Average Directional Index (ADX)

The average directional index (ADX) is a technical indicator used to measure the strength of a trend. It is a non-directional indicator, it only shows the strength of the trend and not which direction the trend is in. So, on charts it is often accompanied by the negative directional indicator (-DI) and the positive directional indicator (+DI) in order to help traders decide whether they should take a long or short position.

Calculating the ADX

The ADX takes the average or mean of the directional movement index over a period of time (usually 14 periods). The directional movement index is calculated by taking the absolute difference between the positive directional indicator (+DI) and the negative directional indicator (-DI) and dividing it by the total absolute sum of the two indicators (+DI & -DI). Then finally multiplying the result by 100.

How to use the ADX

The ADX, the positive directional indicator (+DI) and the negative directional indicator (-DI) are momentum indicators. The ADX tells you trend strength whereas +DI and -DI help determine trend direction.

An ADX above 25 is considered a strong trend and one below 20 is considered a weak trend. Crossovers between the +DI and -DI in conjunction with ADX can be used to generate trade signals. For example if the +DI is above the -DI and the ADX is above 25 this is a strong uptrend and a potential buy signal. And if the -DI is above the +DI and the ADX is above 25 then this is a potential sell signal or a chance to enter a short position.

In contrast if the ADX is below 20 this might mean that the price is trendless and it may not be an ideal time to enter a position.

Limitations of the ADX

The ADX can create false signals with the ADX moving above 25 temporarily followed by quick reversals in price and the ADX. Also with a weak ADX there can be many crossovers of the negative and positive directional indicators creating false and confusing signals.

As with all technical indicators the ADX should be used in conjunction with other indicators and the individual weightings of the indicator should be adjusted with your trading strategy. E.g. You might only want to consider the ADX a strong trend signal above 30 instead of the standard 25 in your trading strategy.

Beginner’s Guide to Futures

A futures contract is a legal agreement to buy or sell a particular commodity, asset or security at a predetermined price at a specified time in the future. The buyer of the futures contract is obligated to buy the underlying asset when the contract expires. And the seller is obligated to provide and deliver the underlying asset on expiry. Unlike forward contracts, futures are regulated and standardized to allow trading on a futures exchange.

Using Futures To Hedge

Futures are often used to lock in the price of a commodity to hedge against market volatility. For example, a manufacturer may need 1,000 barrels of oil in three months, by entering a futures contract with the oil producer for $50 a barrel, the oil producer is guaranteed $50,000 and the manufacturer is guaranteed a price of $50 per barrel for 1,000 barrels. This protects the producer from the risk of oil prices dropping and the manufacturer from the risk of oil prices rising.

Trading Futures

Speculators use futures to profit off the change in price of the underlying asset. For Example, a speculator who believes the price of oil will rise in the next three months may buy futures at $55 and then sell the contract at $60, when the price of oil goes up, making $5 a barrel. It is important to note that if the buyer purchased futures for 1,000 barrels, they would not need to spend $55,000. They would just need to put enough money in the account to fulfil the minimum margin requirements. The value of the futures contract will fluctuate in their account until they close the position. Also, if the loss gets too big, their broker may ask for additional capital to satisfy the margin requirements.

Things To Consider

If you hold until expiry, you are obliged to exercise the contract – This means the short is obligated to make the delivery to the long and the long is obligated to take it. In most cases this will be settled in cash, where the trader simply pays or receives a cash amount depending on whether the price of the underlying asset increased or decreased.

Physical Delivery – In some cases upon contract expiry future contracts will require physical delivery. In this scenario the trader holding the contract will be responsible for storing the goods and would need to cover the costs for material handling, physical storage and insurance.

How to trade futures – To trade futures you need to open an account with a broker. You will need a margin account and be approved as eligible to trade them.

