Options – A Primer

1. What is a Stock Option?

A stock option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying stock at aspecific price on or before a given date.

A stock option is linked to a stock and can be bought or sold through a brokerage.

2. What can I do with a stock option?

• Buy or Sell a stock option.
• Exercise a stock option. If you exercise a CALL option, you will buy and own the underlying stock at the pre-defined price and if you exercise a PUT option, you will sell the underlying stock at the pre-defined price.

2. What is a CALL Option?

A CALL OPTION gives the right to BUY the underlying stock at a specific price within a certain date. A Call Option can be Bought or Sold in an exchange through a brokerage.

3. What is a PUT Option?

A PUT OPTION gives the right to SELL the underlying stock at a specific price within a certain date. A Put Option can be Bought or Sold in an exchange through a brokerage.

4. What is expiration date?

Expiration date is the date on which an option expires. Nothing can be done with an option after it’s expiry date.

5. What is the strike price of a stock option?

Strike price is the pre-determined price at which you can BUY (in the case of a Call Option) or SELL (in the case of a PUT option) the underlying stock.

6. What is a premium?

Premium is the price paid to buy the Call or Put Option.

5 Common Investment Pitfalls

1. Herd mentality

Buying what everyone else is buying may seem like the safe thing to do. However, in the case of stock investments, an investment opportunity will exist for a short interval and will close as soon as investors start investing in the opportunity. Therefore, when everyone starts investing in something, it no longer is a good investment opportunity. 

2. Lack of diversification

All investments possess a certain amount of risk. Diversification is an effective way to reduce risk. A farmer who has other business interests like rental properties or retail stores will suffer less during periods of drought than a farmer who does only farming. Similarly, if you work for a company and invest only in the stocks of that company, you will lose your investment and your job if the company goes down.

The simplest way to diversify your stock portfolio is to invest in mutual funds or index funds.

3. Speculation – Investing without a plan

It is very tempting for a beginner to start buying and selling stocks without a plan. Some transactions may result in profits, leading to more speculative investments. This kind of investing will very soon yield bad results, often forcing the investor to exit the market completely.

4. Greed – Failure to exit

Once an investment has achieved it’s goal, you have to exit and realize the profit. Holding too long with the expectation of further gains will often result in losing profits made.

5. Ignoring transaction and other hidden costs

When planning an investment and setting goals, all transactions and other hidden costs and taxes need to be taken into account. You may have made a profit on a trade, but the net profit should be calculated after subtracting all the costs involved in the trade. The associated costs of a transaction could bring down the profits significantly.

Brokerages – A Primer.

1. What is a brokerage?

A brokerage or stock broker is a company registered with the SEBI. Stocks can be bought or sold only through a brokerage or stock broker. Both the buyer and the seller of a stock will need to have an account with a brokerage or a stock broker in order to buy or sell stocks.

2. What can I buy or sell through a brokerage?

The following products can be bought and sold through a brokerage.

• Stocks
• Options
• Mutual Funds
• Commodities
• IPOs

 3. Do brokerages charge a fee for their services?

Yes, a brokerage will charge a commission for each trade (buy or sell). The commission charged is usually a percentage of the value of the stocks bought or sold.

4. What is a Demat account?

A demat or dematerialized account is similar to a savings account in a bank. A savings account stores your money, similarly, a demat account stores the stocks that you own. In the past, if you owned 100 shares in a company, you will have a share certificate that would state that you owned 100 shares in the company. The share certificate has been replaced by a demat account. So, if you owned 100 shares of a company, the demat account will show that you own the 100 shares. 

5. What is the difference between a brokerage and a demat account?

A brokerage executes a trade for a commission. In other words, a brokerage helps buy or sell a stock and charges a commission for the services. Once the shares have been bought, they are stored in a demat account. Any shares sold through a brokerage account will be settled from the demat account. Each brokerage will need to be linked to a demat account. 

6. Which account do I need to buy and sell stocks?

You will need both a brokerage account and a demat account to buy and sell stocks.

7. How can I pay for the stocks?

You can link your savings account to your online brokerage and pay for the stocks you buy from your savings account.

8. How can I open a brokerage account?

You can open a brokerage account online. During the account opening process, the required documentation needs to be submitted. Once the account has been opened, you can buy and sell stocks online.

9. What are the documents needed to open a brokerage account?

The details of required documentation can be found on the website of the brokerage. In general, you will be asked to provide address proof, PAN card details and photographs.

