Delta, Theta, Gamma and Vega in trading options or stocks

The ancient Greeks are justly praised for inventing much of elementary mathematics. But it was left to moderns to create the tools that help options traders quantify risk and calculate prices. Chief among these tools are several quantities known fondly as The Greeks: delta, theta, gamma and vega.

While the underlying mathematics is heavy going, the basic concepts are simple and can be used by any trader to help measure risk and maximize profits.

The Greeks are based on factors that common sense would suggest affect the price of an option. The determinants are the underlying asset’s market price, the option strike price, the time left to expiration, volatility and short-term interest rates. All these pieces of data are readily available and it’s clear why they would affect an option’s value.

Take the strike price for example. That’s the contractually specified price at which the asset, say a stock, would have to be bought or sold if the option were exercised.

Suppose MSFT (Microsoft) were selling at $28 per share and the option considered was a June 31 call. (Note: the ’31′ refers to the strike price, not the date on which the option expires.) This option is ‘out-of-the-money’ since the strike price is higher than the current market price.

Clearly, the price of the option itself (the ‘premium’) will be affected by just how far out-of-the-money the option is. One measure of this difference is the first Greek: delta.

Not a simple difference, the delta is a ratio which compares the change in price of the asset to the change in price of the option. For example, if the delta in the above example were 0.7, for every $1 rise in MSFT the call option can be expected to increase by 70 cents ($0.70).

A trader doesn’t need to know how to calculate it, only how to use it. (Any good options trading software will show all four Greeks, along with price, expiration, etc.) Delta tends to increase the closer the option is to expiration for those close to in-the-money. Delta is also affected by changes in implied volatility. (The latter is also frequently provided by trading software.)

Theta measures what is sometimes referred to as the ‘time decay’ of an option. Since all have an expiration date, and since the less time left the less likely the market price will move in a desired direction, theta is a measure of risk and value.

Suppose that MSFT June 31 call were priced at $3 and the theta were 0.5. Then, in theory, the value of the option would drop by 50 cents ($0.50) per day.

As expiration nears, the price for a premium can be expected to decline at a faster rate. An option with, say, two days left is losing value quicker than one with three months remaining. That change is reflected in the value of theta.

How to read options values and prices?

Unlike stocks, options have an expiration date. Unless a company goes bankrupt or buys back all its stock, the stock investor always has the choice to wait for a price correction. Sometimes that wait represents the triumph of hope over experience, but more on that elsewhere.

That expiration date makes calculating an option’s value more complicated, but also more accessible to some of the powerful statistical tools developed over the last few decades.

Two of the more common methods for evaluating options involve measuring their intrinsic value and their time value.

The ‘intrinsic value’ is the amount by which the option’s strike price is ‘in-the-money’. Strike price is the contractually set price at which the underlying asset would be bought or sold, if the option were exercised. ‘In-the-money’ means the strike price is lower (for a call option) and higher (for a put option) than the current market price.

For call options: IV = Asset Market Price – Call Strike Price

Since options have an expiration date, but are purchased on some prior date their value changes as the expiration date nears. That change in time results in a decay of the value of the option as a trading instrument.

An option with two days remaining is generally worth less than one that gives the investor three months to act. At expiration the option is either in-the-money, in which case profits are possible, or it’s out-of-the-money and the investor incurs a potential loss.

Time value is the amount by which the price of an option exceeds its intrinsic value.

For call options: TV = Call Premium – Intrinsic Value

[For put options:

IV = Put Strike Price – Asset Market Price

TV = Put Premium – Intrinsic Value

Note: The 'premium' is simply the cost of the call or put.]

For options that are ‘at-the-money’ (strike price = current price), or ‘out-of-the-money’ (strike price higher/lower (call/put) than current market price) the option has no intrinsic worth at that time. It only acquires value in so far as the market price can change, i.e. it has only time value.

For example, suppose MSFT (Microsoft) has a current market price per share of $27 for a June 30 call. The ’30′ refers to the strike price, not the expiration date. If the premium is $2, the option is out-of-the-money – since: $27 – ($30 + $2) = -$5.