Beginner’s Guide to Options

This is the bare bones basics of how option contracts work. There are two types of option contracts, a call and a put. A call is a contract that allows the buyer the right to buy an asset at a given price – called a strike price – at or before a certain date with no obligation to do so. On the flipside a put is a contract that allows the buyer the right to sell an asset at a given price. A typical contract allows you to buy or sell 100 stocks of a company at a given strike price. The amount of the asset the contract gives you the right to buy or sell is called the multiplier and the act of using this contract to buy or sell shares at a given price is called exercising the contract. All this is best illustrated through examples (see below).

One important thing to consider is there are also two styles of options, an American-style contract and a European-style contract. An American-style contract lets you exercise the contract at any time before expiry whereas a European style contract only exercises at expiry. In the examples below we are assuming the contracts are American-style as most are, and we are exercising them early to realise our profits.

Call Contract Example

Say you purchase a call contract on company X with the strike price of $100 and an expiry date three weeks away. You pay a premium of $2 for the contract and it has a multiplier of 100. This means you have the right to buy 100 shares of company X at anytime in the next 3 weeks for $100 per share. And for this right you payed a $2 per share costing you a total premium of $200. Imagine the price of company X is $90 when you buy the contract but sometime in the next 3 weeks the price of company X rises to $120.

Now if you choose to exercise the contract you can buy 100 shares of company X at $100 and instantly sell it on the market for $120 making you $20 per share. This gives you a total profit of $2000 minus the $200 you paid for the contract giving you a $1800 dollar profit on a $200 investment. A return on investment of 900%.

Compare this to a scenario where instead of buying the call you bought 100 shares of company X at $90. You make a profit of $30 per share giving you a profit of $3000 dollars on an investment of $9000. This is a return on investment of 33% compared to the 900% return on investment for the call. For the $9000 you spent on shares you could have bought 45 calls and made a profit of $81,000. This is obviously an extreme in which a company rises 33% in price in under 3 weeks. However it illustrates the massive difference in potential upside.

In another scenario where company X does not reach a price of $100 within the 3 weeks until expiry the call becomes worthless and the buyer loses the $200 invested. Or $9000 if they were crazy enough to go all in with options. Whereas the shareholder still has 100 shares at whatever price company X now trades at.

Put Contract Example

Lets work with a similar scenario to the one above but this time company X is trading at $110 and you think it is overvalued and set for an extreme short term correction. You manage to buy a put on company X with a strike price of $100 and an expiry date three weeks away. You again pay a premium $2 per share and the multiplier is 100. This gives you the right to sell 100 shares of company X at $100 per share to the person who sold you the contract. And for this right you pay $200 ($2 premium x 100 shares).

Now if the price of company X falls to $80 you can exercise the put by buying 100 shares of company X for $80 each and selling them for $100 each. Giving you a profit of $2000 minus the $200 you paid for the contract. This is again a $1800 profit on a $200 investment, this time betting that the price of company X would fall below $100 within the next three weeks.

Things to consider

Most contracts expire out of the money four out of five option contracts never go past the strike price. And many of those that do, don’t make insane returns like the examples above.

You don’t have to exercise the contract – Options are traded on the market and you can sell any contract you bought right back into the market. You could buy a contract for a premium of $2 and sell it for a premium of $3 making 50% returns. Or you can sell it for a lower premium when you no longer believe it will reach the strike price and you can save yourself a complete loss of holding it until expiry.

You can’t exercise a contract without the money to buy the shares – If you have a call giving you the right to buy 100 shares at $100 dollars and you want to exercise it to sell those 100 shares for the new now higher market value. You will still need the $10000 to buy the 100 shares in order to make your profit. If you don’t have the capital for that you can always sell the contract back into the market for a now much higher premium. Which will bank you a nice profit as well.

Common Questions

What if I hold until expiry? On expiry your contract automatically exercises if its passed the strike price and now in the money. Or if it hasn’t reached the strike price it then just expires worthless. In the case of holding until expiry you have to make sure you have the necessary cash or margin requirements to exercise the contract.

Where can I buy options? – You will have to sign up to a brokerage that lets you buy options. Different brokerages come with different commission fees and requirements to trade options, so you can do your research and decide what’s best for you. Also they will have levelled access for trading options in which case you may be limited in how you can trade options. Many may only allow you to buy options and not sell them etc…

Can I trade American style options outside of the U.S? Yes, there are many brokers outside of the U.S that will let you trade American-style options on a variety of stocks both in and outside the U.S market.

