Thursday, November 06, 2008

How am I affected by the tax change to my ESPP?

November 2008: A few months back a respected colleague of mine asked me to comment on the pending, now implemented, tax change to our Employee Stock Purchase Plan (ESPP). Consider this my response.

First let's understand the change. My company offers, as a benefit they proclaim, company stock at a 15% discount of the stock price. For example, if the stock is trading at $25 on the market, we can buy it for $21.25 (i.e. .85 * 25). You have to pre-allocate dollars from your paycheck and can only purchase at the market close of each quarter.

When you sell the stock you must pay income on the 15% the company gave you as a benefit. Before the tax change; if the stock sold for $25, I bought at $21.25 via the ESPP, then turned around and sold it for $25, I'd have to pay income taxes on $3.75.

Moreover, if the stock sold for $25, I bought at $21.25 via the ESPP, then kept it, I wouldn't have to pay any income on the potential gain until I sold it. As a side note, this is what I've done and thus never claimed any income. I'm actually far in the hole and would be able to claim a loss of income if I sold the &%$#@ shares today, Yes, I'm a bit miffed over the ordeal.

This approach is simple and straightforward. However, we all know that it's in our best interest to make taxes complicated and thus, the company ESPP has changed its policy on when income is realized.

After the tax change, income is realized whether you sell or keep the stock. Using the $25 example again; if the stock sold for $25, I bought at $21.25 via the ESPP, then turned around and sold it for $25 OR kept it, I pay income tax on $3.75.

My thoughts on this are twofold. First of all, it complicates your tax situation. You could buy at $21.25, pay income on $3.75 in year 1, then sell for $20 in year 2 and deduct $3.75 in income losses and $1.25 in capital gain losses (if the government differentiates the two) from year 2's taxes. I hope my broker keeps track of this for me, as I won't be smart enough to.

My second though is, you're losing the time value of money. You're paying taxes on $3.75 today, however $3.75 in year one is only worth $3.68 in year 2 (assuming 2% inflation). That sucks.

Overall, the change complicates your taxes and screws you on the time value of money. One should only expect that from big companies and government.

Thursday, October 02, 2008

How did we get in this financial disaster?

October 2008 - A number of you have asked me to opine on the pending financial disaster we're going through. So far my only response has been to not worry about it and just make sure you continue buying stocks. Today as I sit here writing this blog entry, I continue to feel that most of us should buy stock and continue on with our lives. We're in it for the long hall and eventually things will turn around.

I thought it would be good this month to take a look and try to explain, in simple terms, how we got in this mess. I won't try to explain it all as to be honest, I don't really understand all of it. However, I think I understand the basics. Here it goes.

Let's say both Person A and Person B take out $100 mortgages, respectively, to finance a new home. The bank's appraisal agrees that both homes are worth $100 and gives Person A and Person B each a loan. At this point the bank basically owns both houses and expects monthly payments.

The first year goes well for both the home owners and bank. After one year, Person A and Person B have paid off $5 and only owe the bank $95. However, the second year the real-estate market takes a turn for the worse, and both homes drop in value by 10%. That is, now both homes are worth only $90 each. Yet, Person A and Person B owe $95.

This creates a situation where the bank needs $95 in payments for an asset that is worth $90. To complicate matters, both Person A and Person B lose their jobs and are unable to pay their mortgage. Now the bank owns the assets. They paid $100, got $5 in payments, but own houses worth $90 each. Economically, this is considered bad. Unfortunately it only gets worse.

When a bank sells a mortgage (NOTE: I'm using the term bank as an all inclusive term for the mortgage industry) they toss them together and divide up trillions of dollars in mortgages and sell the pieces as securities to investors. Who buys these securities? Those of us looking for a "low risk" investment (e.g. money market funds).

What we have now is banks trying to sell a security, banked by bad mortgages, which nobody knows who much the security is worth. In the example above, is the security worth $200? No, the asset dropped by 10%. Is it worth $180 then? Who knows, the real-estate market could be down another 10% next year and %10 the year after. This uncertainty causes banks to seize up. Investors won't buy securities as they don't know what they're worth. Moreover, banks don't want to lend to other banks as they don't know what the other banks hold in assets. And vice versa.