I.e. if you bought the call and exercised it immediately you’d lose five dollars (plus commission costs).

Since, the option has no intrinsic value (negative intrinsic value isn’t allowed), why would anyone execute such a trade?

Because an out-of-the-money is less expensive than one in the money and the further out-of-the money the cheaper it is. There are many trading strategies that utilize this fact as a hedge or for potential profit. Given a three month period, the market price may well rise to more than cover the premium and produce a profit. That’s what makes options trading speculative.

Hedging

Options – Hedging, Trim Risks Not Bushes

Options are frequently used in hedging.

A hedge is an investment made to offset the risk incurred by entering another investment. Ironically, the basic idea is to bet against oneself, in a way.

Speculate that the market price will rise in the future and buy a call today. (A call is an option that confers the right to buy an asset at a set price in the future.) But, knowing that any price rise is uncertain, simultaneously buy a put. (A put is an option to sell at a preset price in the future.)

Now, why would anybody do such a crazy thing?

Well, hedging is, at bottom, a form of insurance. Though there are traders who use it more actively as a profit seeking strategy, such as hedge fund managers. By carefully selecting the appropriate combinations of strike price, expiration date and type of option an investor can minimize risk and maximize the probability of making a profit.

How?

As an example, we’ll consider a common hedging strategy: the Strangle. No, that’s not something you do to your broker. That would be increasing risk, not minimizing it.

In this strategy, an investor holds both call and put options with the same maturity, but with different strike prices.

The contracts are purchased ‘out of the money’ and are therefore cheaper. ‘Out of the money’ means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the current market price.

Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)

If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options. Therefore the risk (‘exposure’) is limited to $500.

Suppose the price drops near expiration to $15. The call would expire worthless, but the put is worth ($25-$15) x 100 = $1000 – ($2 x 100) = $800. Subtract the cost of the call, $800 – $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.

The difference between the exposure and the potential profit represents a kind of hedge. Though the investor is, in a sense, ‘betting’ that the price could go either way, his downside is limited to the combined cost of the put and the call.

There are, not surprisingly, nearly as many hedging strategies as there are investors. A couple of common types are:

The collar: Hold the underlying asset and simultaneously both buy a put and sell a call of the same asset. The short call limits gains, but the long put hedges against any losses from the underlying asset.

The protective put: Buy the asset and also buy a put option on the same asset. At expiration, the asset may have gained (eliminating the value of the put option), but the rise in the asset offsets the loss.

Exotic combinations abound, but most involve speculating on the price direction of the underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. As with any investment strategy, make sure you understand the pros and cons before laying down your bet.

Options – Calls and Puts

Many readers want to know more details on Options calls and puts. So here is more information on this.

Options are contracts on some underlying trading instrument – shares of stock, bonds, a commodity, a mortgage loan, etc. (The list is endless.)

But regardless of what the option is on, there are common features. One of the most basic is the contract feature specifying what the option owner has actually contracted for.

CALLs

A ‘call’ confers on the (option) contract holder the right to buy an asset at a stated price on or before a specified expiration date. A right to buy, not an obligation. The call owner always has the option to let his option expire. (Of course, he then loses the initial money invested in buying the contract.)

Call buyers are betting the underlying asset – the stock, bond, commodity, etc – will increase in price before the expiration date. And, not only rise, but rise enough to make a profit.

How much is enough?

The price must rise enough to cover the difference between the market price and the strike price (the price at which the stock, say, must be bought). And, since the option itself has a cost, the price has to rise enough to cover that additional amount. That cost is called ‘the premium’.

The cost (the premium) of an option – whether call or put – is determined by several factors, including the price of the underlying asset, the strike price, the time remaining on the option, and others.

(The time remaining is particularly important. Simple common sense suggests that if you have 90 days to exercise an option, your risk is lower than if you have only one day. In 90 days the price may well rise the several points needed to generate a profit. With only one day remaining, the odds are lower.)

Suppose it’s April 1, for example, and Microsoft (MSFT) has a market price of $27. Call options for June 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.

So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you’ve made $200. ($35 – ($30+$3) = $2 per share x 100 shares, ignoring commissions.)

