Technicals: Accounting for Income Tax on Bonus Options

According to ボーイフレンド one very important factor in investing where there is very little coverage for its significance is the implications of taxation and the role it plays in our decision making. I believe this to be true. As someone who has spent over twelve months of their life studying income tax in my tertiary studies, it is a subject that I try very hard to block out of my memory, but remains an unavoidable area of life. Unfortunately it keeps catching up with me, even moreso since I've started investing. So when he posed me a question a few weeks ago pertaining to the Capital Gains Tax (CGT) implications associated with our WGB options, I took it upon myself to dust off my trusty Income Tax Assessment Act (1997) Cth (ITAA) and work out the answer.

"In this world nothing can be said to be certain, except death and taxes"

Capital Gains Tax

It would be of assistance to commence our analysis with a definition of what constitutes CGT which is a tax levied on the sale of a capital asset such as shares or property, the gains (or losses) are the difference between what you get when you sell it compared to when you bought it. Although it is known as CGT and would appear to imply a separate tax regime outright, the gains are actually counted as your income and levied at the marginal income tax rate.

In Australia, since 21 September 1999 there is a 50% CGT discount applied to gains made on capital assets which have been held for longer than 12 months, which is a very important rule in our later calculations.

Although these concepts may seem simple to begin with, it becomes very complicated when we consider it within the context of bonus options. 

Scenario

As mentioned in previous posts, WGB is a share which ボーイフレンド and I have been regularly DCA-ing into during the big crash of 2020. So rather than buying it in a lump sum we have purchased it across multiple months which would in turn affect our eligibility to get the CGT discount. Lets assume our purchases were as follows and run through the options for their tax implications:

Option 1: Sell all the options

If we decided to sell all the options outright immediately this would mean that we would be selling 6614 options at a price of $0.13 per option.

Capital Gain = Selling Price - Cost Base

                    = $0.13 x 6614 - $0

                    = $863.33

However in accordance with the rules pertaining to CGT discount, as it is currently 13 March 2021, there would be 874 options which would be eligible for the discount. 

At a marginal tax rate of 37c your CGT on the exercise of the options would be $746.20 x 0.37 + $113.62 x 0.37 x 0.5 = $297.11

After tax returns being $562.71

Option 2: Exercise all the options, sell the original shares

Given the presumption that we do not intend to add to our total amount of shares held, our next option is to exercise all the options thereby doubling our share holding and then selling our original holdings. If we did this, we would have no CGT on the shares we gained from the options we exercised but we would be paying CGT on our original shares.

Capital Gain = Selling Price - Cost Base

                    = $16,799.78 - $14,000.00

                    = $2,799.78

As mentioned, the earlier purchases would be subject to the CGT discount which means that 874 shares purchased in Jan and Feb 2029 would be eligible.

At a marginal tax rate of 37c the CGT of the exercise would be $2,581.38 x 0.37 + $218.38 x 0.37 x 0.5 = $955.91

After tax returns = $1843.87

This may appear more favourable however the cost base of the 6614 shares we retain will now automatically be $2.54 and the acquisition date will become the date that we exercise our shares i.e. 13 March 2021. This means that we will definitely have to hold on to them for a further 12 months for the CGT discount to kick in. 

Option 3: Exercise all the options, sell the new shares

The third option involves exercising all the options but instead of selling the original shares we held, we sold the new shares. 

As per the ATO website, when options are exercised, the acquisition date of the shares is the date in which the options are exercised. If we exercised the shares today, the cost base of the share would be $2.54 the cost base would also have to include the market value of the option currently, i.e. $0.13.

As such, if we exercised the option and sold the share immediately, we would be incurring a capital loss of （$2.54 - ($2.54 + $0.13)) x 6641 = $863.33

If we applied this loss on another capital gain that we make in the current year (or future years) this would reduce our earnings by the equivalent amount, thereby resulting in a net cash gain of 37c in the dollar, being $319.43.

Although this is a lower figure than the other two, what also needs to be considered is the fact that the shares still retained on hand have a lower cost base but have been held for longer periods of time and will potentially be able to get the CGT discount upon sale.

Conclusion

Based on the above calculations, it appears that the answer is that if the goal were to get a maximum short term gain, Option 2 provides this at a moderate cost of future gains which have yet to be determined. Option 3 appears least favourable of the three and would not be recommended.

Disclaimer: The material on this post (and blog) is provided for general information and educative purposes in summary form on financial topics which is current when it is first published. The content does not constitute legal or financial advice or recommendations and should not be relied upon as such.

Appropriate legal and advice should be obtained in actual situations.

by 小福

Random Musings: On Wilson Global (WGB) and the genius of bonus options

 

One of the long term holdings in my portfolio is Wilson Global (WGB) which is an LIC (listed investment company) run by Geoff Wilson, the legendary CEO of Wilson Asset Management. Prior to the big crash in Feb 2020, I had a small holding which I had gradually bought into as it went down and through the recovery. 

