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How are option prices computed?

Option prices are decided by the buyers and sellers in the marketplace, but are tied closely to the amount of risk inherent in the agreed upon expiration date and strike price. Option prices change as the market factors in the relevant information. The main factor is the strike price. The closer an option’s strike price is to the actual market price of a security, the higher it’s price will be. Once it’s in-the-money, it has inherent value that makes it essentially the same price as the market security that underlies it. The expiration date of the contract is also a factor because if the expiration date is closing in, and the strike price is not quite close enough to the market price of the underlying asset, there is little chance that the option will be useful. Continue reading...

What is the Black-Scholes formula?

The Black-Scholes formula is a formula and market model for explaining or determining the price of European-style options. It was developed in 1973 by two world-renowned economists, Fischer Black and Myron Scholes, and it led to a Nobel Prize in 1997. As opposed to the American-style of options, which can be exercised at any time, European-style options can only be exercised on their expiration date, they are not exposed to dividends, and they have no commission structure to consider. Some are content to use Black-Scholes for quick applications to American-style, but It is not as accurate as it should be. Continue reading...

What is the ‘Risk-Free Rate of Return’?

The risk-free rate of return is the rate an investor can get on a risk-free asset at a given time. It is usually the current yield on a 10-year treasury, which is backed by the full faith and credit of the US Government and is considered risk-free. The risk-free rate is used in several calculations and considerations in finance, to show what return can be earned in the current market environment without being exposed to any risk. Continue reading...

What is the “Riskless” (or Risk-Free) Rate of Return?

For comparisons of the risk/return ratio of an investment, one must start with a benchmark of a risk-free rate of return in the current market. Since U.S. Treasury bills are backed by the full faith, credit, and taxing power of the U.S. Government, they are considered “riskless,” or as close to riskless as we can get. The current yield on a 10-year Treasury note is generally considered the risk-free rate of return. Continue reading...

What is the Three Rising Valleys (Bullish) Pattern?

The Three Rising Valleys pattern forms when three minor Lows (1, 3, 5) arranged along an upward sloping trend line. It often appears at the end of a declining trend – an indication that buyers are overtaking sellers, which ultimately pushes the price higher. This type of formation happens when investors shift into buying mode following a consolidation period. Once the price breaks out from the top pattern boundary, day traders and swing traders should trade with an UP trend. Consider buying a security or a call option at the breakout price level. To identify an exit, compute the target price level by adding the pattern’s height (highest price minus the lowest price within the pattern) to the breakout level (the highest high). When trading, wait for the confirmation move, which is when the price rises above the breakout level. Continue reading...

What is the Three Falling Peaks (Bearish) Pattern?

The Three Falling Peaks pattern forms when three minor Highs (1, 3, 5) arrange along a downward­-sloping trend line. This pattern often emerges at the end of a rising trend, when a security slowly rolls over. It potentially indicates sellers moving ­in to replace buyers, which pushes the price lower. If the price breaks out from the bottom pattern boundary, day traders and swing traders should trade with the DOWN trend. Consider selling the security short or buying a put option at the downward breakout price level. To identify an exit, compute the target price by subtracting the pattern’s height (maximum price minus minimum price within the pattern) from the breakout level ­ the lowest low. When trading, wait for the confirmation move, which is when the price moves below the breakout level. Continue reading...

B-/B3 — credit rating

B- — S&P / Fitch B3 — Moody’s In the world of junk bonds, a B3/B- rating is about as low of a rating as most investors will venture to explore. Bonds are rated by independent ratings institutions known as the Big Three: Moody’s, Fitch, and S&P. Two companies, S&P and Fitch, use the same symbols, and the B- in this example belongs to them. Moody’s has its own system, and the B3 in this example is theirs. Continue reading...

What is a Monopoly?

A monopoly is an unhealthy situation in the market in which a single company is the only option in a specific sector or area, which undermines the principals of a free market. In a free market, there is competition which keeps the prices and the quality of products as good as they can be for the consumer. The consumer will therefore receive the most value, and society will be in its best possible position, when the needs and demands of consumers are being addressed by several companies attempting to outdo each other to earn the consumer’s business. Continue reading...

What is the Hang Seng Index?

The Hang Seng Index (HSI) is comprised of the 50 biggest stocks traded on the Hong Kong Stock Exchange. The Hong Kong stock market is much different than that of China, in that foreign investors are allowed access and the index is calculated on a free floating cap-weighted basis. It tracks the 50 biggest companies on the Hong Kong Stock Exchange, and is a better barometer for measuring overall performance of companies from the region. Continue reading...

What is Acquisition Accounting?

Also known as Business Combination Accounting, there are specific guidelines and bits of information that must be documented on the books during an acquisition. Acquisition Accounting is a standardized way to account for the assets and liabilities of companies who are part of a merger or acquisition. International Financial Reporting Standards (IFRS) stipulate that even in a merger where a new company is formed, one company must play the role of acquirer and the other of acquiree, but that rule really only applies outside of the US. Continue reading...

Which is Better for Me: a Roth or Traditional IRA?

