Selling Puts and collecting premiums is being touted as collecting free money at quite a few places online. I first came across this concept when the Canadian Capitalist wrote about it — showing how wrong it is.
It took me quite some time to understand why some people think that this is free money because the reason is quite absurd.
When you buy a Put — you buy the right to sell something at a certain price and date. That means when you sell a Put — you are obliged to buy that asset at a particular price.
Let’s say that you have an island in Fiji, which has a going rate of 3.5 million dollars. I think that at 3 million dollars — this island is a steal.
I sell you a Put for a 50,000 dollars that gives you the right to sell this island to me at 3 million dollars — one year from now. Now, since I sold a Put — I get to keep the cash and you get to keep the right to sell the island.
After one year, one of the following things could happen:
One look at the table above shows that I make “free” money only as long as the price of the island goes up. If the price of the island goes down — I am forced to buy the island at a premium.
For lack of a better term: the “free money proponents” say that even if I had to buy a 2 million dollar island at 3 million dollars that is okay because that’s what I thought it was worth one year ago.
That’s like saying: when AIG was trading at 50 dollars about an year ago — I thought it is a steal at 40 dollars, so even if the stock is trading at 40 cents today — I won’t mind it at 40 dollars.
SVB recently wrote about how some people have benefited from Cramer’s show over the years and long time viewers are likely to stick to his defense, even as casual followers tune out — given the recent mistakes he made.
The question is — if a financial advisor failed seeing this coming; would you still take his advice?
This question is not about Cramer though, it is about financial advice in general and who you would turn to: for your financial advice.
But, before answering that question, we need to address another —
Do you really heed the financial advice of experts?
To answer this question, let’s take a look at some current examples.
So far, I haven’t seen any one who predicted the current crisis with as much clarity as Peter Schiff. If you don’t know about Peter Schiff yet, take a look at this video before you read any further.
This video is about two years old, so you have to be impressed by the clarity with which he discusses the recession. There are plenty of other videos like this and his message is essentially the same.
His advice right now is for investors to buy gold and foreign stocks, and his prediction is that the dollar will crash in value in the next few years.
So would you follow the advice of someone who got it exactly right?
My guess is –Â only partly.
Because its hard for most people to really visualize a collapse in the value of dollar and so they are at odds with what he says. So even though he was exactly right on the current recession, its difficult to follow his advice in entirety, as it is at odds with your own view of the world.
The other argument against following is advice is that: sure, he got it right once, will he get it right again?
This is a fair argument, but what about someone who got it right consistently?
What About The People Who Consistently Got it Right?
On October 16, 2008 — Warren Buffet wrote an Op-Ed in the New York Times. In that he wrote:
“So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.”
This is a pretty strong statement made by arguably the most successful investor of the world. Yet, how many took his advice?
Not many. Fear was all pervasive at that time (and even now) and it had people in such a strong grip that they couldn’t believe that the stock market will ever go up.
Buffet’s advice at that time was fundamentally at odds with the world view that most people held and therefore it was difficult to heed his advice.
What is common between Schiff’s Video and Buffet’s Op-Ed?
Schiff predicted the housing market crash right at the time when it was peaking. The market was full of euphoria and optimism. Schiff’s voice was drowned out in the sea of good news.
Similarly, Buffet speaks of the stock market going up, right before it hits 12 year lows. His voice of optimism was drowned out in the sea of bad news that was all pervasive at that time.
Both of them were going against the grain.
For most people, this is a very hard thing to do in stuff they understand and deal with every day, but to go against the grain in stuff like stocks and economy is almost always out of the question.
In fact, when you saw the video your first (or second) reaction would be Laffer is an idiot. However, if you have ever studied the Laffer Curve in your economics class — this is the same guy. He has a popular economic theory after his name, which is taught in school and he got it absolutely wrong with respect to the current crisis.
We Heed Selective Advise
As humans we listen to all sorts of news and opinions on TV, Radio, Newspapers etc. and then filter out the views that are not consistent with our world view.
When you say you follow Cramer’s advice, I bet what you really mean is that you follow his advice that you agree with and not all of his advice.
And this is the main point: if you follow someone’s advice selectively then you shouldn’t really point a finger on that person.
As to the question of abandoning someone because he got it wrong, if there is no fundamental shift in the way you think, then even if you dump Cramer, you will adopt someone else who preaches the same thing, but maybe in a different manner. If there has been a fundamental shift in the way you think, then you will listen to people who preach a different message.
Welcome to the March 29, 2009 edition ofthis carnival. As usual, there are a whole host of interesting entries and I want to thank everyone for their contribution.
Before you move on to the great articles here, I want to share a video that set me rolling with laughter.
