Investments with all upside and little to no downside

Quick note

We’ve had a few requests for the report featured in the last post. And a few questions after we sent the report, which we hope, we answered satisfactorily.

If you haven’t requested it, we encourage you to do so, especially because this post has some great option ideas that you can use in combination with the strategy in the report to really make some money.

Just email us at contact@dividendium.com and say “Send me the report!”

On with the show

Last time we talked about borrowing money to invest and eventually ended up with a strategy that basically allowed you to own some options for free. That means you have no downside, since you didn’t pay for the options, and all upside.

Why avoid losses like the plague?

The first reason to avoid losses is that it takes more to get out of a losing position than it took to get into it. Let’s say you buy a stock for $50, and a few months later it has dropped to $25. That’s a 50% loss. If you want to get back to where you started, just getting even, you’ll have to make 100% on your money. Considering that your most recent pick just lost 50%, what’s the likelihood that your next pick is going to be a 100% gain?

The bigger your loss, the more it takes to get back to even.
– 10% loss requires an 11% gain
– 20% loss requires a 25% gain
– 30% loss requires a 43% gain
– 40% loss requires a 66% gain
– 50% loss requires a 100% gain
– 60% loss requires a 150% gain
…and so on.

Time is money

The second reason to avoid losses is the time cost. If you’re trying to get back to even, then you’re not making money. But you are losing time during which you should have been making money. If you lose 50% of your money over 6 months, and then turn around and gain back all of it in the next 6 months, then you’ve just made less money than you could have investing in a CD. And you’ve probably lost value due to inflation.

Sweet dreams

The third reason to avoid losses is psychological. It’s a bad day when you lose money. You don’t sleep well. Every expense seems like someone twisting the knife. And you get irritable. You basically just sold your happiness and didn’t get a thing for it.

So now that we have established why we want to avoid losses let’s discuss how we can do it.

Stock options, an amazing tool

I’m going to assume that you know what stock options are. If not, then do a Google search, or grab a book on options from the library. Learning about these investment vehicles is well worth it. Not knowing about them is kind of like driving a car without knowing about the brakes, or higher gears. You can’t stop without hitting a tree, and it takes you forever to get where you’re going.

At the line put options

Generally with put options there is an in the money strike price at which the option price will lose $.90 if the stock goes up $1, but gain $1 if the stock loses $1. So if the stock falls, you stay even (lose $1, gain $1). And if the stock gains, you gain a little bit (lose $.90, gain $1). And as the stock goes even higher, you gain even more each time. And eventually, you get to the point where you can’t lose any more on the option so you gain $1, and lose $0.

A current example of this would be Microsoft (MSFT). Let’s say you think Vista is amazing and that no one else realizes how much of a cash machine Microsoft really is. But you think it will become obvious in the future, so you think you’ll buy in. The price at Friday’s close was $29.40. The January 2008 put with a strike price of $35 is being offered at an ask price of $6. If you pay $6 for the put, and $29.40 for the stock, then you have paid a total of $35.40, and can sell the stock at any point over the next year for $35. But it still cost you $0.40 per share right?

Well, actually, Microsoft has a $0.40 dividend, so it’s exactly even, not counting trading costs. But you can keep the trading costs pretty low if you’re going with http://www.choicetrade.com/.

That’s a pretty good deal. If Microsoft goes up at all, you make money, if they go down, you don’t lose money. Can it get much better than that?

Evidently it can get better

I regularly read two free stock news letters, both from the same publishing group. One is called Daily Wealth (http://www.dailywealth.com/) and the other is called Growth Stock Wire (http://www.growthstockwire.com/). I highly recommend both of them. But one of the recent articles from Growth Stock Wire might make the above trade even better.

http://www.growthstockwire.com/archive/2006/dec/2006_dec_05.asp

In that article he talks about a way to establish a position in a stock without actually using your own capital. Which means your capital is sitting in your money market earning interest.

