, for example. Would you avoid investing in that company? The point is that the low share turnover ratio shouldn’t be the most important concern when picking a stock.

    Moreover, when a stock is dropping and only a few want to buy it, that stock will have low turnover. But the same is true if the stock is expensive. If single share costs, for example, $800 only a small number of investors can afford to buy it and the share turnover ratio will be very low.

    So, do you understand why this ratio isn’t reliable when you want to estimate how good stock is? That is the reason why you should use the other parameters too. 

    Is this measure important at all?

    In short, yes. 

    It is an important measure and investors should be aware of it. A low share turnover ratio indicates that you may need a lot of time to sell off such stock and, what is also important, the stock price may decrease while you are waiting to find someone and sell it. Hence, not many investors are willing to put their money as such a risk and buy the share of the company with a low share turnover ratio. But always keep in mind, a low share turnover ratio is normal for a small market-cap company. But we owe you an explanation of what is an average daily trading volume.

    Average daily trading volume

    Average daily trading volume or short ADTV is the average number of shares traded during one day in a particular stock. Daily volume simply means how many shares are traded per day. So, we can average daily volume. It is a crucial measure because high or low trading volume triggers different kinds of traders and investors. Some investors and traders favor high average daily trading volume. It is because with high volume is easier to get into and out of the position. As we already said, when the stock has low volume it is more likely to be harder to enter or exit at the proper price since there are less buyers and sellers. But when the traders and investors start to value the stock differently ADTV can increase or decrease. For example, if the average daily trading volume is higher, that means the stock is less volatile and more investors would like to buy it. But this doesn’t mean that stocks with high volume don’t change in price because they can change a lot.  

    The higher the trading volume is, the more buyers and sellers will easier and faster execute a trade.

    This is a useful tool for analyzing the price action of any liquid stock. For example, the increasing volume may confirm the breakout. If there is any lack of volume, the breakout may fail. But that is the subject for a longer article.

    Bottom line

    Several figures and ratios deliver information about stocks and represent great help to investors when deciding whether they should buy or sell. The stock volume and the share turnover ratio are one of them. They provide valuable information about any stock.

    Share turnover ratio is an important measure for investors but shouldn’t be used as a sole criterion. If investors or traders use this one solely it is more likely they will miss out on very important data, for example about the quality of the stock, and make a wrong investing decision.

    One suggestion before doing anything in real: use our preferred trading platform virtual trading system and check the two formula pattern.

  • How to Create a Trading Plan

    How to Create a Trading Plan

    How to Create a Trading Plan
    A trading plan is a set of rules and guidelines that define your trading performance, financial goals,  rules, risk management and criteria for entry and exit positions.

    Why is it so important to know how to create a trading plan? Because if you know how to create a trading plan, you’ll know on which market to trade, how to cut your losses, when to take profits and find other opportunities for investing. But first, we have to understand what a trading plan is.

    A trading plan is…

    It is a full decision-making tool that helps you determine what, when, and how to trade. Every trader has an individual trading plan suited only for her/his style, goals, risks tolerance, capital available, motivation for trading, the market you want to trade. 

    A trading plan is a methodical tool that helps traders to identify and trade securities. If you want to have a successful trading plan you have to take into consideration a number of variables such as time, risk and goals. A trading plan gives you control of how you will find and execute trades, the conditions you will buy and sell assets. Moreover, it determines how large a position you will take, how to manage it. Also, your trading plan will determine what assets you can trade, as well as when to trade or when not to.

    But there is also one important step more. Never invest before you make your trading plan because your capital might be at risk. A trading plan will guide your decision-making process.

    To know how to create a trading plan you must understand it is different from a trading strategy. Trading strategy means you know how and when to enter and exit the trade.

    The benefits of knowing how to create a trading plan

    Since the trading plan defines the reasons why you are making a trade, when and how you are making a trade, it is an outline of all your trades. If you follow your trading plan, you’ll be able to minimize errors and losses.

    Okay, creating a trading plan isn’t the most exciting thing you can do in your lives, and maybe that’s the reason why so many traders think about it as an irrelevant thing. How to think about the trading plan while some sexy things jump every second? News, charts, trend lines, hot stocks are more exciting, right? Wrong!

    Without a trading plan, you cannot use all these sexy tools, you have to couple them with your plan to produce reliable results.

    What do you think now, do you need to know how to create a trading plan?

    Frankly, the trading plan is not necessary to make a trade. You can trade without a plan. But, if you want to hit the road of successful traders, you will need it. We are pretty sure you don’t want a hold-and-pray strategy because it isn’t a strategy at all. It is a sure way to lose everything you have. Maybe it’s better to go to a casino where there will be more chances to win something. Remember, trading isn’t gambling. 

    And without a trading plan, you’re gambling. The truth is that you may have some winning trades from time to time, but your progress will be questionable. Your losses will be bigger than gains, think about this and do smart trading. Learn how to create a trading plan, so create it.

    How to create a trading plan?

    Follow the old saying: If you fail to plan, you plan to fail. Every trader should follow this expression as it is written in stone. While trading you have only two choices: to follow a trading plan and have a chance to win or trade without a plan and lose with almost 100% possibility.