Bohden James presents 8 Easy Ways To Save Money Right Now posted at Easy Ways To Save Money, saying, “Put more money back in your pocket today. Stop letting your money get the best of you. You have to make wise choices and live frugally in these modern times or your money and debt will eat you alive. Find 8 ways to do this and the best part is you can start today.”
Zach Scheidt presents FOMC Pulls Out the Stops – Part A posted at ZachStocks, saying, “The FOMC sent gold spiking and the dollar much lower after announcing they would buy more than $1 trillion in treasuries and other paper. The article reviews effects on the economy and strategies for profiting from the changes.”
Investments
Investing School presents Realized and Unrealized Gains and Losses posted at Investing School, saying, “It’s a simple subject but it’s often confused. Unrealized and realized gains explained.”
The Investor presents How stop loss investing can save you money posted at Monevator.com, saying, “A stop loss order is an instruction to sell your holding in a stock or other security if it falls to a particular price.”
Abigail Perry presents Should our economy fail? posted at i pick up pennies, saying, “It seems as though our economy is only healthy when we’re overspending. Is this a system we want to encourage? Even while damning our past irresponsibilities, politicians are urging us to bolster the economy. So if we have to be financially illogical to keep it afloat, is this system one that we should keep at all? And do we even have a choice?”
That concludes this edition. Submit your blog article to the next edition of OneMint – Economy and Your Finances using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page.
One of the most amusing things I saw this week was this ode to Paul Krugman. Never in my dreams could I have thought an Economist (even if he won the Nobel) will ever have such a fan following. I am fairly sure there is an inverse relationship between the health of the global economy and number of “fans” all economists everywhere in the world have, but no one has done that research yet.
Just to be clear, I am posting this video because I find it entertaining, not because I think “Mr. Geithner is like some little weasel who uses Turbo Tax”.
On to the other interesting stuff around the blogosphere this week:
iShares Silver Trust (SLV) is the world’s larget silver ETF backed by physical stock of silver bullion. It trades on the NYSE Arca and is a good option for investors looking to invest in silver by means of an ETF. The sponsor of iShares Silver Trust (SLV) is Barclays Bank.
Backed by Physical Silver Bullion
As on March 23rd the iShares Silver Trust (SLV) held 8,180.44 tonnes of silver. This stock of silver is stored at SLV’s custodian — JP Morgan Chase.
Some commodity funds not only hold the underlying commodity, but, on top of that — trade on the futures contracts of that commodity on exchanges like COMEX. SLV doesn’t do this. SLV takes delivery of physical silver, which complies with London Bullion Market Association (LBMA) silver delivery rules.
There are other silver funds which take positions in silver by buying stock of silver mining companies. SLV doesn’t do that either.
Passive Investment Vehicle
This means that SLV is a passive investment vehicle and the price of the fund moves in tandem with silver prices. There are no fancy hedging or other active management techniques used by this silver ETF. The lack of active management means reduced expenses and fees.
SLV Price Movement
Here is a look at how the SLV ETF moved since September 2008. There was a 10:1 split on 21st September, so I am not including the chart which includes prices before that date.
Silver Mining vs Supply
In the past seven years — silver mining has increased from 591 million ounces in 2000 to 670.6 million ounces in 2007, which is a growth of 13% at a CAGR of about 1.82%
At the same time the total demand has risen from 824 million ounces to 894.5 million ounces, which is an increase of 8.5% at a CAGR of 1.18%
The gap between total demand and total supply is matched by:
While silver is generally thought of as a precious metal, its industrial use exceeds its use in jewelery and coins. Here is a break-up of 2007 silver usage segments:
This chart shows that the demand for physical silver is likely to be more stable than other precious metals like gold, which have a large component of discretionary spending built into their demand.
Precious metals like gold and silver are getting increasingly popular because they are seen as effective hedges against stock market downturns. Like gold, silver is considered a good hedge against the stock market, as investors flock to safety in times of uncertainty.
The quantitative easing that the Fed is currently employing is expected to result in massive inflation and fall in the value of dollar. This is another reason precious metals like silver are gaining in popularity and seeing a rally.
Conclusion
The iShares Silver Trust (SLV) ETF is a good option for anyone who wants to invest in silver, but is not interested in holding huge quantities of physical silver. However, the prices of gold and silver have already gone up quite considerably and given the enormous interest in these metals lately — this may just be where the next bubble is forming.
Disclosure: At the time of writing I don’t hold any positions in SLV.
When I bought my first stock, I created a spreadsheet. It had optimistic and pessimistic scenarios. The worst case scenario was the stock goes down 50%. I don’t remember the best case scenario.
When I keyed in that scenario, I chuckled to myself and thought that it would never happen. It happened in about two weeks.
That was my first investing lesson:
Stocks can go down to zero.
