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Friday, September 18, 2015

Municipal Bonds and Tax Free Yield - Calculating Tax Equivalent Yield

Municipal Bonds and their rules - regulations are covered quite heavily on the Series 7 Exam. Some of these question deal with the core understanding of Muni Bonds and their advantages. The main quality behind these bonds is their tax free status with regards to interest income. Nothing is exempt from Capital Gains Profit (a trick question sometimes on the Test)

Since Municipal Bonds (large majority of them) are exempt from Federal Tax on the interest received, they do not have to offer high coupon interest rates. This allows States and Local Municipalities to raise capital on borrowed money through a bond issue at a lower cost.

Since many Muni Bonds are backed by taxes (G.O - General Obligation Bonds), this is a benefit to the people who live within that municipality.

Tax Equivalent Yield

This is the yield (not the coupon rate always) that a taxable investment like a corporate bond would have to beat to "out-do" a Muni Bond. This assumes ratings and maturity are fairly equal between the 2.

The formula is:

taxable yield = tax free yield divided by 100-tax bracket

If a Muni Bond had a 3% coupon rate and an investor was in the 28% tax bracket and is also being offered a 4.5% corporate bond, which bond would offer the best yield given the tax advantage of the Municipal.

The Muni in this example is 3%. So 3 divided by 72 (100-28) = 4.16%

That 4.16% is what a taxable investment would have to be better than for the investor to not buy the Muni issue. Again, there will be other factors at play, but strictly speaking YIELD, the Corporate at 4.5% would be better - even though it is a taxable investment.

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Friday, September 11, 2015

Short Straddles - Option Strategy Help

Short Straddles for Series 7 - A tutor and tips post for those needing Options help.

A short straddle is the selling or "shorting" of a call and a put option on the same stock or security. These are part of the Options section on the Series 7 but this tutorial can also help individual traders.

The idea or motivation behind a short straddle is to collect the premiums on both options and then hope they expire, thus keeping the premium and attaining a profit. This is one of the few option strategies where an investor wants a neutral market. Nothing too up or down.

Since you will be tested on questions related to Straddles - their maximum gain, loss, break even etc. Lets lay out an example.

SHORT 1 KLK OCT 35 CALL @ $400
SHORT 1 KLK OCT 35 PUT @ $200

The combined premiums collected is the profit point and is the trader's maximum gain.

The maximum gain is $600

The maximum loss is unlimited because of the short call. When you short a naked call, the maximum loss is always unlimited. Shorting a Put does not protect the call or vice versa.

The Break even points are the combined premiums added to the call strike price of 35 and subtracted from the put.

The combined premium is $600 or 6 points.

Thus, the break even points (there are always 2 with straddles) are 41 and 29. If the stock exceeds or goes below these points, the investor is not profitable.

If this were a LONG STRADDLE - The break evens would be the same but the profit would BEGIN as those points are broken through, since in that case the premiums were paid. Long Straddle Option Strategies were discussed in another post on this blog.


Thursday, September 3, 2015

Options Help For Series 7 Test - Long Straddles

Help and Understanding Long Straddles for the Series 7 Licensing Exam.

A straddle is using calls and puts at the same time. There are long and short straddles. A long straddle is the buying of calls and puts on the same stock or security. Short straddling is shorting calls and puts on the same security. Straddles are tested on the Series 7 exam or other exam where options are part of the outline.

Long Straddle Example

BUY 1 DFG DEC 70 CALL @ $600
BUY 1 DFG DEC 7O PUT @ $150

The main profit aim for DFG stock to rise or fall below the break even points. There are 2 break evens with long straddles since a call and put are held and were paid for. Most long straddle holders are anticipating big movement in the security. They are usually neither bullish or bearish (those terms are more used
with spreads).


The Series 7 will ask the break-even points for straddles. For this straddle:

Call is the strike price plus the COMBINED PREMIUMS. The combined premiums are 750.

So the B/E for the call option side is 77 1/2

The Put side of the long straddle would be the 70 strike price minus the combined premiums of 750 or 7 1/2.

Thus the Break Even for the Put is 62 1/2

Maximum gain on Long Straddles is UNLIMITED.

This is because of the call side of the straddle. If the price of DFG rises above 77.50 and continues to rise, the put can be allowed to expire or traded away. Either way, there is no limit to how high the rise of the stock can go. Anytime you are long a call and do not have an "obligation" that the long call
is covering, your maximum gain is unlimited. If on the Series 7 exam, they present a scenario where the call is traded away and the put is still active, it is no longer a long straddle and the put maximum gain would be the break even in dollars. In this case, the maximum gain is $6250.

The maximum loss is the combined premiums paid. All long straddle's maximum loss is the premiums paid for the call and the put. Obviously if more than 1 contract was bought, the figure will be higher in dollars. If the above example said 3 contracts were bought. The maximum gain would still be unlimted. The break even points would be the same, but the maximum loss would be tripled. 750 times 3.

Series 7 Topic Tip

Key Things to remember on Long Straddles:

They must involve calls and puts
they must be both bought
the profit is heavy movement so the premiums are covered.
No movement will result in a loss of the contracts are held and allowed to expire.
Remember to count the contracts correctly
There will be 2 break even points

Short Straddles will be talked about in a future post, but feel free to post a question here and we'll be happy to answer it.

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