When the market price of a share is above the strike price, the option holder is ‘in the money’. If the market price is lower, he’s ‘out of the money’.

PUTs

A ‘put’, by contrast, gives the option buyer the right to sell an asset at a certain price by a stated date. The right, not the obligation.

Puts are similar to ‘shorting stock’, in this sense. Put buyers are betting the stock price will fall before the option expires.

In this case the market price must fall below the strike price in order to garner a profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is ‘in the money’.

For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Then, buy 100 shares at $25 per share = $2,500 to repay broker ‘loan’ (since shorting stock involves borrowing shares you don’t own, then repaying later).

Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Therefore, your profit = ($3000 – $2500) – ($300) = $200.

(Actually, the broker takes care of all the underlying mechanics. The investor merely orders the trades at a given time and date.)

Whether investing in calls or puts, wise investors do the needed homework. Options trading is risky and somewhat more complicated than simple stock trading. (Which is already complicated and risky enough.)

Study the history, volatility, and other factors of both the option contract and the underlying asset. Blindly throwing darts at a board is the best strategy for losing money.

Options – Calls and Puts

Many readers wanted me to go through the fundamentals of Options. Here you go :-

Options – Calls and Puts

A ‘call’ confers on the (option) contract holder the right to buy an asset at a stated price on or before a specified expiration date. A right to buy, not an obligation. The call owner always has the option to let his option expire. Remember when you buy a call, you have the right and not an obligation. This is very important; basically you don’t risk anything other than the premium.

Call buyers are betting the underlying asset – the stock, bond, commodity, etc – will increase in price before the expiration date. And, not only rise, but rise enough to make a profit.

How much is enough?

The price must rise enough to cover the difference between the market price and the strike price (the price at which the stock, say, must be bought). And, since the option itself has a cost, the price has to rise enough to cover that additional amount. That cost is called ‘the premium’.

The cost (the premium) of an option – whether call or put – is determined by several factors, including the price of the underlying asset, the strike price, the time remaining on the option, and others.

(The time remaining is particularly important. Simple common sense suggests that if you have 90 days to exercise an option, your risk is lower than if you have only one day. In 90 days the price may well rise the several points needed to generate a profit. With only one day remaining, the odds are lower.)

Suppose it’s April 1, for example, and Apple (AAPL) has a market price of $27. Call options for June 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.

So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you’ve made $200. ($35 – ($30+$3) = $2 per share x 100 shares, ignoring commissions.)

When the market price of a share is above the strike price, the option holder is ‘in the money’. If the market price is lower, he’s ‘out of the money’.

Why buy PUTs instead of shorting a stock?

A ‘put’, by contrast, gives the option buyer the right to sell an asset at a certain price by a stated date. The right, not the obligation. Again important; you have the right and not the obligation; the risk you have is the premium you paid and that is all.

Puts are similar to ‘shorting stock’, in this sense. Put buyers are betting the stock price will fall before the option expires.

In this case the market price must fall below the strike price in order to garner a profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is ‘in the money’.

For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Then, buy 100 shares at $25 per share = $2,500 to repay broker ‘loan’ (since shorting stock involves borrowing shares you don’t own, then repaying later).

Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Therefore, your profit = ($3000 – $2500) – ($300) = $200.

(Actually, the broker takes care of all the underlying mechanics. The investor merely orders the trades at a given time and date.)

Remember that options trading is very risky and you may lose all your premium but the returns are wonderful

Stock Splits and how you can profit from it!

When a company’s stock prices goes to all time, it splits to make it easier for people to buy. So for example when Apple stock goes to around 90 (typically), the company announces a 2 for 1 stock split; basically you get 2 stocks for every stock you own. So if you own 100 stocks before the split, you will have 200 stocks after the split with each stock worth $45.

So what is the great thing about stock splits? Usually the stock that split tend to appreciate in price rapidly compared to other company stocks. For example when Apple splits last time, it has almost doubled and now nearing the same peak.