But not all my stocks went down to zero, there were a few which didn’t go anywhere at all. One was stagnant for a full year before it started its upwards journey. I lost patience during that time and sold it off just before the big rally. A stock can jump tremendously in a few trading sessions and investing requires patience. Just because a stock hasn’t moved anywhere in the last year — doesn’t mean that you can’t make a killing on it. That was when I learned:
Growth in stocks is not linear.
When the market peaked last time around, I invested in one particular stock that was trading at its 52 week low and at a reasonable P/E. I expected the markets to go down, but I thought this stock would probably not go down much (as it was already low).
When the bubble burst — this stock nose – dived faster than anything else I owned. The lesson:
Just because it’s low, doesn’t mean it won’t go lower.
During the peak, I was tempted to book partial profits in a lot of my stocks, but I resisted because I generally don’t sell the stocks I own. Instead, to hedge, I bought a lot of PUT options. The trouble was that Options are priced based on price and time to expiry. So sometimes even if the price of the underlying goes down, if there isn’t much time left for the Option to expire — the price of the Option won’t rise by much.
The lesson:
Buying PUT Options is not a simple hedge against market downturns.
When the market eventually did tank, I was really tempted to buy the stocks that have fallen most — to dollar cost average. But, I learned in the dot com crash that dollar cost averaging is just silly.
The reason for that is opportunity cost. When you buy a stock that has fallen, just because it has fallen, you are giving up the opportunity to buy something better, which you don’t already own. If I bought AIG at $30 and the stock drops to 40 cents — there is a great opportunity for me to dollar cost average, but really — is that the best place for my money?
The Lesson:
Buying a stock to lower your average cost price is just fooling yourself.
I am sure that I have not made every investing mistake that I could possibly make, but I do know that I won’t be making any of these mistakes again.
The Uptick Rule states that you can only short – sell a stock, if it trades higher than its previous transaction price. So if AIG traded at $4 and then at $3.95, you can’t short – sell it. You can only short sell it, if it trades higher than $4. In short, you can short – sell it, only if there is an “Uptick”.
The Uptick Rule was introduced in 1938 in the United States and was eliminated in 2007. There have been calls for re-instating the rule, especially with all the volatility and panic in the markets.
There has been vocal debate on the utility of this rule and whether it serves any purpose at all. There are several factors that you have to keep in mind when looking at the uptick rule.
In the Long Run
The SEC banned any short – selling in financial companies for a brief period between Sep 20 2008 and Oct 2 2008. This was done to reign in price volatility and help the stocks of financial companies.
During that time period Citi moved up from $20.65 to $22.50 and AIG moved down from $4.72 to $4.00. Presently, Citi hovers around 3 bucks and AIG has been reduced to a penny stock.
In the long run, stock prices will reflect the underlying value of the company and nothing else. In the short run, the regulator and market manipulators can influence stock prices, which are distorted and don’t reflect fundamentals.
In the long run we are all dead
John Maynard Keynes famously said – “In the long run we are all dead”. In the context of shares of financial companies like banks – a loss in confidence, however, baseless, can cause a run on the bank that can destroy it. Even if the fundamentals of a bank are strong, if all the depositors decide that they want to take their money out of the bank, only government intervention can save it.
Stock prices of banks and insurance companies play a key role in public confidence in that company. If you see the stock price of your bank getting hammered every day – there is a very high chance that you will take your money out of it. Once that vicious cycle starts, even if the fundamentals of the banks are healthy, nothing can stop its eventual demise.
To that extent, while a cement manufacturer may survive a depressed stock price for months, a bank may not be able to do the same.
So even though in the long term the Uptick Rule may have no impact on stock prices at all — that is not reason enough to leave it alone.
Why worry about the Uptick Rule in 2008 and not 2007?
The Uptick Rule has come into limelight about one year after it was repealed. Had the Uptick Rule been the sole contributor of the current downturn — the downturn would have really started in 2007, and not 2008. That alone should prove that the Uptick Rule is not the sole reason or even a big contributing factor of the crash.
Volatility
That doesn’t mean the Uptick Rule didn’t contribute to volatility, when the crash did come in 2008. It is argued that stocks wouldn’t have fallen as sharply as they did, if the Uptick Rule was still in place. Since this is a rule that discourages naked short – selling, it does provide a cushion against rapid decline in stock prices. By how much and to what degree is anybody’s guess.
Does the Uptick Rule Distort Efficient Discovery of Prices?
Since there is no “Downtick Rule”, I’d say that having an Uptick Rule distorts the efficient discovery of prices. However, when you say something distorts price discovery — it conveys a certain sense of unfairness. I think this sense of unfairness is misplaced because an artificially depressed stock price is far more unfair to the future of a business, its employees, customers, counter – parties etc. than an artificially inflated price is to investors.
