Buffett’s best advice…for free

A few months back I read for the third time, from three different sources that I trust, that everyone should read Buffett’s shareholder letters. So I took the hint and started reading them. They are actually quite good and I would suggest reading them as well. There are parts that are less interesting than others, but in bits and pieces he doles out gems of investing wisdom. The letters are located at the Berkshire Hathaway website.

At present I have read through 1983, but I will probably read 1983 again a number of times before moving on to 1984. Last week, I touched on Buffett’s statement at the recent Berkshire Hathaway meeting about inflation and earnings. Interestingly enough, nearly 25 years ago, in the 1983 letter he very thoroughly explained his views on this. I haven’t solidified my understanding of it or how to implement it yet, but I encourage you to read it as well.

Hopefully by next week I’ll have extracted a good investing methodology for utilizing this knowledge and be able to post about it then. But since I haven’t done so yet, let’s move on to the example trades from the Inflatable Dividends service. Just a reminder on June 1st the 75% discount price of $4.95/month will disappear and the full price of $19.95/month will go into effect. So if you’re interested, get in now and get the $4.95/month price before it’s gone.

Inflatable Dividends Real Time Example Trades

SPG Trade

Last week we determined that we bought the SPG trade at $109.15 for the buy write combo. And we said that our stop loss for this trade was when the stock hit $109.15.

The stock did hit $109.15 on Tuesday, 5/15/2007, so we would have sold at that point.

The data I have says that the price of the stock for that day ranged from $111.52 to $108.27. That’s a spread of ($111.52 – $108.27) $3.25. The data I have for the option (SPGEB) says it’s range that day was $1.85 to $0.45. That’s a spread of ($1.85 – $0.45) $1.40. So it’s probably reasonable to say that for every ($3.25 / $1.40) $0.023 that the stock fell, the option fell $0.01.

To hit our stop loss of $109.15, the stock had to fall ($111.52 – $109.15) $2.37, which means the option probably fell ($2.37 / $0.023 * $0.01) $1.03 to ($1.85 – 1.03) $0.82.

So to get out of this position we had to sell the stock at $109.15 and buy back the option at $0.82, for a total credit of ($109.15 – $0.82) $108.33. But because we owned the stock on the ex-dividend day, we are also entitled to the $0.84 dividend. Thus our credit comes to ($108.33 + $0.84) $109.17.

We paid $54,575 for the 5 contract 500 share position plus commissions. I think the commission that was estimated by Fidelity was wrong, so I’m going to assume a commission of $25.65 to get in, and $25.65 to get out. That brings the total investment to $54,626.30 or (54,626.30 / 500) $109.25 per share.

So in total this position was a loss of ($109.17 – $109.25) -$0.08, or (-$0.08/$109.25 * 100) -0.07%. So we were looking for a return of 0.77%, but ended up with a loss of 1/11th of that. If you can keep all your losses to 1/11th of what you expect to make, you can be wrong 9 times out of 10 and still make money. In school you would have flunked out for results like that, but in the real world that’s not how it works. (This is one of the ideas that Van Tharp touts.)

This particular trade turned out to be an excellent example of why you should stick with your stop losses. Friday’s close on this stock was $103.31. If we sold at that price on Monday after the option we sold had expired, then our loss would have been ($109.25 – $103.31) -$5.94 per share or -5.43%.

ALSK Trade

The stop loss for this trade is a stock price of $14.45. Monday of last week (5/7/2007) was our buy in day. Since then, the lowest price has been $15.20. So we haven’t been stopped out yet.

It’s important to note that we also have a target exit point. And if we hit that early, then we will either move our stop up to lock in profit or actually sell at that point. Our target exit is the 2.98% simple return that we opened the position to capture in the first place.

The target exit can be reached either by the stock appreciating in value, or by the option’s time value depreciating. For this particular trade it doesn’t look like either situation has emerged yet.

AEE Trade

We hadn’t yet gotten an execution on this trade when we last looked at it. The buy in price that we are looking for was $44.31 for buying AEE and selling AEELI.

Throughout the week I tried to keep an eye on this one. It may have been executed earlier in the week, but it was too close to call in my opinion. However, on Friday, it closed with a stock price of $54.44 and a call bid price of $10.20 for a total combo cost of ($54.44 – $10.20) $44.24. So we are going to say that we bought in on Friday at our desired buy in price of $44.31, with a stock stop loss price of $44.31 and a target simple gain of 4.3%.

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