The mortgage disaster has created fear and thus created a liquidity crisis. People are fearful and money exchange has come to a halt. And when people get fearful and money stops exchanging, bad, bad things happen.

Monday, September 01, 2008

Should I drop Frontier all together?

September 2008 - Below is a complaint letter I sent to Frontier's Management in regards to a recent sales experience I had with them. What do you think I should have done? Left well enough alone and stuck with digital service? Called to revert my services? Cancel Frontier all together and go with Charter phone?

Good afternoon,

My name is Mac Noland and I'm a customer of yours in Apple Valley, MN. A few weeks back a young man showed up at our door on a sunny Saturday afternoon informing us, in so many words, that Frontier may be doing some digging near our house to install new "digital equipment," or something along that line. I cordially thanked him for the heads-up. He then took out a long list of names and said that he could also sign us up for digital service. Being we're not really interested in the digital features (e.g. call waiting) I thanked him again and tried to shake hands.

Not taking my hint, he said that our current phone bill was around $27 dollars. I don't pay out bills, but I remember my wife telling me the monthly charge was around $28 so I figured he was right. He stated; the new digital service was only $24.99 so it would actually be cheaper. My goodness, that does sound like a good deal. So I signed up right away. He then went into internet service at which point I became skeptical (as I usually am) and said that was quite enough. The digital phone would be enough for us today.

Two nights ago, my wife opened our Frontier bill and to my surprise started asking me pointed questions about what I had signed us up for. Our bill went from around $28 to over $40. I looked at the charges and other than around $5 in setup fees, I couldn't find any mistakes. Sure enough, the charge for our new service was $24.99. I then started to read the entire thing (which I've never done) and found that in addition to our $24.99, we are charged around $10 in taxes, and such.

I took all this information and forged my way to the basement where I keep all the old bills. There starring at me was our previous Frontier bill. I opened it up right away and found that, we also paid around $10 in taxes. What was different though, is the price of the service. It was only $17 (or so).

Honestly, I should have done more research before I signed up. It's my fault. However, my entire complaint here is that your service/sales person sold me on the fact that the digital service, and all its amenities, are less expensive than my current services. In fact, they are not.

We actually really liked the digital services. In fact, I had a note to call back about the internet services as I think my cable company is being a bit aggressive with their charges. But instead, I called back two nights ago and reverted my services to what I had before. It's not the dollar about - I'd actually be happy to pay the extra money for call waiting, caller ID, etc. But the young man's disingenuousness upset me. So much, that I decided to revert our services.

If you'd like to talk in person about my complaint I'm more than willing. You can use this email address or look my number up and call me. Again, it's not the dollar amount. It's that your service/sales person was not genuine. And that is frustrating.

Wednesday, July 30, 2008

Should I use Windows Movie Maker?

August 2008 - My wife rarely reads this blog so I’m not concerned about her finding out. However, if you do run into her, try to keep this our little secret.

We have our five year wedding anniversary coming up in about a week. I've never considered myself a great gift buyer (she took back the mother's day gift I gave her and last year's Christmas gifts) so I decided to dust off my creative energy and make something.

The thoughts are to produce one of those photo videos, with music, that shows us before our son, our son, dad with son, mom with son and then our family. It's kind of like those videos you see at weddings where tender music plays while old, sometimes embarrassing, pictures of the groom and bride transition through. We had one and paid (as in dollars) dearly for it.

My dad, who is an Microsoft curriculum instructor at a community college, is a big fan of Microsoft's Movie Maker. I once asked him how he produces his videos and he pontificated for a good half hour about how Movie Maker can do just about everything, including wash his car. Given his backing, I thought we'd give it a try.

Things started off well. I did a short proof of concept (POC) with one Johnny Cash song and about ten pictures that I had locally on my PC. Using Movie Maker, I was able to put the POC together in about fifteen minutes. Thinking I had everything mastered, I started with the gift.

