The market place has changed, option premiums are not quite as expensive as they were even six months ago. This might seem like a good time to buy options, but the stock needs to move a lot in order to make money on the option premium. For anyone reading this report who already owns stock, especially stock they want to keep, then writing a covered call provides them an additional way to add cash to their accountto build up their asset base. When you buy an option, you have a 1 in 3 chance of making money. When you sell a option you have a 2 in 3 chance of making money. If the stock goes up, you make money. If the stock stays the same, you make money. Even if the stock goes down, you can still make a little bit of money. In short, it is a cash flow strategy to help support your family and pay your bills. It is a strategy that can be mastered. To write in the stock market means to sell. Covered, means you actually own the stock. A call is an option. We are going to sell the call option against our stock position to generate cash into our account.
For example, you have 400 shares of a stock at around $50 per share. Originally you purchased this stock at $45. You find the $55 call for November is going for $2.50. You have 400 shares, so you could sell 4 contracts at $250 each, which would be $1000. You have given someone the right to buy your stock from you at $55; you have been paid $1000 to give them that right. That $1000 is yours whether your stock goes up, stays the same, or goes down. If the stock moves above $55 on or before the expiration date, you could have this stock purchased away from you. You purchased the 400 shares of stock for $45, now you are selling it for $55. That would be a $10 profit per share multiplied by your 400 shares. This would be an additional $4000...
One important question is to ask yourself do I want to sell this stock? If you want to sell the stock, then sell the $50 calls for $4.50. That would generate $1800 into your account, and you would have a higher likelihood of being called out at the $50 strike price. If you really want to sell the stock, you could sell the $45 callsthat would generate $7 each, or $2800. Now as long as the stock stays above $45, you will have it taken away from you electronically on or around the weekend after the 3rd Friday of November. If you do not want to sell the stock, then sell the higher strike price, generate a smaller premium, but then have a lesser likelihood that the stock will be taken away from you. You still have the risk of the stock going down in value. You may want to consider stop-loss orders on your stock so that if it drops, you are out of the stock, then you would have to wind out of the call position.
It can be as easy as 1-2-3. 1) Keep your stock purchases in 100 share increments. 2) Ask your stockbroker about the different strike prices and different months, the further out, more premium, but then the stock is tied up longer. 3) Sell the option contracts against your stockthat money will be in your account in one day, which you can use for anything you want. THIS CAN BE DONE MONTHLY! |
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Years ago, I was a limited partner at Bear Stearns and Company in New York City. Once a year, we would have a partners meeting, and I would attend as a matter of course. Now keep in mind that we were a trading firm, also a brokerage firm. Back then we didnt do nearly the amount of investment banking that is done by some of the majors such as Goldman, Merrill, and Lehman Brothers at the time.
What was most interesting however is that we always referred to ourselves as The Bank. Its a strange term when you consider that we were never licensed as a bank by the appropriate federal agencies. Nevertheless, on Wall Street when people were talking about their own specific firms, they always internally talked about The Bank.
The reason for this term is quite simple and appropriate. Years ago, if you wanted to know how much money a brokerage firm made all you had to do was calculate interest earned versus interest expense, and you basically had the bottom line, give or take a bit on a pretax basis. When I was s Senior Accountant with Arthur Andersen in the early 1970s, this calculation was always appropriate, and we dominated banking and finance type companies at that time.
Recently after all these decades it looks like the same technique applies today that applied back then. Most individuals and institutions are still not making the interest they should be making, on the funds they have deposited with brokerage firms. They need to keep a better eye on their funds. The whole issue is the concept of IDLE CASH, and what is being done with it. Back in the late 70s, Merrill Lynch led the industry with the development of what they called the CMA account which stood for Cash Management Account.
The objective was to go up against the banks both commercial, as well as savings and loan and fight for the cash. What the brokerage firms are doing now is sweeping your idle cash from your accounts on a daily basis and paying you interest on that dollar amount. What are the brokerage firms paying? The answer is probably as little as they possibly can. Recently I saw rates on the order of 1.5%.
What happens is that at the end of the day, the firm checks to see what idle cash is available in your account. It then sweeps the cash and pays you 1.5% on the balance or less. Meanwhile the firm acting like a bank will reinvest your cash over night in its own firm account at a much higher rate. Do these numbers amount to anything?