    So, let’s create a trading plan and see what you have to take into consideration while doing that. Here are some hints.

    First, set your goals. 

    What do you want to get from the trade? Please, be realistic about your expectations toward profits. This will come with a bit more experience. Experienced traders, for example, expect the potential profit triples the risk.

    Can you see how much you have to be focused on risk? So, you must focus on risk. Your trading plan has to mirror your risk tolerance level. You have to determine how much risk you are willing to take. How much of your portfolio are you willing to risk on one trade? And you have to do that for every single trade. The regular risk range is from 1% to 5%, but usually, it is 2%. If your account is small you can take a bit more risk to get a bigger position. But if you lose a predetermined amount at any period in the day, you get out and stay out. Take a break, and then attack another day, when things are going your way.

    Do your research before you enter the trade. 

    Explore the big winners, take a look at the stock charts and find possible spurs to the value of a stock. Be careful while doing this. Your research has to be accurate as it can help you discover if the stock is going to perform in your direction. You can’t be sure 100%, but it will be easier for you to know that you did everything possible to avoid losses.

    Importance of entry and exit in a trading plan

    Every serious trader plans entries and exits. This means you must have a plan on when you enter the trade and where you exit. For that purpose, we are recommending our tool. 

    You must give equal importance to the exit of a trade if you want to make a profit.
    Set a stop-loss, to secure your pull out if things aren’t going in your direction. But you really have to get out at that point. Do you know your profit target? Get out when your profit target is met, don’t be greedy. 

    Take a pen and write down your plan

    Exactly. It is the best way to show how responsible you are toward your capital invested. It is your hard-earned money, you don’t want to fool around with that. Put your trading plan in a visible place, stick it to your computer, for example. Yes, we are recommending your trading plan has to stare at you all the time while you are trading.

    When you exit your trade, review it afterward. You will need to study how the trade went. If something was right or wrong you will be able to repeat or avoid it. So, take notes and keep them in your trading log.

    What do you have to determine else?

    Your stock trading plan should include additional factors to ensure it is completed.

    First is liquidity

    Liquidity can be a problem. When trade stocks this can be a serious element that needs to be considered because you can find a lot of stocks with very low liquidity. This doesn’t mean you should trade only large-cap stocks. You wouldn’t like to limit your opportunities.
    Just filter out the stocks without enough turnover to get in and out of the market quickly. For example, you can trade stocks that have an average daily turnover of 10 or 15 times the size of the position you want to take. Don’t avoid small stocks because they can provide you to trade wider.

    Second is volatility

    Your trading plan should take into account the volatility of the stocks. Some stocks are more volatile some less but, generally speaking, the stocks are volatile. This should befall your trading rules as part of a trading plan. So, adjust your trend filter for the volatility of the stocks. You may have a lot of benefits using that. Your trading plan should be adjusted for what you will do if stocks go bankrupt or are taken over at a premium. You have to position yourself if it happens and you have to do so in advance to protect your overall portfolio.

    Bottom line

    A trading plan should consist of all these factors mentioned above. The stock liquidity, volatility, risks, goals. Consider them when writing it. But even if you do this and more, there is no guarantee that your trades will make you money. As we said numerous times, the stock market is a zero-sum game. It is a system of winning and losing. You have to be prepared for that. One day can be extremely successful but the others could be a total disaster. There is no profit without risk and you can’t always win without an occasional loss. Remember, if you lose a battle, you may win the war. Don’t expect every trade to be a success and every stock in your portfolio to be a winner. Let your profits rise and lower your losses. That’s the way to win this game. 

    We hope you have a better picture of how to create a trading plan now.

  • What Is Options Trading Examples

    What Is Options Trading Examples

    What Is Options Trading?
    In options trading, the underlying asset can be stocks, commodities, futures, index, currencies. The option of stock gives the right to buy or sell the stock at a definite price and specified date. 

    By Guy Avtalyon

    Before we explain deeper: what is options trading, we need to understand why we should trade options at all. If you think it something fancy, you couldn’t be more wrong. Actually, the origin of options trading came from ancient times. For example, Ancient Greeks were speculating on the price of olives before harvest and traded according to that. When someone asks you: what is options trading and argues that it belongs to modern stock brokerages just tell such one about trading olives. 

    From the first day of trade existence, people were trying to guess the price of food or some item they wanted to buy. 

    What is options trading?

    We have a simple example to answer the question: “ What is options trading.”

    Let’s say we want to buy a stock at $10.000. But the broker tells us that we can buy that stock at $20 and the time is limited so we have to make our decision in a short time frame but we don’t know “ what is options trading.” This broker’s offer means that we have to pay $20 now and get a right to buy the stock after one month. Well, our right, in this case, obligates the seller to sell us that stock at $10.000 even if the price increases in value after one month. This $200 will stay in the broker’s account forever. We will never get it back. But we got the right to buy the stock at the price we are willing to pay. 

    How does options trading work?

    We understand there is a chance that the stock price will increase much over $10.200, we want to pay our broker an extra $200 to provide us the right to buy the stock at $10.000. Moreover, we saved the rest of our $10.000 so we can keep it or invest in something else while waiting for the end of the period.