Let’s say you do it for July. With the $30 calls going for $1.75 and the $30 puts going for $1.95 you’d get a $0.20 credit. Then you’ve got $30.00 per share sitting in your money market account for 8 months at 4% or better, which gets you at least $0.80 per share. So the current price is $29.40, and you’re going to pay $30 less a $0.20 credit, and $0.80 in interest earnings, for a total of $29. So you get a $0.40 discount by doing it this way.
Then wouldn’t it be great to couple it with the idea above, so that you have both the access to your capital and the protection for your position?

The savvy shopper will notice that it doesn’t come out so well when you add in the protective put. The lack of dividend does this strategy in and creates a small loss. Note I’m not a savvy shopper. I had to rewrite this post because I got to the end and ended up with a negative number, but was expecting a positive number. I would guess that it may work in some situations, perhaps in ones without a dividend, but I don’t know any off hand.

Nonetheless, I learned a few things along the way (including another “low money down” strategy that I’ll discuss in a second). If I’m buying a put and then selling a put, why don’t I just not do either and call it even?

So instead, you could buy the January 2008 $35 call for $0.85, and keep the cash in a money market for a year and come out with about $1.20 when the call expired. Thus your worst case scenario is a $0.35 gain for the year, with the potential for a whole lot more if the stock goes up. This is the basic premise behind an investment vehicle called a MITT. Except you don’t have to pay someone else a management fee to set it up and you can get in at the ground floor.

(Here’s some further info on MITTs: http://www.investmentu.com/resources/mittsinvestments.html)

The “Low Money Down Strategy” I found

While I was fumbling around in the option prices trying to find a combination that would come out positive, I saw that both the January 2008 $35 puts and the July 2008 $35 puts cost the exact same at $6 per share. But one of them has 6 months more time on it.

So let’s say you buy the January one for $6 and sell the July one for $5.90. Over the coming 8 months if the stock rises, then you would gain money. The put you sold would fall faster in price than the one you bought. You would want to close out the trade before the one you bought went to zero as well.

If the stock falls over the coming months, the two options would pretty much stay even. And if someone put you the stock at $35, you could hold it for another 6 months with the option you already owned and be in a position to not lose and only gain if the stock then turned around and went up. Or you could just sell out look for a better play.

The opposite side could be played as well. Take a look at the April and July $12.50 calls. Again we see they are right at that line where they change dollar for dollar one way and less than dollar for dollar the other way. So if we bought the July and sold the April, we would make money if the stock fell, and stay even if the stock rose. We could even sell it short when it got called and have a free protective call backing us up.

So now we have a strategy that costs very little to setup, and provides a way to prosper if the price rises, a way to prosper if it falls, and if it doesn’t move at all we end up in hedged positions where there is no downside. Did someone ask for the perfect trade?

The things we kind of ignored here were the $0.10 bid ask spreads, and the transaction costs. Also, it looks like the max you might expect from the calls would be about $0.50 per share, and from the puts about $0.40 per share, assuming you sold out before they were called or put. Thus for your total $0.20 per share spread costs, you have the possibility of making 100% to 150% of your money or just ending up with a free hedge. All in all this is a pretty nice strategy.

Conclusion

Basically, stay away from losses. Not only because they are bad, but because they aren’t even necessary.

Where can you borrow money to invest?

Quick Thanks for User Feedback

Last time I said I would talk about borrowing to invest and I’ll get to that in a second.

But first I want to thank Mark for letting us know about the problems we were having with the website. We really appreciate any feedback you want to give us.

Evidently some of the pages weren’t showing up in the dividend calendar data. So we got to work yesterday and redesigned the back end.

Our goal was to deliver on the NASA coined phrase “faster, better, cheaper”.

So we got faster by making the pages faster to load, and by getting the dividend data updated sooner after the close of the market (it should update around 6pm CST now, instead of 8pm CST as before).