It has since become my best performing investment, vastly outperforming the Australian market and recent developments have made it into one of the more interesting ones too. 

On the 10th of February, an announcement went out which gave every WGB holder an option to purchase an additional WGB share without brokerage fee, to be exercised at any time until expiry on 12 September 2022. Early exercise of these options also comes with the benefit of dividends as they become due.

Compared to the standard capital raising process of issuing new shares, there are a lot of reasons why this is far more favourable. In the standard issue of new shares, they would need to be offered to the broader public at a price that is lower than their current value, otherwise there would be no incentive for new purchases. This in turn dilutes the current shareholders by reducing the price of their holding. On the other hand, the option issue that WGB has introduced provides less certainty about the quantum of capital to be sourced, however it keeps shareholders happy as only they are the ones who hold the power to dilute their own shareholdings.

As someone who has spent a bit of time dabbling in the theory of options trading, but never bought any personally, it provides me with a nice introduction into the derivative. Simply speaking, once the options have been issued to me, there are three choices I can make:

• Purchase further shares at $2.54 per share
• Sell the option to purchase
• Do nothing and let the options expire worthless.

As I write this post, WGB is currently trading at $2.63. It would be expected that when the option does get issued, there would be a reduction in share price to the value of the option, however just for educational purposes, I found an online options pricing calculator which utilises the Barone-Adesi And Whaley pricing model for American options gives an indication as to what each option would be worth:

The issue of these options provides me with a first taste at hands on experience in decision making with call options at no upfront cost to myself. In all likelihood, I will probably end up selling the options rather than exercising them, but picking the right time will be paramount and the tax implications will also be interesting. Exciting times ahead.

By 小福

Case Study : GME and WallStreetBets the Game that Stop(ped) the whole world

Readers may note that it has been a short while since I have updated this blog. This has been largely brought about by two factors:

• The idea that houses are going to outperform stocks in the short to medium term due to the yield of cash flow from property given the risk profile, which has resulted in my spending the last several months doing numerous house inspections and dedicating a considerable amount of my waking hours to sourcing an investment property.
• Nothing much had been happening on the stock market

The key word in the second sentence is of course "had". Anyone who has been keeping up with the news of late has of course heard of the Gamestop Wallstreetbets saga and I thought had though that it would be good to wait for the day to day drama to blow over before commenting on it. With the situation calming down a bit, I am finally able to put my "pen" to "paper" and provide my opinion on the last several weeks. 

Before we begin though, some context:

What is GME

Gamestop is an American game retailer with a focus on electronics and consumer electronics sold through their bricks and mortar stores. Founded back in 1984, it was one of the world's largest video game retailers, Australians would recognize their subsidiary EB Games as a regular in large shopping centres. As you would imagine, through the transition to digital rendition of games and the subsequent lockdown, GME has been gradually reducing in price through the years. 

Rise, Short Squeeze and Subsequent Decline

Our story starts with a redditor by the name of Keith Gill who goes by the username r/DeepFuckingValue, reflecting his perchance for value stocks which have been underappreciated by the general public. In September 2019 (when GME was trading at around $5) he purchased a $53,000 position in GME as he believed that it was a value purchase that would eventually rise back up to fair value. Making numerous youtube and reddit posts about the subject. This eventually lead to other posters doing their research on the stock and realisng that GME was one of the most heavily shorted companies with roughly 140% of their public floated stocks being shorted. This means that some of the already borrowed shares were loaned out again to short. One of the biggest holders of these shorts was none other than Melvin Capital, one of Wall Street's best performing hedge funds. 

This prompted a considerable amount of online discussion pertaining to a potential short squeeze whereby highly shorted stocks would have to be brought back at higher prices to stop the losses they had accumulated from their positions, which would of course have lead to an even higher price (for those interested, the VW squeeze of 2008 is a good reference). With this in mind, the masses of retail investors at r/WallStreetBets took up the cause and bought vast amounts of GME, pushing the price from $20 per share up to $483 fueled by a desire to make some tendies and for some, a crusade to make the hedge funds and Wall Street pay for the pain they had caused in the GFC. Of course this had captured the attention of not only stock traders in America, but the whole world. It would have been no understatement to say that the sentiment on r/Wallstreetbets was euphoric:

The fallout from this was significant, with Melvin Capital announcing losses of 53%. Shortly after, brokerages such as RobinHood and IG limiting purchases of GME stock as well as others such as BB, AMC and NOK which had also been pumped in the same manner, the response was furious with other subs such as r/stocks, r/investing and r/options banding together in their castigation of the institutions preventing retail investors from exercising their right to purchase, notably it also briefly united both the left and right aisles of the political spectrum in their condemnation.

Peak frenzy occurred on the 29th of January which happened to be a Friday. The weekend that ensued was filled with misinformation at best and corruption and conspiracy theories for those who are more cynical. R/WallStreetBets subscribers ballooned from around one million to over six million with proven infiltration by bots as well as opportunists who tried to take command of the situation and pump other penny stocks as well as SLV. Their discord server was shut down temporarily on allegations of hate speech and the SEC had announced that they would be actively monitoring the sub for allegations of market manipulation. 