    Okay, the end is here, the one-month period is over so what is the next? Well, we have the right to buy that stock at $10.000 and we noticed the price is much over that amount. Of course, we will buy it at the agreed price. But what to do if the price is below the guessed price? Remember, we have the RIGHT to BUY not OBLIGATION. So, we can buy or not depending on the stock price. 

    This is a very simple explanation on the question: What is options trading, but this is the essence. 

    The options are derivatives. That means their prices are derived from something else, frequently from stocks. The price of an option is connected to the price of the underlying stock. Options trading is possible with the stocks, bonds market, and ETFs, and the like.

    What are the advantages of options trading?

    Some investors are avoiding options because they believe they are hard to understand. Yes, they can be if your broker has a lack of knowledge about them. Of course, you can have less than need knowledge about options trading. But the truth is, it isn’t hard to learn because this kind of trading provides a lot of advantages. Keep in mind that options are a powerful tool so use them with the necessary diligence to avoid major problems.

    Sometimes, we think that characteristics like “critical” or “unsafe” are unfairly connected to the options. But when you have all the information about options you’ll be able to make a proper decision.

    Cost less

    One of the most important advantages of options trading is it will cost you less. Let’s see how it is possible.

    Yes, we know that some people will claim that buying options are riskier than holding stocks. But we want to show you how to use options and reduce risk. Hopefully, you will understand that all depend on how you will use them.

    First of all, we don’t need as much financial assurance as equities require. Further, options are relatively immune to the possible effects of gap openings. But the most important, options are the most dependable form a hedge. Are they safer than stocks though? Yes! 

    Lower risk

    Let’s say this way. When we are trading stocks, we have to set a stop-loss order to protect our position. We are the one who has to determine the price at which we are not willing to lose more. And here is the problem. Stops are designed to be executed when stocks trade at or below the limit we set. So, what if we place a stop-loss order at, for example, $36 for the stock we bought at $40. We don’t want to lose more than 10% on that stock. Our stop-loss order will become a market order and our stock will be sold when the price reaches $36 or less. This is how this order will work during the trading day but what can happen over the night? 

    How to use options as a hedge?

    Here is where the problems arise. Let’s say we closed stock at $38. Almost immediately after the opening bell, the next morning, due to the bad morning news about the company, our stock fell under $15. So that will be the price we’ll get for our stock. We’ll be locked in a great loss. The stop-loss order did nothing for us. If we bought the options as protection instead, we wouldn’t have such a great loss since the options never shut down after the closing bell. We would have insurance 24/7. 

    Can you understand how the options are a more dependable form of hedging?

    And as an additional choice to buying the stock, we could employ the stock replacement strategy. This means we would buy an in-the-money call instead of buying the stock. We have a lot of possibilities with options trading since the options mimic almost 85% of a stock’s performance. The benefit is that they cost 25% of the price of the stock. For example, if we bought an option at $25 instead of a stock at $100, our loss will be limited on that amount, not on the stock price. 

    Do options have higher returns?

    We don’t need to be a great mathematician (well, some of us are, that’s true) to understand that if we pay less and take the same profit, we have higher returns. That is exactly what options trading provides us. 

    Let’s analyze this part and compare the returns in both cases.

    For example, we bought a stock for, let’s say $100. You bought an option of that stock at $25. This stock has a delta of 70, so the option’s price will change 70% of the stock’s price movement. (This is a made-up example, please keep that in mind.)
    So, the stock price goes up for $10, and our position on this stock will give us 10% of the return. You bought an option and your position will give you 70% of the stock change (delta is 70, remember?) which is $7. 

    Do you understand?

    We paid the same stock $100, you paid $25.
    Our return on that stock is 10% which is $10; your gain on investment of $25 is $7 which is a 28% return on investment. Who made a better job?

    Of course, when the trade goes against you, options can impose heavy losses. There is a chance to lose your entire investment.

    Benefits of options trading

    Options trading can be a great addition to your existing investing strategy. They will give you leverage in your investing. You will have cheaper exposure to the stocks, increasing profits and losses when the stock price changes. One of the benefits is that options can reduce the risk in the overall portfolio. For example, a protective put trade. That is when you combine purchasing a put option to sell stock at a specified price. That will provide you the upside when the stock price rises but also, that will protect you from losses when the stock price drops. Also, you can earn by selling the options. You will receive the money even if the stock isn’t exercised. That is compensation for giving someone else the right to buy your stock but that one never did it. You’ll keep the money anyway.

    Bottom line

    Options offer more investment options. They are highly adjustable vehicles. You can use options for positions synthetics. But it is for advanced traders.
    But there are some extreme risks to options. Firstly, options can expire worthlessly. That will be a complete loss of whatever you paid for the options. Further, options are highly volatile. Many brokerages will offer options trading, but with some added requirements before they will let you trade options. 

    Also, speaking about options strategies, they will work well when you make many trades simultaneously. You have to know that options markets aren’t constantly liquid as the stock market. The simultaneous trades don’t always go ideally. So, your strategy may not work the way you expected. Many online brokerages will give you access to options trading with low commission costs. So, we all can use this powerful tool. But, take some time to learn how to use options accurately. It is still new for individual investors. 