Beginner’s Guide to SPACs

Special purpose acquisition companies (SPACs) are companies formed for the sole purpose of raising capital in order to acquire an existing company. They raise capital through an initial public offering (IPO) and are often referred to as “blank check companies” as they IPO without any business operations.

SPACs are usually formed by a group of investors with expertise in one field and the intention of targeting a company in that business sector. Although during the IPO process they don’t release their targets. The money they raise through their IPO is put into an interest bearing trust account that can only be used to complete an acquisition or return money to investors if they fail to do so. After their IPO, SPACs generally have two years to acquire a target or they face liquidation.

How to invest in SPACs

COMMON STOCK (SHARES) – A share of the SPAC will become a share of the acquired company post-merger. Or if the company fails to merge within the given timeframe then all shares are redeemed for a proportional portion of the cash held in the cash account. This gives SPACs a $10 floor as this is what must be paid out per share if the SPAC fails to merge.

So by holding a share of the SPAC your holding $10 (plus interest gained) and the chance to own a share of the company acquired by the SPAC if the merger takes place.

WARRANTS – Warrants give the owner the right but not the obligation to buy a share of the underlying company at a predetermined price (typically $11.50). Close to all SPAC warrants have an expiry date set to five-years after any merger has taken place. However if no merger takes place then the warrant expires worthless.

Most SPACs state that warrants can only be exercised one year after IPO or 30-days post-merger. It is often also stated that if the price of the common stock trades above a certain price (usually above $18 for 20 out of 30 consecutive days) then the company can redeem the shares. Either for cash (the $11.50) or a cashless basis where the owner of the warrant is given a fraction of the share. Warrants have a lower capital requirement to trade and come with a higher risk and reward, but the speculative nature of warrants can lead to wild price swings. To understand how warrants work better read here.

UNITS – During the IPO, SPACs usually offer units almost always at $10 each. A unit consists of one share of common stock and a warrant that lets you purchase a share of common stock. Generally exercisable at $11.50. The warrant in the unit can be a whole warrant, 1/2 a warrant or 1/4 a warrant.

Weeks after the IPO, the common stock (shares) and Warrants included in the SPAC units can be separated and traded individually. So the common shares, Warrants and unseparated units all trade with individual tickers.

SPAC Tickers

SPAC shares usually trade with a four symbol ticker – for example ICTT

SPAC Units trade with the same ticker with a “U” added to the end – for example ICTTU

SPAC Warrants trade with a “W” at the end – for example ICTTW

Post-merger the SPAC and target company will trade under the target company ticker. This includes all warrants and units, for example if ICTT merged with a company with the ticker ABC the new company would trade common shares under ABC, warrants under ABCW and units under ABCU.

The Advantages of Investing in SPACs

High upside with limited downside – When investing in a SPAC you can get massive returns on investment depending on the target company acquired and you have limited downside as if the company fails to merge you still get at least $10 back per share. An example would be the VITQ – NKLA merger. VectoIQ Acquisition Corp (VITQ) traded around $10 per share before it sky rocketed to $80 a share upon announcing it would merge with NKLA. In a world where they failed to find a target to merge with, the floor for the stock would still have been $10.

Warrants increase the upside – In the same example above where NKLA was trading at $80, exercising a warrant would let you buy the share at $11.50 and sell it at $80. That is a profit of $68.50 per warrant exercised. If you bought warrants before the announcement for cheap around $2 a warrant. Then you’ve made a return of over 3400%

The risk of investing in SPACs

Failure to acquire a target – After the SPAC IPO, the common stock usually trades at a slight premium. You are likely to buy the share at $11 or $12 and if the SPAC fails to merge you will get $10 back per share giving you a 10%+ loss on investment.

Opportunity Cost – SPACs have two years to find a target. During this period the value of units wont change much. This means your capital will be locked in a position generating little to no returns. During this time the capital could have been better allocated in other investments.