Since the opening on the Monday after, the stock has seen a fairly sharp decline in price despite cries by alleged shareholders to "hold the line". As it currently stands, GME trades for roughly $60 and shorts are still estimated to be at 100% of the stocks, indicating that the squeeze had yet to occur, but the stock holders on r/wallstreetbets appear to be quite despondent and the prices seem to have stabilised to a moderately slow decline.

Discussion

I've spent the last week or so reading quite a few analytical pieces to try to draw some conclusions on what happened, which I will put briefly:

• In the end, the stockmarket is just that, a market. It is a place for individuals to buy and sell stocks for profit, nothing more, nothing less. Those who wish to use the market to be a weapon of sorts to launch a crusade against the hedge funds for their behaviour during the GFC should reconsider their motives. Even if Melvin went into liquidation, there are still hundreds, if not thousands of hedge funds that are willing and able to take up the void that Melvin created. Rather than trying to take down hedge funds by way of pumping stocks that have been shorted, retail investors should consider that it was the government who made the decision to bail out the hedge funds and the government who offered such a lack of regulation on the industry which caused the fiasco to begin with.
• When the romanticism of taking down the institution is stripped away, this case study is one of a textbook pump and dump on the part of redditors. From the outset, u/DeepFuckingValue has been a self proclaimed value investor who saw the arbitrage between the value of GME and the price in which it was trading for. He had purchased this through both fundamental and technical analysis. Those of whom purchased GME at $300 after it had made headlines around the world were obviously too late. There was no justification at all to be buying the stock for a price which outpaced fundamentals completely, and as we will have seen, those shareholders are the ones who were left with considerable losses. In the end, it is never wise to join in herd mentality and buy what everyone is buying unless you have a firm conviction of why it will go up as well as an exit strategy.
• This case study has proven that social media is an influence in the markets which had, until now, not been factored into traditional risk analysis. Suffice to say, this will definitely have to be captured into any such calculations. 

For those wondering,  I didn't purchase any GME, nor do I intend to dabble in the US market whilst prices are as they currently stand, but it was an extremely exciting rollercoaster to watch, even on the sidelines.

by 小福

Maths : Valuation Models: Discounted Cash Flow and Application to PE Ratio

Within the recent months, those who have mostly invested in Australian stocks such as ボーイフレンド and myself would have seen returns come up mostly flat whilst watching US stocks soar well past their February peaks. 

Stacked atop each other, it is very striking to see the differences in how far the ASX200, S&P500 and NASDAQ have performed since the March crash. If you had invested in NASDAQ at the start of the year, you would currently be up 31.7% whilst you would still be down 12.8% if you were solely in ASX 200. 

For those who have followed the news, it has been apparent that most of the gains made in the US markets are largely attributable to the tech sector. By way of illustration, the following charts show the current year to date return on the ASX, S&P when compared to Tesla, Microsoft, Amazon and Zoom. 

As you would expect from this kind of level of growth, stocks like TSLA, ZM and APPL have dominated a lot of the talking points in quite a few share forums and a few friends have been talking about buying into them lately too. 

As a value investor, whether or not a stock is worth purchasing depends largely on whether it represents good value when considering its growth and return prospects. So this is what we will attempt to discern for the aforementioned stocks by use of the Discounted Cash Flow method for security analysis with specific reference to the current PE ratios of said securities. 

Discounted Cash Flow

Discounted cash flow is a method to calculate the value of an investment based upon the sum of its' total future cash flows and applying net present value of the total of the cash flows. The formula is as follows:

The formula provides a framework to determine what the fair value of the investment is, thereby aiding the determination of whether or not the current pricing is above or below fair value, showing whether or not it is a good buy. 

Usually when calculating DCF, projected cash flows are estimated for the upcoming five years with every year subsequent estimated at the standard 3% being standard GDP growth indefinitely. 

In applying this model, you arrive at a total expected value for the company, which can be divided by the current amount of shares to determine a fair value of the share given it's projected growth (in the next five years). 

Application to PE Ratio

As mentioned earlier, PE ratio is determined by price divided by earnings. This can be utilised by the DCF model to show what the anticipated growth of a company is based on what the PE ratio currently is. 

Without using actual earnings figures, if you assume the first year's earnings to be one and project the next five year's growth and then apply DCF, the resulting figure is the fair PE ratio for anticipated growth. 

By way of example, take the current Australian CAPE ratio, which sits at 17.5 per StarCapital as at 31 August 2020. With an inflation rate of 1.25% and risk free rate of 7.5% it shows that with a PE of 17.5 is fair value if earnings are expected to grow at 3% per year to perpetuity. 

In contrast, we can take a quick look at TSLA, ZM and APPL figures as they are now:

To justify a PE of 1083, Tesla will need to grow at 300% per year for the next five years.