    We’re doing smart trading.

  • Calculate Portfolio Performance

    Calculate Portfolio Performance

    Calculate Portfolio Performance
    Don’t base the success of your investment portfolio on returns alone. Use these three sets of measurement tools to calculate portfolio performance.

    The main goal to calculate portfolio performance is to measure the value created by the investor’s risk management. The majority of investors will judge the success of their portfolios based on returns. But it isn’t enough. To have a sense of how our investment portfolio is well-diversified and how much risk we take we need to calculate portfolio performance. In other words, we need a measure of both risk and return in the portfolio to judge its success. Until the 1960s no one paid attention to the risks involved in obtaining returns. But today we have several ways to calculate portfolio performance and measure it. 

    Our aim is to present you with these valuable tools. 

    Sharpe, Jensen and Treynor ratios pair risk and return performances, and unite them into unique value. Well, each of them operates a bit differently so we can choose one to calculate portfolio performance or mix all three ratios.

    Calculate Portfolio Performance Using Sharpe Ratio

    Sharpe ratio is the measure of risk-adjusted return of an investment portfolio. Or in other words, by calculating it we can find a measure of excess return over the risk-free rate relative to its standard deviation. It is common to use the 90-day Treasury bill rate as the representative for the risk-free rate. This ratio is named after William F Sharpe. He is a Nobel laureate and professor of finance, emeritus at Stanford University.

    The formula is:

    ​Sharpe ratio= (PR−RFR) / SD

    ​In this formula, PR represents the expected portfolio return, RFR is the risk-free rate, while SD represents a portfolio’s standard deviation which is a measure for risk. Standard deviation reveals the variation of returns from the average return. So we can say that if the standard deviation is great, the risk involved is also great. 

    So, you can see how the Sharpe ratio is simple to calculate since it has only 3 variables. 

    But let’s calculate portfolio performance more realistic. For example, our portfolio has a 20% rate return. The whole market scored 15%. So, we may think that our portfolio is greater than the market, right? But it isn’t a proper opinion. How is that? Well, we didn’t calculate the risk we had to take to earn such a great rate return. What if we took much more risk than we thought. That would mean that our portfolio isn’t optimal. Let’s go further in this analysis. Imagine that our portfolio has a standard deviation of 15% and the overall market has 8%, and the risk-free rate is 3%. This is just a random example. Let’s calculate portfolio performance now using the Sharp ratio formula.

    Sharp ratio for our portfolio: (20 – 3) / 15 = 1.13

    and

    Sharp ratio for the market: (15 – 3) / 8 = 1.5

    Can you see now?

    While our portfolio scored more than the overall market, our Sharpe Ratio was notably less. So, our portfolio with a lower Sharpe Ratio was a less optimal portfolio even though the return was higher. This means we took an excess risk without extra bonus. But it isn’t the same case when it comes to the overall market, it is actually the opposite. When the market has a higher Sharpe ratio, it has a higher risk-adjusted return. The best portfolio is not the portfolio with the highest return. Rather, an excellent portfolio has a higher risk-adjusted return.

    Sharpe ratio is more suitable for well-diversified portfolios because it more correctly considers the risks of the portfolio. 

    Jensen ratio

    The Jensen ratio gauges how much of the portfolio’s rate of return is attributable to our capability to produce returns above average, and adjusted for market risk. 

    The Jensen ratio measures the excess return that a portfolio produces over the expected return. This figure of return is also recognized as alpha. Let’s say that our portfolio has positive excess returns, so it has a positive alpha. On the other hand, a portfolio with a negative excess return has a negative alpha.

    The formula is:

    Jenson’s alpha = PR−CAPM

    Here, PR stands for portfolio return and CAPM is risk-free rate+β( beta). We know that beta is the return of the market risk-free rate of return.

    ​By using Jensen’s alpha formula we can calculate an investment’s risk-adjusted value. It is also known as Jensen’s Performance Index or ex-post alpha. Jensen’s alpha tries to determine the unusual return of a portfolio no matter what assets it consists of. This formula was first introduced by the economist Michael Jensen. Investors use this formula to calculate portfolio performance by enabling them to discover if an asset’s average return is adequate to its risks.

    Regularly, the higher the risk, the greater the expected return. So, that’s why evaluating risk-adjusted performance is especially important for making investment decisions. It will allow doing this. 

    This Jensen’s alpha also can be expressed as 

    Jensen’s alpha = Portfolio return – ((Risk-Free Rate + Portfolio Beta x (Market Return – Risk-Free Rate))

    The alpha figure can be positive or negative. When it is higher positive values that suggest better performance in comparison to expectations while negative rates showed that the assets perform below expectations. Jensen’s alpha is expressed in percentages. 

    Let’s take the example of a stock with a return per day based on CAPM. And we see that it is 0.20% but the real stock return is 0.25%. So, Jensen’s alpha is 0.05%. Is it a good indicator? Yes, you can be sure.

    The purpose of this measure is to help investors to go for assets that grant maximum returns but with minimum risks.