10. Can I have a joint account holder for my brokerage account?

Joint holding is normally not permitted for a brokerage account.

ETFs – A Primer

1. What is an ETF?

An ETF or exchange traded fund is a fund that trades like a stock in an exchange. An ETF can be bought and sold in an exchange, similar to the stock of a company. However, it is a fund like an index fund or a mutual fund.

 

2. What are the advantages of investing in an ETF?

Diversification: Similar an ETF is a fund that is composed of multiple stocks, it provides diversification and lowers the risk of the investment.

Easy to Buy/Sell: Since ETFs are traded in an exchange, they can be bought and sold intraday.

Low fees: The management fees for ETFs is low when compared to other mutual funds.

Tax Benefits: ETF investments offer more tax benefits than traditional mutual funds.

Margin trading: ETFs can be bought on margin.

 3. Is margin trading possible with an ETF?

Yes, margin trading is possible with an ETF.

 4. Do ETFs pay dividends?

Yes. ETFs will pay any dividends that are accumulated for the undelying shares in the fund. The dividend is paid out on a pro-rata basis, based on the number of shares of ETFs held.

 5. How can I invest in an ETF?

ETFs can be bought in the market through a broker or an online brokerage.

 

Index Funds – A Primer

1. What is an index fund?

An index fund is a stock fund similar to a mutual fund. It consists of the same stock composition, in the same ratio as the underlying index.

2. What are the advantages of investing in an index fund?

Low management fees: Index funds mirror the composition of the index. Therefore, the fund managers need not actively work on picking stocks to get higher returns, instead they simply invest in the same shares and in the same proportion as the index. This is referred to as passive management and so the management fees is very low.

Low risk: Long term investments in index funds are considered relatively safe. Historically, index funds have outperformed the market and in some cases even outperformed certain mutual funds.

3. What are the different types of index funds?

Index funds can be exchange traded funds (ETFs) or mutual funds.

4. Should I invest in an index fund?

Investments in index funds is a relatively low risk long term investment option. Index funds are generally recommeded as an important part of a well rounded portfolio.

5. How can I invest in an index fund?

Index funds can be picked using screeners and looking at historic returns and fees.

Investing for income – Dividend Stocks

  1. What is investing for income?

The primary goal of any investment is to grow the capital or the money that is invested.

In addition to growing the capital, some investments will also generate income. Some examples of income from investments are the rent from an investment property, the interest from a fixed deposit.

Similarly, while investing in stocks, the dividends paid by the company is the income that is generated from the stock investment.

2. What are dividend stocks?

Stocks that consistently pay dividends are called dividend stocks.

3. Will dividend stocks always pay dividends?

No. There are no guarantees that a company will pay a dividend. Paying dividends to share holders is not a requirement for a company. It is decided by the board of directors based on the company’s earnings and various other factors.

4. How often are dividends paid?

Dividends are typically paid annually.

5. How do I find dividend stocks?

Dividend stocks can be picked using screeners and looking at historic dividend payments of companies.

6. How do I compare the different dividend stocks?

In the case of fixed deposits, the bank that pays the higher interest rate is preferred. Similarly, in the case of dividend stocks, companies with higher dividend yields are preferred.

Dividend yield is calculated by dividing the annual dividend amount paid by the stock price.

India Stock Investments Taxes – Part 1 of 3

1. Are stock investments taxable?

Stock investments are not taxable at the time of the investment. Any income (dividends) or gains (from the sale of the investment  asset) is taxable.

2. What are capital gains?

Capital gain is the net profit from the sale of a stock.

If the stock or bond was sold within 1 year from the date of purchase, any profit from the sale is classified as a short term capital gain.

If the stock or bond was sold after 1 year from the date of purchase, any profit from the sale is classified as a long term capital gain.

3.  How are capital gains taxes calculated?

Short term capital gains are taxed at 10% up to assessment year 2008-2009 and at 15% from assessment year 2009-2010. Long term capital gains are calculated at 20% and adjusted for inflation.

4.    Are capital gains taxable?

Yes.

 5. What are capital losses?

Capital loss is the net loss from the sale of a stock.

If the stock or bond was sold within 1 year from the date of purchase, any profit from the sale is classified as a short term capital loss.

If the stock or bond was sold after 1 year from the date of purchase, any profit from the sale is classified as a long term capital loss.

