October 2, 2012 Corporate Action

Closed:
 Pos    Symbol                   Price     Comm       Net
 34    DYN                        0.03     0.00        0.11


Opened:
 Pos    Symbol                   Price     Comm       Net
 -4    DYN 02OCT17 40.0 C         0.00     0.00        0.00

This is basically the net result for shareholders of Dynegy's agreement to emerge from bankruptcy.

An Options Quiz I

1.  Which day of the month is normally the last day on which standard equity option contracts can be traded?

a) The 20th.
b) The first Wednesday after the 15th of the month.
c) The third Friday of the month.
d) The Friday immediately before the third Saturday of the month.
e) The last Friday of the month.

2. Which event will generally cause the price of a call option to increase?

a) The passage of time.
b) An increase in the implied volatility of the contract.
c) A drop in the price of the underlying security.
d) An increase in the risk-free interest rate.
e) None of the above.

3. If the market for a security is efficient, which of the following should never occur?

a) Expected rate of return on the security is less than the risk-free interest rate.
b) Price of the security doubles in less than one month.
c) A portfolio with an identical cash flow can be created with a lower total price.
d) Highest bid for the security is greater than the lowest ask.
e) Both (c) and (d).

4. A European-style options differs from an American-style options in what way?

a) European-style options can only be exercised on their date of expiration, while American-style options can be exercised on any date prior to their date of expiration.
b) European-style options can be exercised on any date prior to their date of expiration, while American-style options can only be exercised on their date of expiration.
c) European-style options are traded in euros, while American-style options are traded in dollars.
d) European-style options are only traded in increments of five cents, while American-style options are traded in one cent increments.
e) European-style options are traded on commodities, currencies, and interest rates, while American-style options are traded only on corporate equity.

5. Options differ from a futures in what way?

a) Futures can be held as investments, while options can only be used for trading.
b) Short positions cannot be held on options, but they can on futures.
c) "Futures" and "options" are just different names for the same thing.
d) Futures can only be traded on very large positions in the underlying security or commodity, while options can be traded on relatively small amounts.
e) Futures are always settled at expiration, but options are settled only at the owner's discretion.

6. If on the 1st of October, the exchange-traded option contracts available for a particular stock have expiration months of October and November; January, February, and May of the following year; and January of the second following year, then on the 1st of November the following expiration months will probably be available for exchange-traded options contracts on the stock:

a) October, November, and December; January, February, and May of the following year; and January of the second following year.
b) November; January, February, and May of the following year; and January of the second following year.
c) November and December; January, February, March, and May of the following year; and January of the second following year.
d) November and December; January, February, and May of the following year; and January of the second following year.
e) November and December; January, February, May, and August of the following year; and January of the second following year.

Answers:

1(c), 2(b), 3(e), 4(a), 5(e), 6(d)

September 28, 2012 Update

    Cash:                             $ 13,486.80
    Accrued Dividends:                     170.20
    Stocks:                            113,092.42
    Options:                           (10,889.64)

  Account Value:                      $115,859.78

  Equity:                             $126,758.40
  Margin Requirement:                   73,386.51
  Available Funds:                      53,371.89

  Regulation T Margin Requirement:     100,002.19
  Special Memorandum Acct:              43,539.31

On September 29, a $172.00 dividend was paid for 400 shares of ARCC; $2.00 was paid for 200 shares of CSE; and $10.00 was paid for 100 shares of FTR.

The account value of $115,859.78 compares with the value a month earlier of  $114,037.23, a return of 1.60%. This compares, however, with the change in the S&P 500 Index from 1,406.58 to 1,440.67. Adding an estimate of a quarter percent dividend payment (one twelfth of 3%), this gives a return of 2.67% for the S&P 500, so my portfolio underperformed the market in the month of September. This is not too surprising to me because the market did very well during the month, and my strategy is designed to start to bail out when the market does particularly well.

Understanding Utility Theory

Uncertainty and risk have long confounded human reasoning: the syllogisms of basic logic assume certainty in all assertions, and allow no conclusions to be drawn until all factual states are decided.

And, in practice, people often demonstrate themselves to be remarkably poor at making decisions based on uncertain conditions, foregoing much needed insurances while over-paying for absurdly unlikely coverage, for example.

Within this confusion, the intuitively appealing notion of a "risk premium" has arisen. In general, the notion of a risk premium is that reasonable people will not accept risk without an expectation of, on average, profit above and beyond what is available without risk.

Utility theory is a method of quantifying the notion of a risk premium.

The main premise of utility theory is that we should concern ourselves not with the cash value ("wealth") of anything, but rather with the utility (which I guess is just a of saying "usefulness" with a word derived from Latin ...) of the wealth. And then there are just two parameters that the utility function of wealth are held to have to satisfy: the utility of more wealth is always greater than the utility of less wealth; and the rate of increase of utility relative to wealth decreases as the absolute level of wealth increases.

Mathematically, these two properties are stated as follows:

1. dU/dW > 0; and
2. d²U/dW² < 0.

And this is really all that standard utility theory tells us.

There are, however, a couple more things to know about utility theory.

The first is that, in standard financial theory today, utility theory is the beginning and end of how risk is understood. This can perhaps be seen most clearly through a 1963 article by Paul A. Samuelson, "Risk and Uncertainty: A Fallacy of Large Numbers", and through a 1995 article that is largely a reprise of the same argument: "On the Risk of Stocks in the Long Run" by Zvi Bodie (sorry, no link).

"Risk and Uncertainty" relies upon utility theory to demonstrate that if you will not accept, due to risk concerns, a single wager with a positive expected return, you also should not accept any multiple repetitions of the same wager, even if the possibility of any loss under the multiple repetitions is almost zero. "On the Risk of Stocks" uses Black-Scholes options pricing theory -- which is based on utility theory -- to dismiss the proposition that, if your time horizon is long enough, the higher expected return on stocks will make them a more suitable investment than investments with more certain returns, even though you would want the more certain investments for a shorter time horizon.

The second thing to know about utility theory is that it seems to have almost no predictive value whatever in determining how economic agents, like investors, actually behave. In traditional science, having no predictive value is the hallmark of a hypothesis (not a theory ...) that must be rejected.

September 26, 2012 Trade

Opened:
 Pos    Symbol                   Price     Comm       Net
 -2    BHP 16MAY13 45.0 P         1.05     0.76     (209.24)

September 25, 2012 Trade

Opened:
 Pos    Symbol                   Price     Comm       Net
 -3    JCI 19APR13 20.0 P         0.50     0.03     (149.97)

September 24, 2012 Trades

Opened:
 Pos    Symbol                   Price     Comm       Net
 -4    BMY 19OCT12 34.0 C         0.26     1.52     (102.48)

 -2    RIG 19OCT12 50.0 C         0.76     1.52     (150.48)

 -4    C 15MAR13 25.0 P           0.85     1.52     (266.48)

 -4    ABX 19APR13 30.0 P         0.70     3.04     (276.96)

 -2    DDS 17MAY13 60.0 P         2.95     1.13     (588.87)