If you invest on stocks that are about to split, you will most probably be a winner. You can also play your options skill for stocks that are going to split. When stock splits, options also splits. For example if you have an option for Apple stock for $90 expiring in Jan 2008, after the split you get 2 options with a target price of $45 expiring in Jan 2008. The returns on options is spectacular on stock splits .

There are many websites offering “prediction” on stock splits based on the history. One of the website I use is www.stocksplits.net. It is expensive though (about $90 per month) but worth even if you make money on one stock.

Good luck on your investment and feel free to contact us for any questions.

CD Investment Ideas

Many readers especially those who are retired are asking me some investing ideas with CDs; I have analyzed few offers and found one from www.everbank.com looks good. This CD they are offering is from Iceland and it gives APY of 8.24%. The minimum investment is $10,000. There are no monthly fees, FDIC insurance, online access and you get a good support.

I have been using everbank.com for my business account and I am quite happy with their service. Plase check it out and taalk to one of the investment specialists

As always good luck and make decisions with your head!

Some more resources on Options

Many readers have contacted me to learn more about options; I will be adding links where our readers can learn more about options and make more profit.

Here is a page from Fidelity where you can find valueable information.

http://personal.fidelity.com/products/stocksbonds/content/options.shtml

Good luck!

Turbo charge your profits with Options

I know many people who trade stocks. Most of the US house holds have stocks in various companies. Have you tried options?

Many people think Options are only for professional traders and the big boys. It is not so. Let me explain in simple terms what are the pros and cons of options.

Here is how the option works. Assume that you see a house in your street and the owner is planning to sell it retiring and moving to Florida within one year. The current market price for the house is $215,000. You go and talk to the owner Brad and tell him “Hi Brad; I would like to lock in this house for the price of $220,000; I will have the right to buy this house for this price for one year (i.e. till December 2006). For this I will pay you $2000.”. Now you and Brad come to an agreement; Brad gives you the right but not an obligation to buy the house till December 2006 at a price of 220,000. You have the right and not the obligation that is important which means if the house price goes down you don’t need to buy it at 220K.

Now in end of 2006, the house prices came up and now Brad’s house is now worth $235,000. Now you call a real estate agent sell it for 235,000 and give 220,000 to Brad and pocket a profit of 15,000 (minus your option premium of $1000). So your net profit is $14,000 on an investment of $1000. That is like 1400% return on your money.

If you had bought the house at 215,000 and sell it for 235,000 you might have made 20,000 or about 10% return on your money.

Let us consider the story of Bob Stock and Jim Option. Bob always invests in stocks and Jim invests in stocks and options. In January 2005 both Bob and Jim wanted to invest in Apple. At that time let us assume the price was about $40. Bob bought 100 shares of apple at $4000. Jim the wise guy bought 1 option of Apple at a strike price of $50 expiring in Jan 2006 at a price of $200.

Now let us see the technical definition of this option
· Number of contracts – 1 contract gives you the right for 100 stock
· Strike price – The price at which the option becomes “in money” meaning you start making profit from when the stock achieve this price
· Expiration date: Options are not for every; they have expiration date. The option bought by Jim expires in Jan 2006; that is if the apple stock does not go above $50 Jim loses every thing (in this case $200).

Now in December of 2005, Apple price doubled and is around $90 (including splits). Bob made $5000 and Jim made $4000. Bob’s return is 125% whereas Jims return is 2000% or Jim made 20 times of the money he invested.

Story of Bob Stock and Jim Option:-

Date Comments
Jan 2005 Apple stock is $40. Bob and Jim Likes Apple stock. Apple stock is $40. Bob buys 100 stock for $4000 Jim buys 1 option of Apple for a strike price of $50 ; he paid $200 for the option

Dec 2005 Apple stock is $90 (Adjusted for Split) Bob sells Apple for $9000 and gets a profit of $5000 from an investment of $4000. Jim sells his option for $4000 from an investment of $200. Return on investment for Jim is 2000% and for Bob it is 125%.

So what are the negative things of Options; one thing for sure is unless your bet is right you lose the premium and that is all. So your portfolio should contain both Stock and Options.

