The Origin and Exacerbation of the Credit Crunch

I hold some strong views about the most seminal financial event we have experienced in the last 50 years and will hi-jack this post to explain those views and opinions.

For those who have no patience, the cause was socialism.  But read on if you dare.

First, it was not a credit-crunch.  It was debt crisis or grand theft.  To call it a credit-crunch is sugar-coating the scale and core impact.

Secondly our journey begins with world-wide low interest rates during the Greenspan administration at the Federal Reserve.  During this time, non-USA banks were faced with a competitive landscape of interest rates and thus borrowing money globally became cheap.  Houses were built, businesses expanded, money was borrowed, houses were bought and business employed more staff.

As the easy-initial-loan-terms came to an end around 2006, LIBOR rates also rose dealing a double-whammy to borrowers sailing close to the wind (the so-called ‘sub-prime’ borrowers).

So far, so boring.  I think most would agree with this synopsis of the early issues.  From here, though it’s 4 quick steps to disaster with point 3 being pivotal:

1. The banks were regulated to ensure that they had enough money in reserve to support the loans they were making.  The definition of ‘enough’ is that approximately for every $30 the banks were lending they must have $1 in reserve.  Now that is leverage!

2. The FASB decided that this was the right time to force the banks to account for the assets that backed the loans they were making.  Many banks were attaching a high-probability that their loans would get repaid in full and carried the loans on their books as reliable assets.  After all, they bought insurance against the loans defaulting, so-called “Credit-Default” instruments or swaps.  The FASB decreed a new accounting standard, FAS 157 which would force banks to re-value certain assets with a more realistic approach to their value.  Instead of assuming that they will be paid back in full, the banks must look at the market each day and determine the price of the asset.  With defaults rising and the cost of debt insurance rising, these values plummeted and thus drove down the real value of that $1 supporting $30 in the loan market.  The impact was catastrophic.  Credit markets seized.  No banks had the legal right to lend to each other, let alone retail borrowers.  Banks started to fail as the new-look accounting standards made their operation look insolvent.  If there’s one thing a bank must be, it’s solvent.

3. Now the banks also had creditors.  The banks issue bonds (debt instruments) to raise money.   In exchange they pay interest on the bonds (say 4%) but lend the money out at (say) 6%.  That’s banking in a nutshell.  However, many of the banks’ lenders would be in deep difficulty if all the banks failed.  But “so what!”, I hear you cry.  It’s a free-market economy and if rich people lent the banks money and the banks failed, that’s their problem.  Tough.  Investing is a risk business.  However, many of these lenders also lent money to countries.  Countries like the USA and UK.  These countries rely on the international lenders to raise money to pay their state-funded institutions.   In good times, this can work.  In bad times, tax revenues plummet, but the demands of the state (Welfare, Education, Defense and their pension costs) remain insatiable.  There was no alternative for socialist countries like the United Kingdom.  If they did not save the failing banks, their creditors would not lend money to their government.  The UK would be bankrupt within 3 months.  Or at least that was the theory.

4. UK, USA and many other countries’ governments decided that their ability to borrow money as a nation (against the ability to tax citizens on pain of imprisonment) was more important than letting free-market economics determine the fate of the failing financial institutions.   We witnessed the obscenity of rich investors being ‘guaranteed’ that their money was safe.  This was done with future taxes of our children and it’s still happening today.  Probably the single biggest financial theft in history.  A kind of reverse Robin-Hood model.   Bank failures should have united left and right politicians.  Banks should have failed.  Investors should have lost money.  However a government’s greed and ego knows no bounds.  Would it have worked to have let the banks fail?  Compare Iceland (who did) to Ireland (who didn’t).  Whose children are going to be richer?

The socialist imperative to take money from one man and give it to another prevailed.

“Socialism is a philosophy of failure, the creed of ignorance, and the gospel of envy, its inherent virtue is the equal sharing of misery.” – Winston Churchill

© The Naked Putz 2011

Do I feel lucky?

“Well do ya, punk?”

One of the golden rules of Naked Put investing is you’ve “got to ask yourself one question” before you write the Put and it’s not the question in the title of this post.

You must ask yourself whether you would be delighted to own the stock at the net price you would be forced to take ownership of the equity should you be assigned.

The net price is the strike minus the premium you received.  If you would like to own the stock at this price, then you have a trade that will “make your day”.

If you are not happy to own the stock at this price, then you shouldn’t write the Put.

It’s not about luck.

© The Naked Putz 2011

90% of Option Traders Lose Money?

Google the title of this post and you will find many ‘experts’ telling you the odds are stacked heavily against you in the Options market.  Either failed traders or ‘Options Educationalists’ trying to tempt you with their ‘secret sauce‘.

“90% Lose Money!”,  they Scream.  “Don’t do it!”, or “Only do it once you’ve purchased my book”.

Let’s just fact-check this shall we?

If I buy an option, then at expiration I have either made money or lost money and the seller of that option has either lost an amount equal to my gain or gained an amount equal to my loss.

The option is either exercised or it isn’t.  It’s a Binary Event.

For example, if I buy an IBM $105 call option for $1 while the stock is at $100 and IBM rises to $110, I have made $4 ($110-$105-$1 cost of the call premium) and the seller has lost $4 as they have to deliver the stock to me at $105 which will cost them $5 minus the $1 premium they got from me for the Call option.

