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.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s