I have about 110 pictures that I imported and started to work with. I dragged them here and there to make sure they were sorted just the way I wanted them. After about an hour, I decided to add some music and then preview it. Seemed to work well except the music was a bit too long. This is where the problems started.

The first problem I had was you can't change the duration of a picture which is added to your timeline. The default is 5 seconds, but if you wanted to make it say 6 seconds (to match up the duration with your song length), you can't. The only way you can do this is delete the picture, change the default duration and then re-add it. Movie Maker is free (or at least priced in the purchase of your OS) so I didn't complain too much. However, when I highlighted the picture to remove and replace it, Movie Maker froze up. This is after an hour of adjusting pictures and not saving. ;)

Now you're probably thinking that I'm an insouciant idiot for not saving my project. I'll give you that. But, it is my belief that software should not just "hang." I shut down all other applications and waited over an hour. Nothing. Thinking that Movie Maker might have saved a temporary copy of the project for me (like Word does), I ended the Movie Maker process and started to sweat.

From what I can tell Movie Maker was able to recover some of my changes, but I can't verify how many. 110 pictures is hard to keep track of, but I did notice a few were out of place. For the next fifteen minutes I started to adjust the pictures again. Low and behold, once again Movie Maker froze on me. Luckily this time I had saved a copy every five minutes.

This entire process went on for about two days (not contiguous of course). I found myself saving the ignominious Movie Maker file after every change I made. It was getting ridiculous.

Oddly, the fact that I had to save the file so often wasn't the turning point in my relationship with Movie Maker. It was the fact you can't change the duration for added pictures. This small, missed feature is at the nexus of my frustration. And given I was adjusting songs (with different lengths) at the same time, I was pulling my hair out.

It was at this point I decided to change vendors and look for a more robust commercial product. Remembering that Adobe had a number of "creative" tools, I checked out their site and found Adobe Photoshop Elements 6.0. I wasn't prepared to pay the $100 purchase price, but I did find a 30 day evaluation. And it was probably the best decision I've ever made.

Not only does Elements provide a far better user experience, you can easily change the picture duration!!! And even better, you can click a button that says something along the line of "Match duration with song length" which automatically adjusts your video slide show. The duration for 110 pictures over three songs is 5.3 seconds (transitions are two seconds). Instead of adding/removing pictures in Movie Maker, all you do is click a button in Elements.

My conclusion is, that I should never use Movie Maker again and buy Adobe Elements. I see Adobe had a video editing software as well called Adobe Premiere Elements 4.0. The best price I've found is from Amazon.

Monday, July 07, 2008

Should I sod or seed my lawn?

July 2008 - For the past month and a half, my wife and I have been working on installing a new concrete patio. While we still have a few things to wait on, finally our hard work has paid off. To be 100% honest, we did outsource a significant part of the construction, but there is work involved in that and I'm counting it.

The majority of our "real work" was tearing out the old wooden deck and landscaping around the new, stamped concrete, patio. Tearing out the deck took, what I would consider, little intellectual thought. The landscaping on the other hand, was both a cerebral and manual challenge.

We have a slight water problem in our basement. When it rains hard, or if snow starts to melt too quick, we end up with water pooled against the back of the house. Even though our basement is poured (rather than blocked), water finds its way in quickly. We only get "seepage," but any water in the basement stinks. Being we were getting a new patio, we thought it would be a good time to use some creative landscaping to help circumvent the water problem.

After pilling two cubic yards of black dirt, we ended up with a small hill separating our lawn from the neighbor's. The goal is for water to hit the hill, then flow either down the West side or South side of the house. In years past it traveled right up to the house with little to stop it.

Now to my point. The new hill, and the area surrounding the patio, needed grass. My wife, who is a fan of alacrity, wanted to sod it. She felt that sod would be the quickest way to get the project finished. Not to her surprise, I took a contrary point of view and felt seeding it would be best. Why you may ask? First of all, when I put the two cubic yards of dirt in, I was very careful to control my depth in relation to the new patio. I wanted the grass height to be short of the patio instead of overhanging it. Second, I was concerned about economics. That is, I had it in my mind that sod was far too expensive. But was it?