    For example, you found two stocks that are offering similar returns. But one with less risk would be more profitable for investors than the one with greater risk. When calculating Jensen’s alpha you would like to see a positive alpha since that indicates an abnormal return.

    Treynor ratio

    The Treynor ratio is very useful to calculate portfolio performance. It is a measure that uses portfolio beta,  a measure of systematic risk. That is different from the Sharpe Ratio that adjusts return with the standard deviation. 

    This ratio represents a quotient of return divided by risk. The Treynor Ratio is named after Jack Treynor, the economist, and developer of the Capital Asset Pricing Model.

    The formula is expressed as:

    Treynor ratio = (PR−RFR) / β

    The symbols are well-known, PR stands for portfolio return, RFR refers to the risk-free rate and β is portfolio beta.

    We can see that this ratio takes into account both the return of the portfolio and the portfolio’s systematic risk. From a mathematical viewpoint, this formula expresses the quantity of excess return from the risk-free rate per unit of systematic risk. And just like the Sharpe ratio, it is a return/risk ratio.

    Let’s assume we would like to compare two portfolios. One is the equity portfolio and the other is the fixed-income portfolio. How can we decide which is a better investment? Treynor Ratio will help us pick the better one.

    To put this simply, assume for the purpose of this article only, the equity portfolio has a total return of 9%, while the fixed-income portfolio has a return of 7%. Also, the proxy for the risk-free rate is 3%. Further, let’s suppose that the beta of the equity portfolio is 1.5, while the fixed-income portfolio has a beta of 1.25

    Let’s calculate for each portfolio!

    Treynor ratio for a equity portfolio = (9% – 3%) / 1.5 = 0.040 

    Treynor ratio for a fixed-income portfolio = (7% – 3%) / 1.25 = 0.032

    So, the Treynor ratio of the equity portfolio is higher which means a more favorable risk/return option. Since the Treynor ratio is based on past performance it is possible not to be repeated in the future. But you will not rely on just one ratio when making an investment decision. You have to use other metrics too.

    For the Treynor ratio, it is important to know that the negative value of beta will not give exact figures. Also, while comparing two portfolios this ratio will not show the importance of the difference of the values. For instance, if the Treynor ratio of one portfolio is 0.4 and for the other 0.2, the first isn’t surely double better.

    Bottom line

    To calculate portfolio performance we have to determine how our portfolio has performed relative to some benchmark. Performance calculation and evaluation methods fall into two categories, conventional and risk-adjusted. The most popular conventional methods combine benchmark and style comparison. The risk-adjusted methods are focused on returns. They count the differences in risk levels between our portfolio and the benchmark portfolio. The main methods are the Sharpe ratio, Treynor ratio, Jensen’s alpha. But there are many other methods too.

    But one is sure, portfolio performance calculations are a key part of the investment decision. Keep in mind, portfolio returns are just a part of the whole process. If we never evaluate the risk-adjusted returns, we will never have the whole picture. That could lead to wrong decisions and losses, literally.

  • Markets Are Down – Should We Invest Further

    Markets Are Down – Should We Invest Further

    Markets Are Down
    The spread of the coronavirus has disturbed investors. The fears of new outbreaks can push down global demand. The S&P 500 closed down 3% on Tuesday, the index is deeper in the red.

    Markets are down, an inverted yield curve is noticed, coronavirus is progressing and spreading all over the world. Everything tells us that we should be afraid. This inverted yield curve is proof of investors’ fears. They are starting to fear the worst and sell in panic. Almost all benchmark indexes are decreasing. While we have several things that can help- us to avoid infection by COVID-19, what can we do to protect our investments? 

    Stock markets suffered two big drops so far this week. Coronavirus outbreak made a great influence on the global stock markets. An economic downturn has increased quickly following China. It is the reality now in the US, Middle East, and Europe.

    The best sign of how this situation is difficult is visible among the investors who are looking for safe havens for their capital. But there are so many signs that worry us. The yields on U.S. government bonds are dropping to near-record lows and showing red flags. Further, returns are higher for short-term debt in comparison to the 10-years bonds meaning, yields continue inverted. Everything is opposite to the regular situation and some of the experts think that is the sign the recession is coming.

    But our intention is not to cry over this situation. We would like to discuss how to turn this market downturn to our benefit. Is it possible at all? We are receiving controversial information from our governments, experts have their interests also. That makes confusion among investors especially when it is so obvious that stock markets are down. As we said, let’s try to find the way out there. The mother of all questions is:

    Should we invest when the markets are down?

    In short, yes. Why shouldn’t we? We should invest in any case no matter if the stock markets are down, sideways, or they are up. The essence of investing is to reach settled financial goals. To do that we have to keep our eyes on our investments, to the stock prices, no matter what kind of market condition is. That’s a general duty while investing. Otherwise, everything will go apart.

    Let’s say you are going to shop and you notice that something you planned to buy is on discount. What will you do? Step away? Will you buy it or not? Of course, you will. When it comes to stocks, why would your decision be different? As far as we remember, investors’ mantra is “buy low, sell high”, right? Actually, when everyone is selling, the smart decision is to buy. That is according to Warren Buffett. But where is the catch? Don’t buy if you didn’t plan that or just because you saw someone is doing so. Buy only after you made a consistent plan of your investment. Buying cheap stocks just because they are on sale can be the wrong move.