To justify a PE of 472, Zoom would need to grow at 250% per year for the next five years.

To justify a PE of 36.7, Apple needs to grow at 25% per year for the next five years.

The question then as to whether or not these securities are worth purchasing depends on whether the investor considers the expected growth to be in line with the potential growth of the company. In looking at the above three companies, it would not be unfair to say that TSLA and ZM are very unlikely to be able to achieve the growth required to justify their PE ratio, whereas it could be plausible that APPL could achieve it. Given the uncertainties surrounding the tech sector though, these are still not securities that I would really be in a rush to purchase.

by 小福

Maths: On maintaining or increasing dollar cost average

Have taken a short hiatus since my last post. With the February March crash well and truly behind us, the last two months in the market have been extremely flat. Long gone are the days of extreme volatility and since mid June, not much has really happened. This is clearly evidenced in the below chart:

As I write this, the ASX stands at 6126 points, a good 15% below the all time high of 7199. Although the S&P 500 has since reached all time highs and NASDAQ has long surpassed it, the ASX remains steady at around the 6000 to 6100 mark.

Given what had happened in February and March, ボーイフレンド had been a strong advocate for investing more and more the greater the deviation from all time high. At the bottom of the market, he was putting in 16 times his usual investment amount on a monthly basis, and then gradually scaling back as the market recovered. Where we are now, he is still putting in 4 times the usual, which has obviously impacted on cash reserves. With my limited resources, I am also putting in double what I would normally invest into the market. This has obviously resulted in fairly good returns for the both of us, he has long recouped all losses whereas I am roughly breaking even, even though the local market is still significantly lower than it was.

This brings me to current day, where we have fluctuated around this mark for about two months and I had been pondering whether or not to reduce our contributions given it had been eating into our cash reserves and that some developed countries had opted to go into lockdown again given second wave covid.

Essentially the dilemma I was facing was as follows:

• If I keep contributing a greater amount than usual and the market crashes or suffers a correction due to second round lockdowns or other unforeseen circumstances, the funds I had invested in the market would be hit and I would also have a significantly lower cash reserve to throw into the market to get the benefit of better value shares.
• If I reduced my contribution to my original standard amount, even though the market stands at 15% lower than all time high, and a crash does not occur, the cash I hold in the bank will be making negligible returns and whatever I do not invest now will have to be invested at a later date where the prices may have inflated considerably.

In pondering what to do with this conundrum, he mentioned the utility in working it out via outcome matrix given the range of potential situations and our three variables:

• Increased or standard contribution
• Depth of crash
• Potential of crash

We worked this out using the following simulation. Whilst the current Australian CAPE stands at 19, there was no consideration for us to cash out any of our holdings, which meant at least one less factor. Assumptions we made in the following examples are as follows:

• Standard contribution is $5,000 per month, increased contribution is $10,000 per month
• Where the market doesn't crash, it goes up by the annual amount of 10%
• Starting portfolio is $0 as what is already in the market is irrelevant.

Outcomes of our simulations are as follows:

Allowing for a 40% crash in 3 months

Allowing for a 30% crash in 3 months

Allowing for a 20% crash in 3 months

From the results, it can be easily distilled that the lower the chance of a crash, the better it is to go in with a higher contribution so as to maximize returns on cash. By putting these numbers into the matrices provides a quantifiable outcome for either scenario, thereby allowing me to consider which course of action I ought to take.

With the Australian Market pricing in zero profits across the board for the future year and a half (using CAPM and DCF models given risk free rates), it is fairly safe to say that the odds of a significant correction in the market is lower than usual, provided a Republican win in the Presidential Election in USA. Given the above modelling definitively shows that there is a strong reason to continue to contribute aggressively to the market whilst prices are still at their current rates.

by 小福

Random Musings : "The market is detached from fundamentals!"

It has been a while since my last post. The reason for that is a change in pace of my work and also the fact that this post has taken considerable rumination and consideration on my part prior to committing it into writing.

As I write, we are already currently nearing the end of July with the last six months of the ASX looking like this:

The market has taken a fairly remarkable rebound and we are sitting at a mere 15% from peak, whilst the S&P 500 is 3% from peak and NASDAQ is already 900 points above its February highs.

Since our initial lockdown in March, we have seen a gradual reopening in June and a subsequent re locking down of Melbourne due to an uptick in cases. Allegedly NSW is one month behind them and we may yet see numbers spike again across the country. America still hasn't seen much by way of respite in infection numbers and Hong Kong has also been locked down yet again.

Given what is happening around the world, I have seen numerous articles and also friends alleging that the market is detached from the fundamentals (i.e. global recession, unemployment, insolvencies, social unrest), a second crash is forthcoming and that this is the biggest bull trap in history.

I have spent the last month pondering this and trying to come up with an explanation as to why the market is still going up. Having done considerable reading and research of past historical events, I can only come to the conclusion that the stock market has almost always always ignored the economy.