Would you believe that last year in 2006 Merrill Lynch must have made net, net $2 billion for its own account after paying out lesser amounts in interest to its customers on their idle cash balances? Thats right; they made $2 billion after expenses but before taxes. Is this any way to run a firm? You bet it is. The $2 billion was up from $1.3 billion two years before that. This means the firm is getting better at sweeping the balances, and they are sweeping bigger balances.
Morgan Stanley started getting into the act last year, and Smith Barney which is owned by Citigroup got into the game late by starting up last September with the same technique. When Merrill was quizzed about the practice, they came back and said that the brokers at the firm are encouraged by the firm to discuss higher-interest options in order to meet specific client demands. Now I own a brokerage firm, and have been in the business for 30 plus years, my answer to that is SURE.
The master of this game is Charles Schwab, the discount brokerage house. They were using this technique years before anyone else. Merrill apparently took it from them. Today if you study Schwabs financials closely, there is no question that they make more money from sweeping the idle cash from their clients accounts, plus margin interest than they do from brokerage commissions.
Brokerage firms also pay different interest rates on these idle cash balances depending upon the actual balance. The small guy gets hurt, as he always does by having less money to deal with. Balances below a $100,000 usually get the lowest rate which is probably about 1.25% at the moment. The big boys who have over a $1,000,000 sitting in the account can easily negotiate a higher rate by simply picking up a telephone. What the brokerage firm counts on is not getting that phone call.
Since most people with brokerage accounts are always transacting business by buying and selling securities, they are not consciously aware of their idle cash balances all the time. They are thinking about gains and losses, not interest. This is a mistake, because if you are not watching your money, whos watching it. The guy in charge of sweeping your account, is he watching it? You bet he is, but its not your interest he has at heart. His year end bonus is completely dependent upon how much he sweeps, and how little he has to pay you for your own money.
Forget about reading the small print in your agreements with the investment companies. They use language that requires a lawyer to interpret. Thats why the agreements are written by lawyers. The agreements will tell you that the accounts are tiered. This means the larger the balance, the more interest you will get. Now how are you supposed to know that?
Wachovia which owns the old Prudential broker network waits until the fourth paragraph of their customer agreement to tell you that Wachovia may seek to pay as low a rate as possible. This reminds me of the time that I was talking to a General Motors engineer about how much the jack cost in the trunk. His answer at the time was a50 cents. I said you got to be kidding, are you telling me that my life is dependent upon a 50 cent jack when I get a flat tire in the middle of a winter night. His answer was Yes, 50 cents is what we pay. As I walked away, he yelled, Do you want to know why we only pay 50 cents for that jack. I said sure, why? He said, Because we cant get one for a quarter.
Be careful what you do with your cash, whos calling the shots on it.
Goodbye and Good Luck
Richard Stoyeck
Value Investing at StocksAtBottom.com |
You might be familiar with Amaranth LLC, the giant hedge fund that collapsed last fall, after blowing up $6 billion of investors money. It now comes out that the circumstances under which they self-destructed are worth studying.
But first A METAPHOR
What would happen if you had a pain in your chest, and you had tests taken at your doctor on a Monday who you have known and trusted for 30 years? He tells you that the results will tell you if you are going to live or die, no in between. You now visit the doctor on a Friday to discuss the results. The doctor says to you how would you like to bet on the results.
You offer to bet $1 million that you are going to live. The doctor says, I will take your bet myself. Would you still make the bet? The answer is no, of course you wouldnt because the doctor already knows the result. and you dont. Its like betting against the house in Las Vegas when the house already KNOWS how the results will turn out.
This is the same situation in our opinion that Amaranth the hedge fund faced during its trading crisis. Hedge funds have to book their trades through a clearing firm, no different than many major brokerage firms clearing trades for smaller brokerage firms. The smaller firm pays a fee to the bigger firm that clears the trades for them.
In the case of Amaranth the hedge fund, JP Morgan was the clearing broker, known as a Prime Broker. In essence Amaranth made bets on the energy futures markets, and these bets went the wrong way. As a hedge fund, Amaranth uses leverage when it trades against its equity, usually borrowing about 6 to 1, and sometimes as high as 8 to 1. JP Morgan as the clearing broker was the lender of the additional margin.