Investing in the Stock Market by Charles M. O’Melia

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Investing in the Stock Market

by: Charles M. O’Melia

From the book ‘The Stockopoly Plan’ by the author Charles M. O’Melia
There are several factors an investor in the stock market should consider:
1. All stock purchases should be commission-free.
2. All stocks purchased should be from a company that has a history of raising their dividends every year.
3. The company should not only have a history of raising their dividend every year, but should also show price appreciation in the market place, on a year to year basis.
4. All dividends from the companies should be rolled-over into more shares of the company, until retirement. This should be done by the company, for the shareholder, commission- free.
5. The companies purchased should have staggered dividend pay-out dates so the income from 12 companies will provide the shareholder cash dividend income every week of the year. No more than 12 companies should be owned, otherwise, you’re probably spreading your money too thin.
6. A systematic approach of dollar-cost averaging should be done on a quarterly basis. A savings plan should be adopted to add to your holdings every quarter, along with the dividend reinvestment.
7. Stocks purchased should pay a dividend yield of at least 2.0% or better. A low 2.0% dividend yield isn’t necessarily bad because it means the company in question is using most of their profits too expand. In other words, it’s a growth stock with business, profits and earnings growing. A growth stock makes up for the lower dividend yield because their stock prices will more than likely rise faster.
8. The company should have been in business at least eight years, showing dividend increases each year. This will eliminate the risk involved in putting money into a risky new start up company (the kind that is going to change the world – they are just too hard to find).
9. The company must have a stock dividend reinvestment plan (DRIP). If the dividend paid by the company is $2.63 for the quarter, all of that $2.63 will purchase a further percentage of shares (partial shares) and this should be done automatically for you by the company or their Transfer Agent.
10. The companies you purchase should be purchased with the intent of realizing ever-increasing cash dividends for you and your family for the rest of your lives.
Everything you would need to know to start an investment program which emphasizes the considerations above is explained to you in my book ‘The Stockopoly Plan’, soon to be published by American-Book Publishing.
Below is an excerpt from the book I would like to share with you!
Have you ever noticed how some words in the English language are so perfectly named for what they describe? And how some words seem to be, I guess you could say backwards? For instance, the word sunflower! How wonderfully aptly named is the sunflower, that beautiful yellow flower that follows the sun from sunrise to sunset. And then there are those words in the English language where there meaning appears to be backward, so to speak – like parkway and driveway. When my car is parked at home, I would think it would be parked on, well, a parkway – and when I’m on the road driving somewhere, I would think I’d be driving on a – a driveway.
In the stock market world, I think the word analyst is a perfect word in the English language and stockbroker sounds right to me, too. And this leads me to what I call the ‘brainwashing mantras’ of Wall Street.
The brainwashing mantras of Wall Street may take the form of a number, such as a stock rating of 1, 2, 3 etc. Or the mantras may be a star, 1 star, 2 stars etc. The mantras may be a word or a group of words- attractive, unattractive, neutral, market perform, market out-perform, market under-perform, market under-weight, market equal weight, market over-weight, sector perform, strong buy, buy, sell, strong sell.
These mantras are so ingrained in Wall Street and investor’s minds that they have created multi-billion dollar industries. There are other types of mantras, such as RSI (relative strength index – a trading volume indicator), Bollinger Bands (named after its creator John Bollinger (he use to be a regular on CNBC) and the bands deal with the channels a stock trades in, in relation to its ‘moving average’- another mantra), Stochastics (used to tell if a stock is 75 % overbought – too many people have been buying) or 25% oversold (too many people have been selling), Momentum, MACD (Moving Average Convergence/Divergence – price of the stock, up or down, in relation to its moving average), 50 day, 200 day moving averages, triple bottoms and tops, pendants, flags, bear and bull markets, head and shoulders formations, double bottoms, P/E ratios etc, etc, etc. All these mantras serve a purpose (and if you’re inclined to trade in the market they are, I admit, useful tools) – they create commissions. And in my opinion, have no meaning what-so-ever for the long-term, dollar-cost averaging, buying investor of company’s shares, free of commission charges, whose companies raise their dividend every year, with the investor’s idea or purpose being to provide an 85% tax-free income, through ever-increasing dividends for the rest of their lives, no matter what the price of the stock at any given time in the market place may be. (Whew! What a sentence!)
For more excerpts from the book ‘The Stockopoly Plan’ visit http://www.thestockopolyplan.com