The choice between a Roth IRA and a Traditional IRA depends on available discretionary income and financial situation. Both IRAs have the same contribution limits. The Traditional IRA goes in pre-tax (generally), grows tax-deferred, and is taxable as income on withdrawal. The Roth goes in after-tax, grows tax-deferred, and is not taxable upon withdrawal. That’s the primary difference. This will allow you to lower your current taxable income by making Traditional IRA contributions, which may seem more appealing in a number of ways. There’s the effect of immediate gratification that leads investors to favor this way, and the fact that you’re technically paying more (by the amount of taxes you paid on the after-tax Roth) to make the same current contribution to a Roth. Continue reading...

What is market exposure?

Market exposure is the degree to which an investor is participating in the risks and returns of the market as a whole or a particular sector. Exposure can have a positive or negative connotation, but, as they say, “nothing ventured, nothing gained.” Market exposure allows an investor to participate in the potential upside of the market, but can also subject the investor to the inherent risks. Some people save money religiously but are not likely to retire the way they want to because they aren’t willing to let their money be risked in the market. Continue reading...

What is the security market line?

The Security Market Line (SML) is a visualization of the Capital Asset Pricing Model (CAPM) and shows the theoretical relationship between risk and return between securities and the entire market. The SML is plotted on a graph bound by an x-axis, which represents Beta (volatility above or below the market average), and a y-axis, which represents the rate of return. Beta is a volatility indicator that measures how many changes in price, and by how much, a security experiences over an amount of time. It describes whether the risk associated with a particular security is above or below the average of the market (or a more specific index), where 1 is a correlation with the market, and numbers above or below describe increased or decreased volatility, respectively. Continue reading...

What is Bond Insurance?

Bond insurance is a contract that protects the issuer and the holder of bonds from the risk that bond payments will not be made. Bond issues from the corporate or municipal world, or from derivative sources as with asset-backed securities and CDOs, come with the risk of default-- that is, that payments will not be made on time. The major credit ratings agencies (CRAs) assign a risk of default to each bond issue with proprietary analysis methods and ratings. Continue reading...

What is Mutual Fund Classification According to Market Capitalization?

One way of classifying mutual funds is by the market capitalizations of the companies they invest in. Mutual funds can invest in stocks and bonds of foreign corporations, or corporations in the biotechnology industry, or with any other objective they may have. But one way to manage it is by size—to capture market exposure for companies of different sizes. The size of a company is defined by the amount of market capitalization it has, which is the number of shares outstanding multiplied by the share price. Some indexes and funds will adjust market cap rankings to give weight to “free float,” which is the amount of market capitalization that is freely trading, and is not held by other companies, governments, or founding families. Continue reading...

What is a Merkle Tree?

A Merkle Tree is a technique widely used to create the blocks in blockchains. When records of numerous transactions are blended together into a block and sent to a blockchain to be deciphered and validated, Merkle Trees are generally the design with which they are put together. Ralph Merkle first designed this hashing method in 1979 but didn’t see it popularized for some time. They are sometimes called hash trees. In case you are unaware, the difference between hashes and encryptions is that hashes are not intended to be decryptable unless someone has the original content. Hashes are basically symbols of a certain length generated using the “seed” of the actual content that was fed into the hash function. If the same content is entered as the seed, it will produce the same hash, but any differences will yield a completely different result. Continue reading...

What is Discounted Cash Flow?

Discounted Cash Flow (DCF) uses an estimated future cash flow amount and a Discount Rate to determine the Present Value (PV). An investor or business executive might project an estimated future cash flow for a business based on recent growth rates, industry information, futurism, estimated inflation, etc. The most common future cash flow to use is free cash flow, which takes out capital expenditures. Continue reading...

What is Required Rate of Return?

Required Rate of Return is the return that investors will expect to earn on their money, given the risk and costs involved. Required Rate of Return is determined by the market for a particular security or asset at a given time. Issuers of fixed or variable coupon bonds must look at the rates offered by their peer institutions with similar credit ratings. Investors will require a certain rate of return if they are going to invest their money, and this is where the RRR gets its name. The calculations which help an issuer to arrive at the RRR will include the current risk-free rate (10 year treasury bond rate), liquidity, inflation, and so on. Continue reading...

What is Cash Flow After Taxes?

Cash flow after taxes (CFAT) is nearly the same thing as EBITDA, but with taxes left in. One way to arrive at Cash Flow After Taxes is to take the net income of the business and add in interest, amortization, depreciation and other non-cash expenses. This is one item away from the formula for EBITDA, which also adds tax back in to arrive at the Earnings Before Interest, Taxes, Depreciation and Amortization. Continue reading...

What is Bond Yield?

Bond yield is a measure of the return on investment for bonds, and there several kinds of yield that can be computed. Yield on a bond is the amount of interest that it pays annually, as a percentage of the amount invested — at least, this is the most common type of yield discussed, which is known as Current Yield. If a bond pays quarterly or monthly income to the investor, these payments are totaled up and divided by the amount invested. Continue reading...