Conclusion
There is only anecdotal evidence that repealing the Uptick Rule contributed to the volatility in the recent downturn, but the rule did exist and worked fine for close to quarter of a century.
In fact, after the Asian crisis — Hong – Kong adopted the Uptick Rule. Even when the arguments for or against the Uptick Rule are not really clear, history shows that its existed for a fairly long period of time and in that time there was no compelling reason to get rid of it.
I wrote about TALF a week ago. TALF was supposed to kick start lending and get the credit market going again. TALF covers the following four categories of loans:
Student Loans
Small Business Loans
Car Loans
Credit Card Debt
The first round of TALF loan requests is over and the NY Fed has posted the results.
Amount requested for Student Loans and Small Business Loans: 0
Amount requested for Car Loans and Credit Card Debt: 4.7 billion dollars
Mr. Geithner’s plan to remove bad assets from bank’s balance sheet is finally out and is a roaring success with the market, which rallied about 7% today.
The plan is divided into two parts; the first part deals with the problems of “Legacy Loans” (formerly known as toxic assets). The second part is an expansion of the TALF program about which I have written earlier, so I will only write about the Legacy Loan program in this post.
Here is how the Legacy Loan Program will work:
1. Since the whole idea behind this program is to rid banks off their toxic assets — they will be asked to identify which assets they wish to sell. For example – Krypton bank decides it wants to sell its cattle ranch at Krypton, which has a face value of $1000.
2. After the banks decide what they want to sell, they approach the FDIC and get their assets evaluated.
The FDIC plays a very critical role in this plan.
It insures the debt that will be issued to fund the purchase of the bank’s asset.
It determines the level of leverage that is safe for this transaction. The maximum leverage that FDIC can allow is 6:1.
Let’s say Krypton Bank approaches the FDIC, which thinks that a 6:1 leverage is good for the cattle ranch at Krypton.
3. Once FDIC determines the leverage — the pool of assets is sold off in a bidding process. The highest bidder will have to bring 50% equity, he will get the remaining 50% from the Public Private Investment Program (Government).
Now, this is the most interesting part. Suppose you always dreamed of buying a Cattle Ranch on Krypton, but never had a thousand dollars. In fact, all you have is 50 dollars.
You can put up that 5o dollars as your equity, the government will match that up with 50 dollars of their own. So, the total equity is now 100 dollars. Since the FDIC has approved a leverage of 6:1 — they will insure loans up to 600 dollars. It won’t be too difficult to raise the money because the FDIC is insuring the debt — so you put in a bid of 700 dollars (50 dollars of your own + 50 dollars from the government + 600 dollars of debt). This 700 dollars happens to be highest bid for the Krypton Cattle Ranch.
4. If the bank agrees to the highest price, the buyer will issue debt that is guaranteed by the FDIC. The asset will then act as a collateral for the FDIC guarantee.
In our example — Krypton Bank is only too happy to sell you the ranch and you issue debt to raise the money and become the proud owner of a Cattle Ranch in Krypton. Of course, you have to keep the ranch as a collateral to FDIC, which has insured your debt.
5. The buyer will manage the asset from here on and hopefully make a profit on it. All the best with the ranch.
We will soon know how well the plan will work. As soon as the first block of bank assets come up for sale and the buyers start bidding, we’d know where this is going. If the government has to increase the leverage or the equity participation then that is not a good sign. On the other hand, if the sales start taking off, then that means that the plan is working.
If anything, a down-turn is a great teacher. People start to pay attention and take notice of the mistakes they made. This has been true for me and hopefully I will not make the mistakes that I made this time, ever in my lifetime again.
A lot of people share the same sentiment as me and hope that they don’t repeat their mistakes. But what if they err in identifying their mistake?
A person I know, jumped into stocks during the boom; traded like crazy and made a lot of money.
Just before the bust, he got a new job and it kept him really busy. Since he wasn’t able to trade, he decided that he is going to buy and hold now.
In the next few months, the market tanked and he lost his shirt.
Guess who he thinks the culprit is?
Buy And Hold.
His reasoning is as follows:
He was making a lot of money when he was trading, then he stopped trading and became a long term investor — see where that got him?
To me, this guy is making a major error in judging his mistake, but, it is a very human error.
The only other reason to for his loss would be:
He was not a financial genius and just entered the market at the right time, he benefited out of the general euphoria and his profits had nothing to do with his own brilliance. When the market tanked, he made a loss, much like everyone else and there is absolutely no difference between him and anyone else.
It is easy to see which reason is more palatable.
Until the time I find someone who thought flipping houses was good and the only reason he is upside down on his mortgage is that he decided to live in his house — this is the worst lesson learnt from the recession.