The same is true for any strike and closing price and whether you are a buyer or a seller and whether it’s a Call or a Put.

For every options trade there is a winner and loser of equal proportions.

Some of these ‘loser myths’ stem from the experiences of novice traders trying to make that big kill on the cheap 5c call option, hoping the underlying spikes by $5 and the delta sees their option grow by 1000% to $5.05.   Successful trades of this type are rare and probably account, in part, for the misinformation.  The truth is much simpler and if you understand the dynamics of risk, you will be able to make money in Options as there are an equal number of winners and losers.

Options trading is a zer0-sum game and don’t let anyone tell you any different.

© The Naked Putz 2011

Naked Puts versus Covered Calls

Naked Puts are often equated to the same risk/return profile as Covered Calls.   Instead of buying the underlying and offsetting the price with a premium, you commit to buying the stock in exchange for a premium.  Both have limited upside and the same downside profile.

So why do I choose Naked Puts?

1. I don’t have to purchase the underlying and can thus keep my cash in an interest-bearing instrument while the trade is active
2. The wash-sale rule doesn’t apply to selling Puts (as long as there’s not an odds-on chance of the Put being exercised)
3. Commission costs on a Covered Call are higher to open the trade.  You buy the stock and you sell the Call.  A Naked Put only requires you to sell the Put

Traders often tell me “Yes, but you might miss the dividend by not owning the underlying”.  That’s true, but in my experience:

1. Dividend stocks are often less volatile and thus don’t often meet my premium requirements
2. In my experience, when a stock goes ex-dividend, the share price usually (and miraculously!) drops by the dividend amount
3. I usually trade near-term options (current month) so there is much less chance of me owning a stock during a quarterly dividend payout.

And that, friends, is why the Putz is Naked.

© The Naked Putz 2011

How the Financial Times can make you a millionaire in less than 25 years.

The FT can make you £1.3m ($2m) in 25 years.  Follow these steps:

1. Ask your local newsagent to deliver the FT daily
2. Now call him to cancel the order
3. Save the money for one year you that would have spent on the FT
4. Invest in the DJIA
5. Continue to save the money you would be spending on FT daily and invest at the end of the year in the DJIA
6. Repeat 5 for 24 years
7. Collect £1.3m pounds

Really?  Yes really.  The FT is £2.  It was £1 in 2007.  That’s a 100% increase in three years or 28% per annum.  (the weekend FT is actually £2.50, but we’ll keep things conservative for now).

The DJIA returned an average 11% from 1926-1999.  The real stinker is the price inflation on the FT which will have you paying £748  a copy in year 25 if the last three years’ cover price is anything to go by.

The power of compound interest.  I’m conveniently ignoring the eroding effects of inflation and tax, but the power of compound interest is astonishing.

© The Naked Putz 2010

The only formula you will ever need…

This is magical.   This is how money makes money.  This is the simplified compound interest formula.

Once you understand and appreciate it, there is no looking back.   It’s divided civilizations and helped to create some of the richest and some of the poorest people in the world.

• P is Principal, the amount of money you start out with.
• r is Rate, the interest rate expressed as a decimal (ie 0.05 for 5%)
• n is Number of times the interest is applied (ie number of years for annual interest)

How powerful is it?  Start out with $10,000 in my favourite currency at 10% per year and after 40 years you’ll amass $452,593 gross.

Perhaps you can add 1,000 each year to the Principal?  A variation on this formula shows you will have grown to $939,444.

But what pays 10%?  Corporate bonds.  But be careful on the ratings.

Of course inflation eats at this and tax has to be considered, but the power is immense.  It’s that apple-sized snowball that you roll from the top of the snow-covered hill.  It just grows and grows and grows.

Get this into your DNA.  The investing road ahead is tough and you’ll get beaten up from time to time.  This formula is your light at the end of the investing tunnel.

© The Naked Putz 2010

What’s an Option?

As Julie Andrews once said and Oscar Hammerstein once wrote, let’s start at the very beginning, a very good place to start.

This is 101.  Get this and you can go on to lesson 2.

If you buy an option, you acquire the right to buy or sell something at a specific price and time.

What the hell is that all about?

Ever put down a deposit on a vacation/holiday?  Then you have purchased an option.  You’ve bought the right to pay for a vacation at fixed time and price.  You can choose to proceed or not.  You have purchased an option and have the right, but not the obligation, to pay the balance and take the vacation.

The travel company has sold you that option.  They have the obligation to deliver your vacation at the agreed price and time if you so wish (by you paying the balance).

1. If you pay for an option, you have bought it and have rights.
2. If you have received money for an option, you have sold it and have obligations.

These are the immutable laws of options.

Ok, that’s enough.  If you understood that much, then the next article on Options will expand (a little, not a lot) further on the concepts and practicalities of options.

© The Naked Putz 2010

Why oh why?

Why am I starting this blog?  What’s possessing me to share my thoughts on options and the trades I make?

I’m smitten by options and believe it’s a powerful way of leveraging years of experience in stock-market investing.

I have some knowledge to share but am still learning.

I hope one or two find it useful.  All others can have their money back.

© The Naked Putz 2010