We got better by making sure that we won’t have missing data pages any more.

But how could we get cheaper? I mean, the site is already free. We’d have to give you money to make it cheaper. But you gotta do what you gotta do. So watch for our offer to give you money later on in this post.

Borrowing to Invest

Last time I talked about the benefits of using borrowed money to invest in an inflationary environment. So now I’ll talk about where to borrow that money from.

Margin

When we’re talking about investing in stock, the first place that comes to mind is buying on margin. Generally you can borrow up to 50% of the value of the stock you want to buy. The interest rates aren’t terrible, but they aren’t great either. At this writing http://www.choicetrade.com/ has an 8.95% interest rate posted on their website, and http://www.interactivebrokers.com/ looks like its offering about 6.8%.

Although it’s available, I’ve never actually gone this route. I’ve always found cheaper sources of funds before I got down to margin.

Auto

The next cheapest place might be to borrow money against your car. If you read my earlier rant on expensive cars, you know that I don’t like to tie up money in my transportation. But if you already have the car and you’re not willing to just straight out sell it and buy a cheaper one, then this might be an option for you.

Bank of America seems to be offering as low as 7.6% on a used car for 60 months, and a local credit union is offering as low as 5.65%. These are lower amounts than trading on margin, but you have the added “invisible” expense of the car depreciating. But I already went over that in the rant, so I’ll stop picking at it.

Home Equity

You could always borrow against your home. Among the options would be to do a home equity loan, a refinance, or a line of credit. This might be cheaper than the previous two because it’s possible that the interest would be tax deductible (check with your accountant).

Staying with Bank of America from above, they are offering as low as 7.74%, which after taxes (assuming 25% tax bracket) is about 5.8%. By the way, I’m not recommending Bank of America, just using them as a reference. In fact I would actually recommend against them because they seem to be the highest cost in anything I’ve ever looked at them for. Anyway, jumping back to the credit union I see they are offering as low as 5.65%, which would be about 4.3% after taxes.

Of course this doesn’t take into account any costs to obtain the loans, so that might change the actual amount paid for the loan. But in this case you are most likely borrowing against an asset that will appreciate rather than depreciate (like the car). Unless that is you live in California or Florida where you’re likely to see your house value drop over the next few years due to the bubble deflating.

401k

You could borrow from your 401k. Generally you can borrow up to 50% of the value of your account. The interest rate that I’ve seen for my 401k is 9.25%. That’s not too bad considering that I am paying the interest back to myself. The loan term is 60 months and the fees come to about $115 over the life of the loan. One other hitch is that if I lose my job for some reason, then I have to pay it back immediately or suffer a 10% penalty for early withdrawal. But the loan default doesn’t go on my credit report, so maybe that’s a “glass is half-full” kind of thing.

The down side here is that I am the one both lending and borrowing. So for our purposes of borrowing money in order to get ahead in an inflationary environment, at first glance, this doesn’t seem to do it.

However, we need to consider how that money got in there. Money in my 401k is growing tax deferred. That means that really I’m borrowing the taxes I would normally have paid to the government and using them for investment purposes until I have to pay them later when I make withdrawals. Thus this does meet our requirements of using other people’s money to invest.

A bonus is that by taking the loan, and paying it back with interest, you are actually able to deposit more money into your tax-deferred 401k than the annual limit. So you can have even more to borrow later and even more to grow tax-deferred.

Another point to make is that if you take a loss on an investment out side of your 401k then you can take a tax deduction for that loss. If you take a loss in your 401k, you can’t take a deduction. So you give your 401k a guaranteed return in the form of the interest you pay, and you make your riskier investments outside of the 401k where you can get the tax deduction. Not a bad deal really, but it could be even better I think.

Withholding

This idea requires a little more planning than the others. You could change your withholding at work. This is the amount of money that they take out of your check to pay your taxes.

