Specks and Pen: May 2014

Basic Book of Options Basic: Stock

Stock

A stock is simply a unit of ownership in a company.

How Stock is Priced?

The price of a company's stock is based on the net value of the company (assets minus liabilities) PLUS some amount over or under the net value. There are dozens of statistical formulas to assist in calculating what a stock is worth. For example, the “P/E ratio” is one of the more familiar terms you will hear when talking about stocks. This is simply the price of the stock (say $50) divided by its earnings per share (say $2.90) – or how much the company makes.

Three main schools of thought regarding stock evaluation:

A) Technical Analysis

Technical analysis is the study of charts and past price movement of stocks in the attempt to glean a forward looking guidance to future stock movement.

B) Fundamental Analysis

Fundamental analysis is the more scientific method of determining future stock prices via the use of ratios and statistics as illustrated in Figure 1.3 ratios.

C) Random Walk Theory

Random Walk (RW) theory is the mathematical formalization of successive movements in order to explain stocks, psychology, physics, biology, economics and chemistry. RW theory has also been called “the drunkard's walk” because the markets move in a random fashion and cannot be predicted. Since Princeton Economist Burton Milkiel wrote the text “A Random Walk Down Wall Street” in 1973, RW theory has been accepted as fact by many economists and large proprietary trading firms. Random Walk Trading believes that evaluating stocks and trying to predict the future is too slow and difficult of a method for making money in the markets (for all but a select elite group of individuals). It is our belief that winning in the stock market can be best accomplished through superior strategies. More extensive material can be found in any library or bookstore if interested in further reading.

How Money is Made on Stock?

A. Buying Stock - Money is made on stock as the price of the stock increases if you own the shares. The formula is very simple. All you have to do is multiply the number of shares by the amount of the move, and this will tell you how much you have made (or lost on the stock).

B. Short Selling Stock - Money can also be made on selling stocks that you do not own. This sounds almost illegal, but it is not. It is actually done all the time in business.

Often people with little or no knowledge of stocks and/or options have a strong suspicion that a certain stock may decline in price by a large amount. You hear, for example, that there may be an accounting irregularity at a firm called Enron. Despite the superior reputation for excellence, brilliance and ethics that Enron has, you know what devastation even false rumors can have on the price of a stock. Certainly there must be a way to profit from the inevitable decline in the price of the stock before these false rumors are cleared in the next few months and this wonderful stock bounces? Typically, people buy a stock and then sell it after it goes higher. Here we are going to do the same thing, just in the reverse order. We will sell a stock when it is high and close the transaction when buying it back at a lower price. This is called “short selling”.

As stated, the process works the exact same way that buying a stock to sell at a higher price works, just in reverse. Technically, though you need not concern yourself with the details, you have to “borrow the stock” from someone in order to sell it. Once borrowed, the stock is then sold and you can buy it back anytime you want. At the time you buy back the stock to close the transaction, you then deliver the shares back to the person you borrowed it from and the transaction is closed. The difference between where you sold it and bought it back is the profit (or loss).

Full text is available in the Random Walk Trading website

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Sunday, May 18, 2014

Summary of Basic Book for Beginners in Option Trading - Stock