Options trading and the cost of equity capital
In recent years, volume in the options market has exploded as more and more traders shift over to derivatives trading. Average daily volume for the year was 4. This marked the fourth straight year that volumes exceeded 1 billion contracts on the CBOE. The rising popularity of options comes at a time when volume in the equity market has been falling.
As more and more liquidity migrates into the options market, these derivative products have become fertile ground for individual traders to hunt for profitable opportunities. Options offer a number of advantages compared to other products such as vanilla equities and futures. This product diversity provides traders with a tremendous array of potential strategies and profitable niches within the marketplace.
Not only do traders have a wide variety of different underlying assets to choose from, but within each market there are numerous contract expirations. This allows for a significant number of different strategies to be employed. For example, stock options are now available with weekly expiration dates. These products have become extremely popular in a very short period options trading and the cost of equity capital time.
Options known as LEAPs are on the other end of the timescale, with expirations lasting as long as three years. The most common type of options, however, have monthly expirations. There are two types of basic options contracts, puts and calls.
A put option gives the owner the right to sell a specified amount of an underlying security at a specified price within a specified time. Alternatively, a call option gives the owner the right to buy a specified amount of the underlying security options trading and the cost of equity capital a specified price within a specified time.
Traders can both buy and sell puts and calls to try to generate profits. Many strategies include buying and selling a combination of puts and calls, such as spreads, collars, straddles, strangles, butterflies, and condors. While more advanced options strategies can get complicated, the basics are fairly easy to grasp. Furthermore, many of the most consistently profitable strategies are simple and straightforward.
In addition to the diversity of the options market, there are other distinct advantages to trading these derivatives. In general, call and put options allow traders much more leverage than many other asset classes while also providing the ability to limit risk. This can make options trading an attractive alternative for traders with smaller account sizes. In the case of call options, the profit potential is theoretically unlimited.
It is not uncommon for traders to realize profits which are multiples of their original capital outlay in a short period of time when trading options. This example highlights the leverage available in the options market. While most individual options traders prefer to buy options contracts because of the limited risk and possibility of very large short-term profits, selling options can be a very high probability strategy for traders who are well-capitalized and have a strong understanding of hedging.
In options trading and the cost of equity capital, many of the most successful options trading and the cost of equity capital traders prefer to sell options rather than buy them.
In addition to learning about the wide variety of strategies in the options market, it is important for traders to find the right broker when entering this potentially lucrative arena. Just as importantly, they have the ability to calculate the reduced capital requirements of most hedged options strategies which allows the trader or investor to maximize the use of their capital.
As traders become more experienced, these types of orders and automatic margin requirement calculations are essential. It is also very important to use a broker with very competitive commission rates. Just like options trading and the cost of equity capital the stock or futures markets, profitable short-term strategies will almost always require very low commission rates to reach their full potential. Options provide a multitude of potentially profitable strategies and niches for the enterprising trader who utilizes the diversity and flexibility that is inherent in this rapidly evolving market.
This article is provided for educational purposes only and is not considered to be a recommendation or endorsement of any trading strategy. The author is not affiliated with Lightspeed Trading and the content and perspective is solely attributed to the author. Looking for New Trading Opportunities? Consider the Options Market September 28, Tweet. Navigating Taxes as an Active Trader.
Large Cap Momentum Trading. Open an Account Try a Demo.
In economics and accountingthe cost of capital is the cost of a company's funds both debt and equityor, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital.
Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk; this is the opportunity cost of capital. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation.
However, for projects outside the core business of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of the businesses are not the same. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt options trading and the cost of equity capital the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future.
This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt. Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital WACCcan be calculated.
This WACC can then be used as a discount rate for a project's projected free cash flows to firm. When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt. The cost of debt is computed by taking the rate on a risk-free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases since, all other things being equal, the risk rises as the cost of options trading and the cost of equity capital rises.
Since in most cases debt expense is a deductible expensethe cost of debt is computed on an after-tax basis to make it comparable with the cost of equity earnings are taxed as well. Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as. The cost of equity is inferred by comparing the investment to other investments comparable with similar risk profiles.
It is commonly computed using the capital asset pricing model formula:. The risk free rate is the yield on long term bonds in the particular market, such as government bonds. An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of the Fama—French three-factor model. The expected return or required rate of return for investors can be calculated with the " dividend capitalization model", which is.
The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1. This value cannot be known " ex ante " beforehandbut can be estimated from ex post past returns and past experience with similar firms. Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings internal equity is equal to the cost of equity as explained above. Dividends earnings that are paid to investors and not retained are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
The weighted cost of capital WACC is used in finance to measure a firm's cost of capital. WACC is not dictated by options trading and the cost of equity capital.
Rather, it represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. The total capital for a options trading and the cost of equity capital is the value of its equity for a firm without outstanding warrants and optionsthis is the same as the company's market capitalization plus the cost of its debt the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes.
Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. To options trading and the cost of equity capital the firm's weighted cost of capital, we must first calculate the costs of the individual financing sources: Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital. Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity this is only true for profitable firms, tax breaks are available only to profitable firms.
At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order options trading and the cost of equity capital borrow money.
By utilizing too much options trading and the cost of equity capital in its capital structure, this increased default risk can also drive up the costs for other sources such as retained earnings and preferred stock as well. Management must identify the "optimal mix" of financing — the capital structure where the cost of capital is minimized so that the firm's value can be maximized.
The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin. If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.
From Wikipedia, the free encyclopedia. Weighted average cost of capital. A Practical Guide for Managers, p. Corporate finance and investment banking. At-the-market offering Book building Bookrunner Corporate spin-off Equity carve-out Follow-on offering Greenshoe Reverse Initial public offering Private placement Public offering Rights issue Seasoned equity offering Secondary market offering Underwriting.
Debt restructuring Debtor-in-possession financing Financial sponsor Leveraged buyout Leveraged recapitalization High-yield debt Private equity Project finance. List of investment banks Outline of finance. Retrieved from " https: Options trading and the cost of equity capital Read Options trading and the cost of equity capital View history.