    Buy, buy, buy

    We don’t want to diminish the influence of the coronavirus outbreak. It is a horrible situation, a possible dead-ending disease, very dangerous. But what we know is the financial markets have been almost immune to the influences of earlier epidemics. 

    Stock prices are affected by various outside factors and some of them have nothing to do with companies’ operations, that’s true. The prices will decline on the bad news such as the coronavirus outbreak or a downturn in the overall economy. But that has nothing to do with the company, to repeat. The circumstances like this one actually represent a great opportunity. For example, you were looking at some company for a long time and its stock was too pricey for you. Due to the markets down it becomes cheaper. Maybe you have enough capital to buy it since it is such a good market player. 

    We have a great reason to change our position and buy more stocks

    Why not? It is a good time to buy more at fire-sale prices. But what if you don’t have suitable cash to deploy? Think! Maybe you can find one or a few investments in your portfolio to sell and buy a new one.

    Always keep in mind, your investment decisions should be based on your financial goals, not managed by market movements. That’s why you should buy stocks when markets are down only if you wanted particular stock and it is suitable for your goals. Don’t rush with that because buying stocks just because they are cheaper at this very moment is also an emotional reaction as much as selling when the markets are down.

    What are we doing instead?

    Well, we are doing smart trading. We must have a plan, investing schedule and stick with it. That means we already planned some cash reserve and we are ready for a situation like this new market downturn is. So, we are able to look at this like a buying opportunity that comes.

    Buying stocks while everybody is selling isn’t a strategy without risk. There is always a chance that the market doesn’t go to the bottom. But if we buy when the markets are down, we have a chance to have larger gains when the market rebounds. More than the investors who didn’t buy.

    A few days of bad news are not a reason to sell in panic

    To be honest, drastic drops can be upsetting to look at. The markets trended upward for so long and suddenly we have this. But we have to consider this situation as a buying opportunity.
    The worst strategy when the markets are down is to sell your portfolio. Okay, maybe the worst of the worst is to take the short positions. The stock market knows how to punish investors who are too bearish.
    Rather, maintain a notable piece of your portfolio in stocks, even now when the stock markets are down. The point here is to be in position and take advantage when the markets turn forward. Of course, you would like to protect your portfolio against dangerous market forces as much as possible.

    So what and how to do it?

    Well, you have to reduce your stock exposure but you have to keep the main strengths. Keep the winners. You can sell the positions that are not performing well because they represent the weak part of your portfolio. So, during the market correction or situations like this one when the markets are down, those stocks or funds might get the most critical hit. Further, even when the markets are down you may have some positions that are extremely good but you assume that they will not play so well. Your actions should be – take a profit. Yes, why not? Just do it at market peaks to have profits.

    Further, consider the way you invest, maybe it’s time to change something. Maybe index-based ETFs are not the best choice, they work well during bull markets, but bear markets are less safe. 

    Don’t follow the prevailing sentiment and sell investments. Rather sell risky positions, for example, some with a high beta. Also, think about selling some with a history of volatility. Yes, we know there are some investors who sell their positions in the most steady companies to avoid losses. What we can say is that they are very nervous. Who else wants to sell everything and sit at the sideline? You know, the market will bounce back one day. But if you sell everything you hold now you will miss big gains when it happens. Sell risky investments only, as we said. Hold blue-chip companies!

    Bottom line

    The keyword for overcoming the market’s downturn is advance preparation. There is no better strategy. The nature of the stock market is to experience declines from time to time. Preparations mean having enough cash to provide ourselves more opportunities in investing. Think about this downturn as a normal cycle. As said, it is so normal for the stock market to go down after it reached its peak. Savvy investors made some other preparations while the market was at the peak. They already lowered their exposure on time.

    But it isn’t too late yet. At least once in life, every single investor has to deal with weak market conditions. So, we truly believe you are prepared for this one. Stay calm, lower your exposure to stocks, sell stocks that are not good players, buy more. But never try to stay at the market with knee-jerks reactions. Don’t sell in panic, that will ruin your investments, your capital, family and finally you. Stay stick with your investment goals and wait for the market to rebound. It is the only proper way to overcome the market’s downturns.

  • P/E Ratio An Quick Method to Value a Stock

    P/E Ratio An Quick Method to Value a Stock

    P/E Ratio An Quick Method to Value a Stock
    Investors use the P/E ratio to unveil the relative value of a company’s stock. Also, the P/E ratio can be used to compare a company’s historical data or to compare markets as a whole over time.

    By Guy Avtalyon

    The  P/E ratio or price to earnings ratio calculates the market value of a stock in relation to its earnings and do it by comparing the market price per share by the earnings per share. To put this simple, the P/E ratio indicates how much the market wants to pay for a particular stock based on its current earnings.

    Investors often use the P/E ratio to assess a stock’s fair market value by predicting future earnings per share.