Seeing my lawn cost $85 dollars. That's $12 for three pounds of seed, $13 for fertilizer and $50 for an erosion mat. An erosion mat is that green mesh that you put down over seed to keep rain from washing the seed away. The new hill desperately needed one.

Sod at the local Bachman's in Apple Valley is $5 for a 2.5 x 6 foot role. I figure the area we wanted to cover is 250 square feet. Meaning I'd need about 15 rolls for a total of $75. I'm thinking that since my car is pretty small and my wife's is new, we'd need delivery. While I didn't check on prices, let's assume divert is $25 (they are right down the road).

My calculations leave me with seed costing $85 and sod costing $100. Though the numbers are closer that I thought, I went with seed. Today, after learning some of the benefits of sod (better for erosion areas), I may have went with sod. However, the seed was cheater and easier to plant. And if it wasn't for the erosion mat, seeding would have been a no brainier for my small section.

After the grass is in, or if it is washed away and we decide to sod, I'll provide everyone an update on where we're at.

Tuesday, June 03, 2008

What do you learn in a macro-economics class?

June 2008 - This last semester I finished up with my first, and probably last, macro economics course. The professor was a bit absentminded and self-absorbed, but I learned some interesting information. In case you don't have plans to take a graduate macro course, which I can understand, let's see if I can give you a quick run down. It might save you money and time.

The course started off with a review of the Federal Reserve System. All you need to remember here is that there are 12 members of the Federal Open Market Committee. Eight of them are permanent, while the other four rotate. Ben S. Bernanke is the Chairman. If you wish to sound knowledgeable at cocktail hour, he's the only one you need to remember.

The goals of the Fed are simple. They want to keep unemployment low (less than 5% works), keep inflation low (around 2%) and keep moderate short-term interest rates. How do they do this? The current approach is to expand or contract the money supply. The Fed controls the money supply by setting the Fed Funds rate, which is the interest rate banks charge other banks for borrowing money. Or setting the Discount rate, which is the interest rate the Fed charges banks for borrowing money. After learning what the U.S. Fed does, you may study the Bank of Japan and European Central Bank. The operate similarly, with slightly more emphasis on inflation (i.e. price stability).

Next on the syllabus is growth. That is, why and how do countries grow. It's become common thought that growth is good. And for the most part, macro economic data show that a people's quality of life increases as they become wealthier. Date show money does buy happiness.

Growth is complicated, so any good macro class will simplify it. We studied labor policies, inflation and fiscal policy. Think of labor policies as how hard it is to hire and fire people. The data show that on average, gross domestic product (GDP) grows faster if companies can fire people without too much hassle. A harsh reality, but true. Inflation is pretty straight forward. Countries with hyper-inflation (e.g. Argentina) have difficulty growing because inflation strains the economy. The exchange of currency becomes inefficient. Lastly is fiscal policy, which may be the most important aspect of responsible government. If a country wants to growth their GDP, they can't spend, spend, spend. Countries need a stable balance sheet to be successful. That's why the pundits are concerned about the U.S. right now. We've got a lot of debt and seem to be increasing it.

After growth is business cycles. What's more important, aggregate demand or aggregate supply? They are both equally important. Aggregate demand is the total demand for all goods and services. As a country grows, demand increases. Aggregate supply is the total supply of all goods and services. Aggregate demand and supply balance each other in a sense. If the demand curve increases, prices will increase until the supply curve adjusts back to the steady state. If that is confusing, which it may be, here is an example. If everyone started drinking Summit beer (a reasonable presumption), the demand of Summit would increase. In the short-term the price of Summit would increase. But eventually the smart suites at Summit will increase supply, thus pushing the price back to the steady state. And if they don’t, brewers like Surly will increase supply to fill the void.