In essence, the role of the stock market is to accurately quantify investors' views on the future prospects of publicly traded companies. During any of the catastrophic or more turbulent times of the past, stock market returns have largely been uncorrelated to these events.

Whether or not the market is considered overvalued (refer to my previous post) or not depends on what investors' appetite for risk and return are. Given the fact that everything else is offering meager returns, investors may be willing to pay a higher price for stocks on the promise of a higher yield. In January, the cash rate was considerably higher than it was now and having adjusted the discount rate for the massive drop in interest rates, it could be said that equity pricing is fairly reasonable.

In fact, whether or not the market is currently overvalued is merely a function of expected return and the expected return of other asset classes. Given that people are still pushing up the prices of equities simply means that they are still content with the projected return, given the current value. As such, although some people may say that the market is expensive, which is in itself a subjective measure, it would hardly seem overvalued. For those who allege that the market is detached from fundamentals, I daresay that there is hardly a time in history where the market reflected the political and social environment, all it needs to do is provide an accurate reflection investor's perspectives on future prospects, and to this point, I would think that it does its job fairly well.

by 小福

Random Musings : "Overvalued" vs "Expensive"

A fairly short post, which to some may pose a fairly obvious point, but it didn't occur to me as apparently as it should have until quite recently during one of ボーイフレンド and my more robust discussions about the current state of affairs. With some light prodding, I was finally enlightened by the clear distinction between the difference between the concept of being "overvalued" as opposed to being "expensive", which is fairly important and hence worth dedicating an entry to.

To the untrained (or maybe just me), the two words can be considered somewhat interchangeable when applied to daily life references, there are in fact significant differences when applying these terms in a financial investment context. Expensive simply means that the investment vehicle is outside the purchasing power of the individual. Overvalued implies that said asset is priced above its intrinsic value, that is a function of its return and risk.

In an investment context a clear analogy would be an annuity promising to pay $10m to the holder every year indefinitely, sold for the price of $50m. Unless hyperinflation was a legitimate concern, there are very few who would consider the annuity to be an overvalued asset, although it would be considered expensive and outside of their purchasing power for the majority of people.

The reason for considering this is in consideration of the more recent developments in the fairly sharp rebound of equity prices after the Feb - Mar crash, something which will probably be covered in another entry in the near future, something to look forward to once I de-muddle my mind.

by 小福

Maths: Greek

In the course of my reading what I consider to be fairly technical financial reports and analyses, I often come across references to Greek. Having covered them briefly in the finance courses of my commerce degree years ago, I thought that it would be a good time for a slight refresher on what I already know in addition to learning things whilst providing a reference guide for the future. 

The first two Greeks that I'll discuss relate to the broader notions of investing and have a fairly wide range of applicability while the remaining deal specifically with options.

Risk Ratios

Alpha

Alpha is defined as excess return on investment when compared to an indexed benchmark. Therefore alpha is calculated as actual rate of return less benchmark rate of return. The resulting figure gives an indicator of whether the investment over-performed (if the number is positive) or if it under-performed (if the number is negative), essentially providing a measure of relative return.
A positive alpha indicates an investment had a good return given it's underlying risk whilst a negative alpha indicates the opposite.
When people say they have a high alpha, it means they have a tendency to outperform the market.

Beta

Beta is defined as the measure of relative volatility compared to the market as a whole. It is used to measure systemic risk of a portfolio when compared to the benchmark.
The formula for beta: 
Although it looks fairly complex, it can easily be calculated with excel by using variance and covariance formulas.
By definition, the market as a whole has a beta of 1. A resulting number of less than 1 indicates that it is less volatile than the market which can often be found in lower risk investments such as bonds or gold. A higher beta indicates that it has more volatility than the market. For those who dabble in inverse indices, a negative beta demonstrates that the investment moves in the opposite direction of the market.
High beta vehicles often offer higher returns whereas low beta investments offer lower returns. By utilising the Capital Asset Pricing Model, one can then derive what a fair return on investment ought to be given any beta.
In combining the two, it can therefore be concluded that the most attractive investments are those that offer the highest alpha with a low beta.

Options Greeks

Delta

For those who remember from their high school days, Delta is a measure of change. In the finance context it measures the rate of change of an option with the change in underlying asset's price.
The formula for delta:
The resulting number ranges between -1 to 1 with negative numbers for puts and positive for calls. Delta represents the change in the price of the option for every dollar movement of the share.
Options which are deep In The Money (i.e. calls where the market price > strike price and puts where market price < strike price) will have a delta closer to one whereas options which are deep Out of The Money will have delta closer to zero. In practically applying delta, it is often used as a rough indicator of the probability that the option will expire in the money. A delta of 50 would mean that it has roughly half a chance of profiting by expiry. The higher the delta the more chance you have of profiting, but usually this would correlate to higher premiums for the contracts.