About The Author

Charles M. O’Melia – an individual investor with almost 40 years of experience and passion for the stock market. Author of the book ‘The Stockopoly Plan’, soon to be released by American-Book Publishing.

charles@thestockopolyplan.com

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Mutual Funds: What Investors Need to Know About Morningstar Mutual Fund Fiduciary Grades by Sam Subramanian

Mutual Funds: What Investors Need to Know About Morningstar Mutual Fund Fiduciary Grades

by: Sam Subramanian

Morningstar now provides Fiduciary Grades on mutual funds. How does Morningstar determine these grades? How can mutual fund investors use these grades to better manage their portfolios?
Mutual fund investors use Morningstar Ratingâ„¢ as a sign post of mutual fund performance. These ratings have proved to be a valuable tool for objectively comparing the performances of different mutual funds.
In 2003, New York Attorney General, Elliott Spitzer launched actions against some mutual fund companies for allowing their privileged clients to profit from improper activities such as late trading.
In the aftermath of these developments, investors realize that they need more than the historical performance based Morningstar Ratings to evaluate mutual funds. The Morningstar Ratings do not get at critical intangibles. How seriously does the mutual fund company take its fiduciary responsibility to mutual fund investors? How aligned are the interests of the mutual fund manager and the mutual fund company with those of the mutual fund investor?
To address this need, Morningstar has embarked on a system called the Fiduciary Grade. Morningstar has so far graded about 635 mutual funds, including 500 of the largest ones. Morningstar plans to provide Fiduciary Grades for a total of 2000 mutual funds over time.
The Morningstar Fiduciary Grade System Basics
The Morningstar Fiduciary Grade is based on the evaluation of five areas critical for mutual fund governance and mutual fund operations. Morningstar generally assigns to mutual funds points ranging from 0 (Very Poor) to 2 (Excellent) in increments of 0.5 for each of these five areas.
1. Regulatory Issues: Morningstar examines if the mutual fund company has had any regulatory issues within the past three years. If so, what corrective action has the mutual fund company implemented? Unlike the other four areas, the minimum score here can be a minus 2.
2. Board Quality: Morningstar looks for a demonstrated track record of the mutual fund board protecting the interests of mutual fund investors. Mutual funds get kudos if their independent directors invest in the mutual funds.
3. Manager Incentives: This score is based on Morningstar’s evaluation of mutual fund ownership and compensation structure. Mutual funds where the fund’s manager owns a meaningful stake in the fund score high on the fund ownership dimension. A compensation structure that rewards the mutual fund manager for long-term mutual fund performance is favored.
4. Fees: Mutual funds are rewarded for having expense ratios lower than that of their peers and for effectively reducing their expense ratios with growth in their assets.
5. Corporate Culture: Morningstar looks for tangible evidence that the mutual fund company takes its fiduciary responsibility seriously. Among the factors Morningstar considers are softer issues like whether the company closes mutual funds when they get too large and whether the company starts trendy mutual funds to garner assets.
The points scored on each of the above areas are aggregated and the Fiduciary Grade is assigned based on the total: A=9-10, B=7-8.5, C=5-6.5, D=3-4.5, F=2.5 or less.
How Investors Can Use the Morningstar Fiduciary Grade
Here are some ways investors can use the Morningstar Fiduciary Grade.
1. Buy and Hold Investors: Buy and hold mutual fund investors first need to examine how mutual funds held in their portfolios stack up on the two dimensions, Morningstar Rating and Fiduciary Grade.
Mutual funds that rank favorably on both dimensions may be retained and mutual funds that rank unfavorably on both dimensions may be replaced by ones that rank favorably.
For mutual funds that rank favorably in one dimension but not in the other, the answer is not clear-cut. Retaining a fund with strong Morningstar Rating but lower Fiduciary Grade is a matter of personal choice. Conversely, a mutual fund’s Fiduciary Grade may be satisfactory but the Morningstar Rating may be unfavorable. This may just be a case of the mutual fund manager going through a temporary bad patch. Investors have to weigh these factors along with tax consequences before deciding to sell a mutual fund.