6. Are capital losses tax deductible?

No, capital losses are not tax deductible.

Capital losses can either be offset against capital gains during the same assessment year, can be carried forward as a loss to the following assessment year for a period of up to 8 months.

Ask MumbaiTrader – 28th January 2012.

I am a 32 year old software engineer working with a leading IT company. I bought a flat and am paying EMI on it. I want to start investing in stocks. I have heard that it is possible to make high profits in daytrading, I am comfortable with software and computers. Should I try to do day trading?

Congratulations on buying a house and planning your next investment steps! However, day trading is extremely risky especially for new investors.

Day trading requires 2 major items – i) stock analysis skills ii) Extensive time investment – day trading is often a full time job! If you are seriously interested in day trading, you should begin with practising stock analysis in a practice trading environment like the one at http://mumbaitrader.com/Trade.aspx

From an investment perspective, you can begin with investing in stocks or mutual funds with a long term horizon. Choose stocks that are low risk and that have long term growth prospects.

I will be retiring this year and will be getting a lumpsum as a retirement benefit. I am trying to decide how to invest this amount. The banks are offering a good rate on fixed deposits. I have never invested in stocks, but my colleagues tell me that it is a good way to invest my money. Is this a good idea at my age?

Growing your retirement funds is a very important task, especially if you do not have  a regular pension. With life expectancies increasing, it is quite a challenge to make sure your retirement funds grow enough to meet all your needs.

If you were to live another 20 years, you will need this money for regular expenses as well as large ticket items like healthcare etc. Assuming that the bank interest will cover your regular expenses, you’ll still need to grow the principal to meet your other needs.

Investing in stocks is a good way to achieve this target. We will recommend investing in low to medium risk mutual funds and stocks with a 1-5 year horizon.

Submit your question – Ask MumbaiTrader.

Please email your queries to ask@mumbaitrader.com.

Ask MumbaiTrader.

Do you have a question related to stocks, markets, investments or the economy?

The stock markets can be very interesting and intimidating at the same time. While it may be exciting to be an investor during good times, it could get equally frustating during bad times.

Do you wish to seek some advice, ask a question, or discuss a topic in general?

This is an effort to create a medium to address common concerns of investors. Send in your queries that are generic in nature and would benefit fellow investors. We will answer them and the most popular ones will be published in the blog.

Submit your question – Ask MumbaiTrader.

Please email your queries to ask@mumbaitrader.com.

Money Manager, Investment Advisor or Broker?

As a new investor, one of the important decisions to make is whether to use the services of a money manager, investment advisor or a broker? All of these entities offer services tailored to the individual investor.

MONEY MANAGER:

i) Who is a money manager?

A money manager, as the name suggests, manages the money of several individual investors. A money manager can be an individual or a firm. Individual money managers are often experienced investors who typically manage the funds of friends and family. Institutional money managers offer their services to both individuals as well as institutions.

ii) What are the services offered by a money manager?

Money managers charge a fixed annual fee for their services and may also charge an additional commission on any profits accrured. They may also offer downside protection by guaranteeing a minimum return on the invested amount.

iii) Who should use the services of a money manager?

A money manager’s services is useful for individuals who wish to invest in the markets but do not have the time and expertise to follow up on a regular basis. Risk averse investors can opt for investments in money management funds of large banking institutions.

INVESTMENT ADVISOR:

i) Who is an investment advisor?

An investment advisor is an individual who offers investment advisory services to clients. An investment advisor can be an independent or can work for a firm.

ii) What are the services offered by an investment advisor?

An investment advisor offers a variety of services like designing an investment portfolio based on the client’s profile, recommending stocks to buy or sell, recommending different financial products like insurance, stocks, bonds, mutual funds etc.

Investment advisors typically have access to sophisticated tools and research and are hence in a position to provide a better insight to clients.

iii) Who will benefit from the services of an investment advisor?

An investment advisor’s services are useful for clients looking for additional information and advice to support their investment decisions.

BROKER:

i) Who is a stock broker?

A broker is an intermediary between the client and the exchange. Exchange traded stocks, bonds and derivatives can only be bought through a stock broker.

ii) What are the services offered by a broker?

A broker could be a regular brokerage firm or an online brokerage firm. Brokers sometimes offer minimum advisory services like research reports and market updates to clients.

iii) Who will benefit from a broker’s services?

A broker’s services is sufficient for experienced traders and investors.