The last major macro subject we studied was exchange rates. If you've never dealt with exchange rates, get ready to be royally confused. Just kidding. Once you get a handle on them, they are not so intimidating. Just think of exchange rates as this; given one U.S. dollar, how many Euros would you be given today? As of this writing, you'd get 65 cents. Last year you'd get 75 cents. The dollar has depreciated against the Euro by 10 cents (13.5% if you're wondering). Help on exchange rates can be found at Punch in some random numbers against the dollar and see how far it has fallen in recent years. This is why your foreign funds have been doing so well!

A macro class will go into greater detail than I have in this short write-up. However, these are the basic subjects you'll cover and I'm not charging you $900 dollars a credit.

Friday, May 02, 2008

Why are my international investments doing so well?

May 2008 - Do you ever wonder why, lately, your foreign investments seem to grow at 20-30% while your domestic ones grow closer to 10%? For example my American European Pacific Growth Fund has an annualized three year return of almost 20%. On the contrary, my Growth Fund of America fund has a three year annualized return of 12.47%. Are the international companies that much better than American ones? No. Have international companies found unexplored markets with endless growth? No. So what is happening?

While a youngster in college, I joined a large group of friends that went to spring break in Mexico. I actually did it three times, and only remember bits and pieces of each of them. If you throw out drinking and socializing with friends and new friends, exchanging money was my favorite activity. For some reason I really enjoyed walking up to the exchange window and cashing in my U.S. dollars or Travelers Checks for paper with a picture of some Mexican nobles.

Back then I could get eight Mexican pesos for a dollar. That would buy you three to four beers on the beach, if I remember right. I just checked and today you get 10.5. That is, the dollar as appreciated 24% against the peso since my college days.

Now, let's say that I met a seemingly successful business woman or man in Mexico and invested one dollar in their company, or in other words bought one share of stock for eight pesos. And for simplicity, let's say that things didn’t turn out as expected with the business and they only covered their expenses for the past ten (or so) years. That is, my eight pesos have just been setting there not gaining any equity leaving my stock worth eight pesos. Having enough with that investment, today I decide to take my eight pesos back. Well guess what, the eight pesos they give me now is only worth 76 cents. Hey, I just lost 24 cents on this investment, yet my stock price did not change?

Let's take this example and reverse it. Say I'm a Mexican and went to Minnesota for spring break (yes that would be crazy) and made a similar investment. That is, I purchased a one dollar stock for eight pesos. And now ten years later, I wanted to sell my one dollar stock and get my pesos back. Since the dollar had appreciated 24% against the peso, when I sell my one dollar stock I get 10.5 pesos back. Hey, I just made a 24% return!

This simple example explains why my (and your) foreign investments have been doing so well. The dollar has been depreciating the past few years, which made foreign returns look bigger than they actually were.

Should we continue to invest internationally? I argue that you should be globally diversified, meaning you should continue to invest a portion of your assets globally. However, remember that some day the dollar may appreciate again and you could end up taking a major hit. Keep that in mind before you toss all your savings into an international investment.

Thursday, March 27, 2008

How do you create a round-robin schedule?

April 2008 - This year we've added two more teams, for a total of ten, to the golf league I run. Being our regular season is fourteen weeks, putting together a round-robin schedule in the past for eight teams was pretty easy. Each team plays each other twice. Now that we have ten teams, cramming us all in fourteen weeks is a bit more difficult.

I spent a few hours trying to figure out how to setup a round robin schedule. After frustrating the hell out of myself, I broke down and asked Wikipedia. The first search I ran, gave me the algorithm that I needed.

Thinking back on it, it's actually pretty simply. I started by creating a spread-sheet and matched up 1-2, 3-4, etc. Then I simply held the "1" team constant, and used the algorithm to rotate each team around in a circle. It looked something like this as I went through.



If you do this nine times, each team of the ten will play each other. When you do it the tenth time, you'll find yourself back at the beginning. Finding this exercise fun, I simply followed the algorithm a total of fourteen times to give us our regular season. That means each team will play each other once. Then you'll play five other teams twice. Not ideal, but it works.