    It is one of the most broadly used methods for determining a stock value. It can show if a company’s stock price is overvalued or undervalued. But the P/E ratio can reveal a stock’s value in comparison with other stocks from the same industry. This ratio is also called a “multiple” because it shows how much an investor is willing to pay for one dollar of earnings

    That is why the P/E ratio is also called a price multiple or earnings multiple. Investors use this ratio to determine how many times earnings they are willing to pay.

    Calculate the P/E ratio

    The formula is simple. Just divide the market value price per share by the company’s earnings per share.

    P/E ratio = share price/earnings per share

    Earnings per share or EPS is the volume of a company’s profit for each outstanding share of a company’s common stock. It is a kind of indicator of financial health. Earnings per share present the part of a company’s net income that would be gained per share if all the profits is paid out to its shareholders. If traders and investors want to discover the financial health of a company they use EPS.
    In P/E calculation, the amount of “earnings” or “E” is provided by EPS.

    P/E = EPS/Saher Price

    Where the symbols show:

    P/E = Price-to-earnings ratio
    Share Price = Market value per share
    EPS = Earnings per share

    ​ For example, at the end of the year, ABC company reported basic or diluted earnings per share of $3 and the stock is selling for $30 per share. Let’s find the P/E ratio:

    EPS = $4
    Share Price = $30 

    This ABC company P/E ratio was: 

    P/E = $30/$4 = $7.50

    So, the company was trading at ten times earnings. So what? This indicator isn’t helpful without comparison to something. As we said, this figure has to be compared to the historical P/E scale of this company stock, or to peers from the same industry.

    For example, this P/E ratio was lower than the S&P 500 (the S&P 500 average is about 15 times earnings) but we can compare this P/E ratio to peers. And we noticed that the company XYZ had the P/E ratio of 11 at the end of the same year. What can we conclude? Well, ABC’s stock is undervalued. It is lower than, for example, the S&P 500 and for the same period, had lower P/E than its peers.

    You can calculate this ratio for each quarter also but it is common to calculate it at the end of the year.

    Use the P/E ratio to calculate earnings yield

    This is particularly useful. The formula is actually inverted P/E ratio and looks like this:

    Stock’s Earnings Yield = (EPS / Share Price) x 100

    or in our ABC company case:

    earnings yield = (4/30) x 100 = 13.33

    Can you see, to calculate the stock’s earnings yield you have to divide EPS by share price and multiply by 100 to turn it into percentages.

    The earnings yield of a stock is the percentage of each dollar invested in company stocky. It is calculated by dividing earnings per share of the company to its share price. 

    And as you can see, our ABC company has a low P/E ratio but high earnings yield. That will always be like this, the stock with a lower P/E ratio has a higher earnings yield, and the stock with a higher P/E ratio has a lower earnings yield. 

    This lets you easily compare the return you are earning from the underlying company’s business to other investments. Also, this will provide you to avoid to get in bubbles, panics, and fears. It gives you an insight into the stock market and directs on the underlying economic facts.

    Of course, you don’t need to perform all these math even if it is totally simple. This is especially important for beginners in the market. 

    The majority of stock market sites will automatically figure the P/E ratio and you can see it immediately. With help of this number, you can understand the difference between a stock that is selling at a high price because it suddenly became an analysts’ darling and a stable company that is out of analysts’ kindness and investors are selling it for a part of what it truly deserves.

    The two types of EPS metrics 

    Forward P/E ratio

    The most common types of P/E ratios are the forward (also known as leading) P/E and the trailing P/E.
    The forward P/E uses expected earnings guidance instead of trailing figures. It is useful when you want to compare the current earnings to the future.
    While it is helpful it also can lead you to some confusion. The main problem is that companies often underestimate earnings. The reason behind this is they want to beat the estimated P/E when they announce the next quarterly earnings. Also, some companies will declare too strong and enthusiastic the estimation but later adapt it in the next earnings report. Of course, there are always analysts to provide estimates but can confuse too.

    Trailing P/E ratio

    The trailing P/E the most popular P/E metric. It takes into account past performances. To calculate the trailing P/E you have to divide the current share price by the EPS earnings for the last 12 months. Investors mostly like trailing P/E because it is more objective.
    But this ratio also has weaknesses since the past performances don’t guarantee future performances. It is always better to invest money based on future earnings chances. 

    The other problem is the EPS figure is constant. You know the stock price is changing. If some company event pushes the stock price higher or lower, the trailing P/E will not reflective of those changes in full. The trailing P/E will alter as the price of a company’s stock moves because earnings are published each quarter. On the other side, stocks trade every day.  That’s why investors favor forward P/E. When the forward P/E ratio is lower than the trailing P/E, you can be sure the analysts are expecting earnings to increase. And vice versa.

    What are the limitations of P/E?

    The P/E ratio has some limitations. When it is low you may think the stock is good but the stock isn’t good just because it is cheap. You have to know the growth rate, free cash flow yield, dividend yield, and many other metrics also, to make a qualified decision when buying a stock.

    Build a diversified portfolio that not only holds assets that were handsome but also reduces risk.

     

  • Adjusted Closing Price – Find a Stock Return By Using It

    Adjusted Closing Price – Find a Stock Return By Using It

    A basic mistake is considering the closing prices of stocks for analysis instead of Adjusted closing price. 