Redemption risk for Warrants – If the common stock trades above a certain price for a sustained period of time the warrant may be redeemed by the company for a nominal consideration. This forces public warrants to be exercised making them lose value,

Beginner’s Guide to Warrants

A warrant gives you the right but not the obligation to purchase a share at a predetermined price. Very similar to how options work. Say you bought a warrant for $2 that lets you buy a stock of company X at a strike price of $11.50, if the price of company X reaches $20. Exercising your warrant would let you buy a share of company X at $11.50 and sell it at $20. Giving you a profit of $8.50 minus $2 (the price you bought the warrant for). This gives you a return on investment of 325%.

Compare this to a scenario where instead you buy a share of company X (a SPAC pre merger). You would buy company X for roughly $11 and sell it for $20 giving you a return on investment of 82%. This highlights how warrants can give you better returns on SPACs. However there is also a higher risk.

In another scenario where company X is a SPAC that never merged, your investment in the common stock of company X gives you an approximate 10% loss as the value of company X falls from $11 to $10 (the floor for SPACs), However your warrants become completely worthless losing you any money invested.

Things to Consider

Warrants can’t be exercised right away – Usually warrants can only be exercised 30 days after the merger or a year after the SPAC IPO. This means if the price of the SPAC shoots up based on speculation of a merger but sufficient time hasn’t passed you won’t be able to exercise the warrant.

Only whole warrants can be exercised – You can’t exercise 1/2 a warrant. Which is sometimes the portion of the warrant offered in Units on a SPAC’s IPO. You would have to buy another 1/2 to have enough to exercise or just sell your 1/2 for a profit.

Ratios of warrants – most warrants have a 1:1 ratio between the warrant and how much common stock you get when exercising a warrant but not all do. Many have a 2:1 ratio so you would need 2 warrants for the right to buy 1 common stock at the pre-determined strike price. And some even have a 4:3 ratio in which you need 4 warrants for 3 common stocks. You will have to verify the ratio for the SPAC your looking to invest in.

You need enough capital to exercise a warrant – If you own 100 warrants with a strike price of $11.50 and you wish to exercise them to profit off the current stock price being higher than $11.50, You need 100 x $11.50 to exercise the 100 warrants. You cannot exercise the warrants without the money to buy the underlying stock in the first place. If you don’t have the money required you can still just sell the warrants and make a profit.

Cash redemption – If the price of the underlying stock remains above a certain price for a certain amount of time this usually gives the company the right to redeem the warrants. Usually the price of the stock would have to remain above $18 for 20 of 30 consecutive days. In a cash redemption the company offers a nominal consideration for the warrants (e.g. 0.01 per warrant) this forces public warrants to be exercised or lose immense value. If you hold them passed the expiration date of the early redemption call they become essentially worthless.

Cashless redemption – Most redemption calls are cash redemptions but in rare cases a company may have a cashless redemption. In a cashless redemption your warrants automatically convert into the equivalent value of stock. In this conversion there is a standard formulae used so for the investor they get as much value as if the warrants were exercised. But in this scenario the company doesn’t receive the $11.50 they usually would in a cash redemption, so they reduce the cash generated but they also reduce share dilution. As a whole new stock being offered per warrant in the warrants being exercised adds more stocks to the market than the fraction of a share given out per warrant in a cashless redemption. Although this is more rare as companies post merger usually still prefer to raise money.

Common Questions

Do warrants convert to the new company when SPACs merge? Yes, a warrant of the SPAC becomes a warrant of the new company post merger.

Do I have to exercise them? No, You can trade the warrants on the market. They are very liquid which adds to their appeal.

Do I have to hold them through merger? No, you can always just trade them on the market at any time.

What if I don’t have the money to exercise the warrant? Your best option is to sell the warrant. Or if you have many warrants you can sell some of them until you have the capital required to exercise the rest.

How do I exercise warrants? This varies across brokers. You will have to call your broker to find out how to exercise the warrants and whether your particular broker even allows you to purchase warrants in the first place.