So basically you submit a new W-4 at work with no more than 10 deductions. If you do more than 10 then the company has to report it to the IRS. (Check with your HR person to make sure on this.) Then each of your paychecks will be higher by the amount of tax that you would normally have paid out to the IRS.

But you must pay a minimum amount through withholding by the end of the year. So near the end of the year, you’ll want to submit a new W-4 that increases your withholding. Make sure you do this when there are still enough paychecks and pay left in the year to cover the minimum amount that you need to pay.

The rule is that you must have paid at least 100% of your last year’s tax bill by the end of the year through withholding, or you will owe a penalty on your income taxes. There are other options, like paying 90% of this year’s tax bill, or owing less than $1000 at the end of the year, but paying 100% of last year’s tax bill is the safest in my opinion because you’re not estimating.

So here you are borrowing money from the IRS in the form of taxes that you normally pay. The interest rate (assuming you avoid the penalties correctly) is 0%, but the loan term is short. You start in January, probably stop in October, and you only get a small amount of the “loan” each month. Plus you have to do the switching around of the W-4s. Thus I would say this is an interesting possibility, but I would like to see it get even better.

Tax Credit

This doesn’t really qualify as a loan, but it’s a place you can find some money, I recently heard about it, and tax time is coming up, so I’m throwing it in here.

http://www.snopes.com/business/taxes/excise.asp

That’s an article that talks about the refund of the excise tax credit that used to be paid on long distance phone bills. It doesn’t appear on local phone bills, but it does appear on cell phone bills. After looking back at some of my bill history, it turns out I paid $2/month in excise taxes on my cell phone. Over 42 months that comes to approximately $84, which is higher than the $30 they are offering as default. Since this is a credit, that’s $54 that will go right in my pocket, or rather into my investment account.

Options

Stock options aren’t exactly a traditional loan as we have been discussing, but they do represent borrowing someone else’s purchasing power. An option allows you to control more stock than you would other wise be able to with the same amount of money. So it does work for our purposes of borrowing to invest. The “interest” is paid through the premium in the option when you buy it.

Credit Cards

The last idea I have is to use credit cards. Now you could use the ones that have a 39% interest rate on cash advances, but I’d probably recommend against that. Instead, I’d say to pick up one of the 0% cards.

A while back we were offering a report on how to make $40/month. We laid out specific instructions for borrowing from a credit card and depositing the money in a secure investment. We also pointed out all the land mines in this process, how to avoid them, and how to make it dead simple without any management headaches. The hardest part is sitting back collecting the earnings each month.

At the time, we could only offer a 90 day money back guarantee because that’s as much as PayPal allows. But we really wanted to offer a never-ending guarantee because we don’t believe you should pay for something that doesn’t give you value or that you don’t want.

So here goes. Email us at contact@dividendium.com to request the report. We will reply with the report as an attachment. Then we will check back with you in a few months. We have been doing this for years now, so we know it works. If you decide to follow our lead and do it too, we’d appreciate if you would buy the report retroactively. If you decide not to, then that’s your prerogative and it obviously wasn’t a value to you. (Update: click here to download the report)

(So there, now the site is cheaper too. Our goal of “faster, better, cheaper” has been realized.)

In any case, let’s say you use the report and start an income of around $40/month. After 12 months, you’ll have $480. It’s a guaranteed return. So that means you can take $480 of the credit card money now and invest it knowing that you will have $480 in 12 months to pay it back with assuming you lose it. If you don’t lose the $480, you’ll have it and the $480 you make from the credit card report.

Since this is basically “found money”, you might consider leveraging it even further by using it to buy long term options on Wal-Mart as we discussed in the previous post.

Conclusion

So there’s my pitch. Use the report to start an income, use the income to pay off a very small loan, use the small loan to buy options. So we have no downside and the possibility of a nice upside. That’s my kind of investment.

I really like this theme of investments that have no downside and all upside, so I’ll be talking some more about these kinds of investments next time along with why I like them so much.