    If you’re a beginner in investing, you probably already noticed the expression like “closing price” or “adjusted closing price.” These two phrases refer to different ways of valuing stocks. While with the term “closing price” everything is clear when it comes to the term “adjusted closing price” things are more complex. 

    When we say closing price it refers to the stock price at the close of the trading day. But to understand the adjusted closing price you will need to take the closing price as a starting but you’ll have to take into account some other factors too to determine the value of the stock. Factors like stock split, dividends, stock offerings can change the closing price. So we can say that the adjusted closing price gives us more exact the value of the stock.

    What is Adjusted Closing Price

    Adjusted closing price changes a stock’s closing price to correctly reveal that stock’s value after accounting for every action of some company. So, it is recognized as the accurate price of the stock. It is necessary when you want to examine historical returns.

    Let’s say this way, the closing price is just the amount of cash paid in the last transaction before the closing bell. But the adjusted closing price will take into account anything that might have an influence on the stock price after the closing bell. When we say anything it is literally anything: demand, supply, company’s actions, dividends distribution, stock splits, etc. So, you will need adjustments to unveil the true value of the stock.

    It is particularly helpful when examining historical returns. Let’s do that on an example of dividend adjustment calculation.

    Adjusted Closing PriceThe adjusted closing price for dividends

    When a stock increases in value, the company may reward stockholders with a dividend. It can be in cash or as an added percentage of shares. Whatever, a dividend will decrease the stock’s value since the company will get rid of the part of its value when paying out the dividends. So, the adjusted closing price is important because it shows the stock’s value after dividends are posted.

    Subtract the amount of dividend from the previous day’s price. Divide this result by the same day’s price. Finally, multiply historical prices by this last figure.

    For example, the prior trading day was Tuesday and a stock closing price was $50. The day after, on Wednesday,  it starts trading at a last price minus dividend, for example, trading ex-dividend based on a $4, so the stock will be trading on Wednesday at $46. If we don’t adjust the last price the data, for example, the charts will show a $4 gap.

    What do we have to do?

    We have to calculate the adjustment factor,

    So, by following already described we have to subtract the $4 dividend from the closing stock price on Tuesday (in our case)

    $50 – $4 = $46

    Further, we have to divide 46.00 by 50.00 to determine the dividend adjustment in percentages. 

    46.00 / 50.00 = 0.92

    The result is 0.92.

    Let’s see how to adjust the historical price.

    The next step is to multiply all historical prices preceding the dividend by this factor of 0.80. This will alter the historical prices proportionately and they will stay logically adjusted with current prices.

    After stock splits

    Stocks split occurs when the price of individual shares is too high. So, the company may decide to split stocks into shares. When the company increases the number of shares, the logical consequence is the value of each share will decrease due to the fact that each share factors a smaller percentage.

    In our example, if the company splits each $50 share into two $25 shares, the adjusted closing price from the day prior to the split is $25. The adjustment reveals the stock split, not a 50% decline in the share price.

    New Offerings

    For example, the company decided to offer extra shares to boost capital. This means the company issues new shares of stock in a rights offering. The right offering means that the shareholders have the chance to buy the new shares at lessened prices.

    But what happens when new shares come to the market? The price of the shares, of the same company, that are already on the market will drop. How is that possible? Well, think! The number of shares is increased and each of them now cost less. It’s almost the same with a stock split.

    The adjusted closing price values the new offerings and the devaluation of each individual stock.

    Find a stock return 

    A stock’s adjusted closing price provides you all the info you need to watch closely to your stock. You can use some other methods to calculate returns, but adjusted closing prices will spare you time. As we see in the text above, adjusted closing prices are already adjusted. The dividends are posted, the stock’s splits are done, the rights offerings also. So we can make a more realistic return calculation. The adjusted closing prices can be an excellent tool that can help us improve our strategies. Moreover, we can do that in a short time since the adjusted closing price already took into account almost all factors that directly impact the overall return. For example, just compare the adjusted price for a particular stock over some given period and you will find its return.

    It’s easy to find historical price data, just download it. Further, mark the column of dates and a matching column for adjusted closing prices and set up in descending order. For example, you want to examine a period from March to October. On the top, you should have data for March and below data for April and so. 

    Let’s find the return

    Firstly, compare the closing price in one month to the closing price from the prior month. To unveil the percentage of return you have to divide the chosen month’s price by the previous month’s price. Subtract the number 1 from that result, then this new result you have to multiply by 100 to turn it from decimal to percentage form.
    It should look like this:
    In March stock price was $50, in April it was $55, so the return was 10%

    ((55/50)-1)x100 = 10

    Since you have to do this calculation for each month add the column for return if you are working in a spreadsheet.

    To calculate the average return for the given period, from March to October, just sum each return for all months you observe and divide the result by the number of months.

    Simple as that.

    Bottom line

    The adjusted closing price is a stock’s closing price on any chosen trading day but altered to cover dividends posted and the company’s actions like split shares and the rights offerings that happened at any time former to the next day’s open.

    So, you can see that for serious analysis, the closing price will never reveal the real value of the stock, the stock’s value after considering any company’s actions. So it is always suggested to use the adjusted closing price if you want reliable analysis.

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