Once I had the schedule in place, I had to assign team names to 1, 2, 3, etc. I thought about drawing numbers out of hat like last year, but my wife was uninterested in helping me out and when trying a sample drawing with my seven-month-old son, he started to eat the numbers. Being I've spent a significant amount of my career and education working with technology, I fired up the spread-sheet program again and used a random number generator to rank the teams. Mentally Handicap came in at the lowest (0.378373293) which made them team "1". Brad Smith's new team, Missing Links, was the highest (9.788895237) and thus was the "10" team.

At this point I needed a cold beverage to celebrate. As I cracked a cold Surly, my wife said "why does the "1" team always golf first?" She had a point; our tee-times needed to be ranked. To do this I went back to the random number generator and created a ranking for each week. The lowest random number got the first tee-time (3:44) while the highest got the last (4:48). Now you'd think that a random number generator would equally space each team so we don't have the same teams always teeing off at the same time. Apparently this is tougher than expected though so I had to manually adjust five to six times so that we didn't have Noonan! teeing off at 3:44 every week.

After ranking the tee-times, I started sipping on my Surly, admired the creation and started thinking about all the shots I plan on shanking. Happy golf season!

Monday, March 03, 2008

What causes inflation?

March 2008 - This morning I heard a local bread baker say their flower prices have went from nine dollars a bag (not sure how big the bag is) to twenty nine dollars a bag in the past year. This confirms my local pizza guy's claim when he said their food costs have doubled in the past year. So this got me wondering, what causes these prices to inflate?

Appropriately enough, I'm taking a class called World Economy from the University of Minnesota. The first section covered how the Federal Reserve Board works. The second section is on inflation. Could my registration in this class be fate?

From what we've learned, inflation is when the value of a monetary representation (e.g. dollar) looses purchasing power. Remember that age old saying "a dollar today is worth more than a dollar tomorrow?" It's kind of annoying, but all too true. Every day, money looses value due to inflation. The percentage that is lost, fluctuates. Let's look at why.

Governments love to spend money. Defense, welfare presidential parties; they call cost money and someone has to pay for them. Similar to a fiscally responsible person or family, a fiscally responsible government will spend only what it can afford. We all know that the government is hardly ever fiscally responsible though, and so they have a propensity to run deficits.

Once a government has a deficit they have to pay for it. This can only be done on two ways; raise taxes or print money. Everyone knows how political raising taxes is. Many of us Republicans will vote a person out of office for even thinking of such a thing. And though I don't agree with the Republicans all the time, raising taxes will harm growth.

The other way to pay for a deficit is to print money. Basically this means increasing the money supply. Wouldn't it be nice if it was that easy? Just print money and everything is kosher again. Bills are paid and we can start spending once again. Sound too good to be true? It is.

When the money supply is increased, the value of existing money goes down. That's a fundamental of economics. Supply goes up, price goes down. Money is no different.

So where does this leave us? The U.S. government is running a deficient right now. In the long-term we can pay for this by raising taxes or printing more money. In the short term, we're paying by borrowing. Borrowing will only last so long. At some point, we'll need to pay.

Since raising taxes is so political, the only way to deal with our growing deficit is to increase the money supply. Meaning that our free government's free spending will eventually lead to higher inflation. Looks like that pizza guy down the road might have to raise prices even more in the near future.

Saturday, February 02, 2008

What interest rate does the fed cut?

February 2008 - Most of you have heard that the "Federal Reserve Bank (I'll use fed from here on) cut interest rates by 50 basis points" this past week. What the heck does that mean? Hopefully I can provide some clear insight for you.

First of all, there is not one interest rate. There are two. The discount rate and the Fed Funds rate, respectively. Both are different. And how the fed adjusts them is very different. Let's start with the discount rate which is easier to understand.

In this example you're a bank. You lend money to your mom, dad and lazy brother (if you're wondering, none of my brothers are lazy in reality). Mom and dad pay back their loan, but your lazy brother defaults. As it turns out, the asset backing the loan (e.g. house) has depreciated. Meaning you, as the bank, paid more for what you're getting in return after your lazy brother files for bankruptcy. Remind you of the current subprime mortgage issue? It should.

The bad loan made to your lazy brother puts you in a crisis. You just lost a ton of money and now to stay on your feet, you need to take a loan out yourself. This is where the fed comes to your rescue.