Gamma

Again one from high school mathematics, Gamma represents the derivative, that is rate of change of Delta with respect to the change in the underlying asset's price.
The formula for gamma: 
Simply put, gamma is to delta as acceleration is to speed. Gamma is always positive and highest when the option is closest to At The Money (market price = strike price). It is sometimes called the "Uncertainty Factor" because of this, since when options are closest to  ATM the higher the chances that it could end up either way.
Practical example, if a stock had a value of $100 with the correlating call having a delta of 0.45 and a gamma of 0.05, when the stock goes to $101, the delta becomes 0.50, so the value of the premium goes up correspondingly.

Theta

Theta is a function of measuring an option's time sensitivity. It gives an indication of the change in the value of the contract given a one day change in time.
The formula for theta:
Short options, that is selling contracts, has positive theta whereas long options have negative theta because the closer you get to expiration date, the less the underlying contract is worth because of the lower probability of market value making the required strike price. By way of example, a Theta of -0.10 means that every day that the stock price does not move, the value of each contract will reduce by $0.10. The lower the theta, the slower the rate of decay is on the contract.
For those who browse forums as much as I do, you may have come across the term Theta Gang. Theta gang represents those who sell options to profit from the decay in value when it expires OTM.

Vega

To clarify, Vega is not actually a Greek letter, rather it uses the letter nu, but as the character bore similarities to the letter v, it has been named vega in line with beta and theta. It measures the change in the option's value with every percent change in implied volatility.
The formula for vega: 
All options have a positive vega. When implied volatility is higher, options are worth more as people think that there is a higher likelihood of meeting the required strike price. As such, with the most recent volatility in the market, options would have sold for a far higher premium and as volatility subsides they will be worth considerably less, hence the term IV crush.

Though I have little intention to dabble in options, having a good understanding of the above is always useful when assessing other's option purchases to consider their viability. It's also very interesting to learn on the side anyway.

by 小福

Obiter Dicta: CAPE Ratio

Having recently written a bit on the Sharpe Ratio reminded me that I hadn't actually covered the CAPE ratio on my blog. This was particularly surprising as it was one of the first things that ボーイフレンド taught me, even before I had started my own portfolio.

Invented by the Nobel Prize winner Robert Shiller, it stands for Cyclically Adjusted Price to Earnings Ratio, also known as the P/E 10 Ratio. Starting again on fundamentals, PE ratio is one of the first tools that you learn in finance. It is simply calculated as follows:

It is a very blunt instrument that provides rough guidance on whether or not a share is overpriced. The higher the PE ratio, the more likely it is that a share is overvalued or a high growth is expected, vice versa, the lower it is the more likely it is undervalued or slow growth is expected. In comparing PE ratios, it is best to compare with competitors in the same industry or with the company's previous years' performance to ensure consistency of benchmark. Being a very simplistic indicator, it doesn't take into account projected earnings, especially for startups which may yet have started turning over a profit. It is also often limited by fluctuations experienced annually throughout the course of a business cycle.

This is essentially what lead to the creation of the CAPE ratio, to smooth out fluctuations in corporate profit over a decade. The formula for CAPE ratio is:

The use of the CAPE ratio for individual companies is largely to assess the long term financial performance to determine whether or not a share is over or undervalued. Limitations of the ratio include the fact that it is always only backward looking rather than forward looking and it doesn't take into account changes in accounting standards which may also affect the figures used in the calculations.

Other than for individual companies, I find that a far more useful application of the CAPE is in considering the historic CAPE ratio for an individual country. The CAPE Ratio by country is calculated by averaging a country's average equity price by their ten year average inflation adjusted earnings weighted by market capitalization. The resulting figure provides an indicator on whether or not the country's stocks are considered over or undervalued.

When considering a country's current CAPE ratio to it's historical average, we can determine the propensity for a substantial corrections in it's equity prices. From the chart below, it is clearly apparent that the crashes in US and Australian stocks corresponded to a much higher than average CAPE ratio, notably the dot com crash and the GFC. Therefore in the short to medium term, investing in a country with considerably above average CAPE ratio is likely to result in lower than expected returns in the foreseeable future.

It is also of interest to note that different countries' CAPE ratio cannot be compared against each other because different countries specialize in different industries with different average PE ratios, so a country's CAPE ratio ought only to be compared with it's own historical average.

Given the above, there is little doubt as to why CAPE ratio poses such a useful tool in measuring not only a company's stock but for a whole country's projected future performance. Definitely a worthwhile indicator to consider when assessing future investments.

by 小福

Book Review: Affluenza - Clive Hamilton

Has been a while since I've had time for a book review. Not so much because I haven't had time to read but due to the time I've spent dwelling on the recent current affairs and state of the world. Finally finding a brief respite amidst the turmoil, comes another book review, Affluenza, When Too Much is Never Enough by Clive Hamilton and Richard Denniss. Surprisingly it was recommended to me by Mr A quite a few years ago rather than my ボーイフレンド .