Now when a trade goes against a hedge fund, the fund may be called upon by the clearing firm to put up more margin, meaning cash, or securities to protect the clearing firm. In this case the problem happened on a Friday. Amaranth wanted to get rid of billions of dollars of toxic bad trades by giving them to Goldman Sachs, who agreed to take them if Amaranth would give Goldman $2 billion in cash along with the trades. Goldman would then assume the risk of what happens to those trades. Amaranth wanted its clearing firm, JP Morgan to give Goldman the $2 billion from its capital account simultaneous with the movement of the trades.
JP Morgan would not release the funds. They barked, stating that they felt they would still be at risk if this were to happen. A clearing firm hates risk, and never wants to take risk. Amaranth very quickly had to operate in the most treacherous waters imaginable. They had to begin talking to outsiders in a desperate attempt to structure a transaction with anyone capable of taking these trades or injecting new additional capital. Remember, this is Wall Street, the sharks were circling.
Anyone who had knowledge of Amaranths trades knew immediately how precarious the oil markets that Amaranth was involved in. They also knew how to play the market to its own advantage using Amaranths weaknesses. The SHARKS came in and did trades that would work to their advantage. Within a matter of trading hours, this giant hedge fund was losing hundreds of millions of additional dollars. Merrill Lynch decided to take a piece of the funding deal, and this drove Goldman Sachs up a wall. Goldman upped the ante, and decided to charge Amaranth hundreds of millions more to do the deal which would partially save Amaranth.
Now heres where our story of the doctor with the patients information and the patients bet come in handy. JP Morgan as the clearing broker was in a position to know more about the condition of Amaranths books, and their trading positions than anyone else in the industry. Since JP Morgan also trades in the same market as Amaranth, the bank knew the markets condition better than anyone else also.
When the Morgan bank was informed that a deal was imminent between Goldman and Amaranth, the Chairman of Morgan got involved himself and called in his top energy trader over the weekend. Morgan was thinking of making their own deal for Amaranths positions, the very positions that they cleared for Amaranth over the preceding months.
The Morgan bank was sitting in the catbird seat. They knew everything; they saw everything, no different than a black jack dealer in Las Vegas being able to tell everyones cards. As a person who has been in this field for 30 years, and watched a few firms go down the tubes in a deal like this, I tell you, it doesnt SMELL RIGHT.
JP Morgan knew that Amaranth couldnt make a deal with anyone as long as the Morgan bank held the collateral. No deal could be structured if Morgan wouldnt release at least part of the money in the Amaranth account at Morgan. The Morgan bank was in complete control of Amaranths destiny. What would the bank do?
JP Morgan also acts as a giant hedge fund trader for its own account in the energy markets, and in other markets. In a sense it competes against its clients if it chooses to, in these markets. The difference is when you are a major clearing firm as well as trading yourself, which is what Morgan does, you have the advantage. You have an understanding of the market place that nobody else can even dream about having. It is the traders ultimate dream. There are times when the clearing firm can dictate the market.
The FINAL DEAL
Discussions ensued through the weekend, into Monday, and Tuesday. Amaranths finally capitulated at 5:30AM on Wednesday morning, and guess who signed the deal. J.P. Morgan in conjunction with the Citadel Investment Group, another hedge fund inked the deal. Amaranths $800 million in portfolio losses from the weekend would be eaten by Amaranth themselves. Morgan and Citadel got $1.6 billion in cash to take the trading positions in the portfolio off Amaranths books. They got another $300 million to assume options positions, plus a $250 million kicker for commodity investments.
Whats the bottom line here? It just became public information that J.P. Morgan made $725 million for its bottom line on the deal. Congratulations to a nice conservative bank, that always catered to conservatively managing the trust funds of its wealthy clientele. Do you think that GREED had anything to do with the banks decision to cut the deal with Amaranth, as opposed to arranging a bailout? Gee, a bank wouldnt function like that, would it?
Goodbye and Good Luck
Richard Stoyeck
Value Investing at StocksAtBottom.com |
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Reuters - Procter & Gamble Co , the world's
largest consumer products company, posted higher quarterly
profit on Tuesday, as price increases and cost controls more
than offset soaring costs for oil and other commodities.
Reuters - Sony Corp (6758.T) agreed to
buy Bertelsmann's 50 percent stake in their Sony BMG music
joint venture for around $900 million, ending a four-year
venture that never managed to beat the music industry's woes.
AP - The U.S. service sector contracted in July 聴 though less than expected 聴 as new orders decreased and prices rose, stifling growth for truckers, retailers and insurers.