We all need banks. Even banks need banks. And when a bank needs to get a loan from their bank (i.e. the fed), they can loan money from the fed at the discount rate. That is, the discount rate is the interest rate banks get charged for borrowing money from the fed. Wouldn't it be nice to have a line of credit from the fed!

Now the Fed Funds rate is a bit different. The Fed Funds rate is simply the interest rate that banks charge other banks. Remember that lazy brother that put your bank in a crisis? Well to cover your losses, you could borrow the money from another bank instead of the fed. In fact, in recent history, borrowing money from the fed has been a sign of weakness. Thus, most banks prefer to lend from their contemporaries instead of crawling into the fed and talking to Bernanke.

The fed does not set the Fed Funds rate, but they do strongly influence it. This gets a bit complicated, so I'll try to keep it real simple. Remember supply and demand from college? Supply goes up, prices go down. Supply goes down, prices go up. Keep this in mind as you follow me.

If the fed purchases Treasury Bills from the market the amount of money available is increased. That is, the money supply goes up. As the money supply goes up, interest rates go down. The inverses is also true. If the fed sells Treasure Bills, they collect the money thus reducing the money supply. Reducing the supply of money, makes prices go up. That is, the interest rate goes up.

Understanding the Fed Funds rate is confusing, I totally admit. Even after taking almost three years of business classes, I'm not 100% sure I even understand it. But don't worry. You don't really need to understand all this. And if you don't, you're in good company as most people simply know that if the fed raises or lowers some interest rate, their interest rates (e.g. car, CD, money market) will most likely go up or down as well.

Here we have it. Next time the fed decides to cut an interest rate, first find out which one, and second remember back to my blog when we opened this conversation.

Wednesday, January 02, 2008

What are financial "options" and why do I care?

If you take a second level finance course in college you're probably going to run across discussing financial options. And if you're like me, you're going to be flustered, to say the least.

There are a myriad of sites and books on options. They are all full of confusing information. But you've got to struggle through them as they are actually quite important. Now that I've scared you, let me take a shot at explaining finance options and why you should care about them.

There are two types, call and put and they are related to a stock. Morningstar has a number of Google call and put options you can buy and sell just like stock. Today we'll just be discussing buying as it's much similar to understand. If I get time in the future I'll discuss selling, but to be honest, once you understanding buying you might be able to figure out selling on your own.

If you buy a call option (again just like stock) you have the right to buy stock at the option's exercise price. For example, let's say you buy a call option with an exercise price of $10. When the call option expires (i.e. when you get buy it), you have the right to buy the stock at $10. If the stock is currently trading at $15, then you exercise the call option (i.e. you buy the stock for $10) and make $5. If the stock is currently trading at $5, then you don't exercise the option (i.e. you don’t buy the stock for $10) and you simply walk away. Easy right!

Now let's switch to puts. If you buy a put, you have the right to sell the stock at the option's exercise price. Let's stick with our $10 option. If the stock is worth $5, then you'd exercise the options and sell your stock for $10. You're in the money and just made $5! However, if the stock is worth $15, then you don't want to sell it for $10 as you'd be losing money. The stock is worth $15 on the market!

Basically it comes down to this: If you think the stock is going to go up, buy a call. If you think the stock is going to go down, buy a put.

So why do we have options and what can they do for us? Honestly, to the average investor, they don't do anything for us. However, indirectly they help us as our investments (e.g. mutual funds) use them all the time. One example is to hedge a stock to protect it from losing too much value. Or worst, all it's value.

Let's say you buy a stock for $10. Because you have a mob of angry investors that have trusted you with their money, you can't afford to have the stock go under $5. If it does, they loose their retirement and you lose your job. So what do you do? You buy a put option that allows you to sell the stock at $5 no matter how low it goes. For example, if the stock goes to $0, you can still sell it for $5. Buying the put is simply insurance on the stock.

I hope these two simple call and put options help you get started understanding this arcane subject. If your ebullient curiosity is asking for more, Yahoo has a nice site for learning more about options. Enjoy!