Reading it after The Millionaire Next Door, I found that it built upon a lot of those foundations and provided a more in depth analysis on the spending habits of the the majority who live in first world western society. As you can probably guess by the title, Affluenza is a portmanteau affluence and influenza, it covers the topic of over consumption in our current culture. The premise of the book considers how we are often conditioned by media and more recently, social media to aspire to the lifestyles of the rich and famous and at the cost of our mental wellness and financial future. It covers the vast amount of possessions that we buy each year, upgrading to the newest, fanciest model of accessory whilst throwing out an unprecedented amount of waste. In the end it presents a message of downsizing, weighing up what is an essential rather than shallow desire to ensure that we can live a more fulfilling and fruitful life. It also means that for those who are stuck in jobs that they do not enjoy as much, they can become financially independent and retire earlier.

In a nutshell, affluenza can be encapsulated in the following:

 “We buy things we don't need with money we don't have to impress people we don't like.”
― Dave Ramsey

by 小福

Obiter Dicta: Sharpe Ratio

The relative calm of the recovering market means I have had more time to ponder theory surrounding financial mathematics rather than the pragmatic application of theory to real life when a crisis is unfolding. 

Having gone through the recent downturn and observed the gains by some investors, it made me wonder whether or not return on investment was the single best measure of performance. Considering that some have taken higher risk than others to achieve comparable returns, I recalled  ボーイフレンド had mentioned that the Sharpe Ratio was a good measure of this, so it was time for a bit more technical research.

The Sharpe Ratio is calculated as follows:

rx is the rate of return for the investment
Rf is the risk free rate of return, which we can take to be the RBA cash rate (currently 0.25%)
StdDev(rx) is the standard deviation of the portfolio. A guide on calculation can be found here.

The higher the Sharpe Ratio of your portfolio is, the better the returns are at the undertaken risk. As good a tool as it is, the Sharpe Ratio does come with drawbacks, substantively the premise that the lower the volatility, the better the portfolio, it negates the positives of upside volatility. Those who are familiar with the formula are also able to cherry pick performance to demonstrate stable earnings to boost risk adjusted returns as well, so as with most blunt instruments, due consideration needs to be given in application.

In the end, both return and risk need to be considered when evaluating whether or not a portfolio is superior. Just because you took a very high risk and it paid off handsomely doesn't make you a skilled investor so much as it means that you are a lucky gambler (for now).

By 小福

Case Study - BBUS and BBOZ: The First One's Always Free

Those who have been dabbling in stocks during the most recent period of volatility will undoubtedly have gained invaluable experience in the market during the Feb to April downturn and subsequent uptick. In summary, from 19 Feb to 23 Mar, the S&P 500 lost 33.9%, making it the fastest crash in history. This was followed by growth of 17.5% from 24 to 26 Mar, being one of the biggest three day gains for almost a century. It would not be an exaggeration to say that what we lived through was truly extraordinary. What was even more amazing was to watch the market response to these violent movements. 

As my readers will now have discerned, my investment strategy has been a fairly conservative one where I dollar cost average twice a month, largely into index funds and by exception individual shares where they appear to be of exceptional value and worthy of the additional risk involved. Whilst I stuck to my plan throughout, I have found it to be infinitely fascinating to watch the response of average retail investors who succumbed to the dark side and were burned hard by the market. 

In observing the people around me and a plethora of online forums, there were two main poisons which decimated portfolios, one was Put Options, the other was Inverse Indices. Today's topic of discussion will revolve around two highly popular inverse indices, BBUS and BBOZ. 

 

The simple way to explain inverse indices is that it is exactly what the name purports, an inverse of an index fund. While BBUS is a leveraged inverse of the S&P 500, BBOZ is a leveraged inverse of the ASX 200. By utilising futures contracts, every 1% lost in the relevant index results in a 2% to 2.75% gain for the holder. As you can envisage, this became a highly attractive investment vehicle to make some gains during the intense drop. Although it may sound like a good idea to buy when the market is falling, there are a number of reasons why a beginner or even novice investor shouldn't touch these products.

Market Timing

When you buy into index or a fairly stable blue chip share, it is almost an inevitable outcome that the shares will go up in the long run. Since BBUS and BBOZ are inverse indices, they obviously go down in the long run as demonstrated in the chart below.



When you look at the prices for BBUS in the last several months the returns look extremely attractive after the fact. If you bought on 20 Feb for $2.67 per unit, this would have become $6.63 by 23 Mar. However, given the state of the economy on 20 Feb, who would have been able to foresee the impending crash and buy into BBUS? Very few. Given the uncertainties surrounding the impacts of coronavirus on the economy and subsequent fall out, most people held onto their portfolios for at least several days until a downward trend was established when it was somewhat higher in price. I know of at least one friend who put their whole portfolio into BBUS at peak for $6.63.