Given the number of mutual funds available, investors seeking new mutual funds to add to their portfolio should in general have no trouble in finding mutual funds with favorable Morningstar Rating as well as Fiduciary Grade.
2. Tactical Asset Allocators: A tactical asset allocator uses an active investment strategy and typically invests in mutual funds such as sector funds. For example, AlphaProfit, http://www.alphaprofit.com uses its ValuM investment process, http://www.alphaprofit.com/mutual-fund-selection.html to periodically alter the mix of its mutual fund model portfolios to take advantage of specific trends (e.g. rising natural gas prices, introduction of new wireless technologies).
Since tactical asset allocators seek superior performance during their mutual fund holding period, factors such as superior long-term performance which determine Morningstar Ratings are less important to them. However, these investors typically seek to own mutual funds within a single family such as Fidelity Investments for purposes of administrative ease. As such, tactical asset allocators will find the Fiduciary Grade useful in evaluating and choosing mutual fund families to implement their strategies.
Our Take on the Morningstar Fiduciary Grade System
The Fiduciary Grade system is a blend of several metrics. The grading of mutual funds on regulatory issues is backward looking rather than a prognosticator of potential future trouble. The grading system includes a quantitative dimension in mutual fund fees. Also included are qualitative dimensions such as mutual fund corporate culture, manager incentives, and board quality.
The Mutual Fund Fiduciary Grade ranking provides mutual fund investors with much needed insight on the governance and operations of mutual funds. The Morningstar Fiduciary Grade System is a good first step. We believe Morningstar will refine the Mutual Fund Fiduciary Grade system over time, just as they refined the Morningstar Ratings system.
While Morningstar Ratings do an excellent job of objectively evaluating past performance, financial markets by their very nature do not allow the investor to predict future performance based on these ratings alone. Many times, funds with Morningstar Ratings of 4- or 5-star do not live up to their expectations.
The utility of the Morningstar Fiduciary Grade will be significantly enhanced if superior Fiduciary Grade either by itself or in combination with the Morningstar Rating becomes a better indicator of superior future performance. We believe the Morningstar Fiduciary Grade has the potential to become a worthy metric of mutual fund stewardship over time.
Notes: This report is for information purposes only. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice. This report does not have regard to the specific investment objectives, financial situation, and particular needs of any specific person who may receive this report. The information contained in this report is obtained from various sources believed to be accurate and is provided without warranties of any kind. AlphaProfit Investments, LLC does not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. AlphaProfit Investments, LLC is not responsible for any errors or omissions herein. Opinions expressed herein reflect the opinion of AlphaProfit Investments, LLC and are subject to change without notice. AlphaProfit Investments, LLC disclaims any liability for any direct or incidental loss incurred by a pplying any of the information in this report. Morningstar Rating™ is a trademark of Morningstar, Inc. The third-party trademarks or service marks appearing within this report are the property of their respective owners. All other trademarks appearing herein are the property of AlphaProfit Investments, LLC. Owners and employees of AlphaProfit Investments, LLC for their own accounts invest in the Fidelity Mutual Funds. AlphaProfit Investments, LLC neither is associated with nor receives any compensation from Fidelity Investments. Past performance is neither an indication of nor a guarantee for future results. No part of this document may be reproduced in any manner without written permission of AlphaProfit Investments, LLC. Copyright © 2004 AlphaProfit Investments, LLC. All rights reserved.

About The Author

Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. Sam developed the ValuMâ„¢ Investment Process for managing investments. He edits the AlphaProfit Sector Investors’ Newsletterâ„¢, a publication that discusses investments using Fidelity mutual funds. For the 5 year period ending December 31, 2003, AlphaProfit model portfolios increased by up to 252%, a compound annual return of 28.6%. To learn more about AlphaProfit and to subscribe to the FREE newsletter, visit http://www.alphaprofit.com