Given investor psychology surrounding the Dunning Kruger effect, even the investor who bought in at the peak was determined that the falls were not yet over and any minor dips constitute bear market rallies and the big crash has yet to come. Of course the media also fanned flames during this period, hyping up death stats and forecasting the end of civilization as we know it, but the unsavvy investor failed to realise that this was already priced in when the market tanked. As a result of this, they consistently held on whilst their portfolio was was violently wiped out.

As of today, BBUS currently stands at $3.39, almost down to what it started on. Are we in the middle of a massive dead cat bounce and the big crash is still coming, or whether we are in for a V shaped recovery? I don't know, which is why I will continue with my dollar cost averaging. Short of being able to accurately time future market movements, it would be imprudent to purchase such a risky vehicle. Having said that, if you are able to accurately foresee the future, why wouldn't you just maximize your gains on minimal cost by buying next week's lotto ticket and min maxing your profits.

Compounding Risk aka. Volatility Decay

Another reason why leveraged inverse indices shouldn't be held for an extended period of time, but isn't apparent to most until demonstrated by a worked example.

For simplicity, let's do two worked examples on the following parameters:

• Starting portfolio is $10,000
• Every day the market moves up or down 1% (10% in the other simulation) returning to parity every second day
• For simplicity we will take the leverage of inverse index at a multiple of 3.

As you can see, whilst market returned to parity every second day, the value of the portfolio was gradually reduced, whilst the results were subdued when volatility was small, when movements were violent, decay was also extremely brutal. Given the fluctuations of the last several months, I have no doubt that quite a few people suffered considerable losses from volatility decay.

For further clarity, consider the fund strategy that BetaShares proposed for both BBUS and BBOZ whereby returns of 2% to 2.75% for every 1% drop are only for any given day, thereby indicating that those returns cannot be expected to continue for periods over one day.

Expenses

Due to the nature of inverse indices attaining their benchmark leveraged returns through use of complex mechanisms like derivative contracts, the associated expenses of high fees, high transaction costs and re-balancing costs also eat into returns considerably. Although simple, for someone who puts money into ETFs for their low management costs, this is clearly reason why inverse ETFs should be considered with a grain of salt.

Conclusion

The last months have provided me with precious insight into the workings of the human mind and how the fear of loss coupled with greed to make gains have pushed innumerable investors to the dark side. From moderate gains during the remainder of the bear market to the eventual wipe-out with the recent rally, millions have been lost on the market because The First One's Always Free and the lure of quick gains is intoxicating. For this, I am grateful to have held firm to my resolve and weathered the storm.

It has also provided a practical example to ボーイフレンド as to why retail investors often under perform when compared to index returns.

As a final point, for those who are wondering. Mr A, who got bored of checking on his brokerage account and continued to DCA through the dip on a preset diversified spread has now returned to -13% on his portfolio whilst the market is still at -20% from peak, outperforming everyone that I know personally.

By 小福

Book Review: The Millionaire Next Door - Thomas J Stanley and William D Danko

As the turmoil starts to subside, and the VIX falls back to 40 after some all time highs I'd 80, I finally have some time to go back to some general reading without having to follow current affairs like a hawk every day, so of course it is time for another book review(´｡• ω •｡`).

The Millionaire Next Door by Thomas Stanley and William Danko was actually recommended to me by ボーイフレンド during our first date(=`ω´=). Of course I went home and read it all within a matter of days and it proved to be more insightful than I expected.

Essentially the book covers some studies that were done on households with a net worth over one million dollars and compares the behaviour and habits of Under Accumulators of Wealth and Prodigious Accumulators of Wealth. In terms of spending, PAWs are far more likely to spend significantly less than they earn and they also tend to make considerably less purchases of luxury goods and status items (・_・)ノ. The book shows surprising evidence that the supposedly wealthy people you see living in lavish mansions driving luxury vehicles are often only able to do so via debt, leaving them with a considerably reduced net worth. As someone who doesn't really indulge in luxury goods, it served as a firm reminder that the sacrifices that I was making towards my goals were worthwhile. In summary, the book demonstrates that with hard work, discipline and prudence, almost anyone living in a first world country can attain millionaire status.

It was quite eye opening to me when thinking about friends and family around me and considering what their underlying financial situation was. For instance, I have a beloved relative who inadvertently ticks all the boxes of a UAW whilst I had never noticed it in the past (〃＞＿＜;〃)  and I have a work colleague who appears to be very low key pragmatic but is almost a textbook exemplar of a PAW. Guess I know who to go to for advice in the future╰(*´︶`*)╯ .

One surprising fact that I did also note, which turns out to make sense when you think about it, is the concept that offering financial aid to children often results in financially underperforming children who become entitled to the regular handouts. For people considering raising a child, this is also quite sobering and offers ideas as to how to raise your child to ensure they become PAWs.

For those who are interested, Thomas Stanley and his daughter Sally Stanley Fallaw have recently published a follow up of the study, The Next Millionaire Next Door. Apparently the book demonstrates that in modern times it has become even easier to grow wealth than before. No doubt I will read it in due course („• ֊ •„).

By 小福