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March 26, 2009

Hard Money

Real estate investing can generally be summarized into three steps:

• Find It
• Fund It
• Finish It

You must be good at all three steps in order to be a successful real estate investor. In today’s real estate market, “finding it” has become a lot easier. Foreclosures are at record highs. REOs (Real Estate Owned) are numerous. Motivated sellers are everywhere. All you have to do is go out and spend a little time, and you can usually find all the properties you want. The third step, “finish it” (sell or rent), is a topic for another day. But if we can’t “fund it,” we don’t have to worry about “finishing it,” because we won’t even have it!

So let’s talk about the second step: “fund it.” Funding it is a lot harder these days. If you happen to be a cash-rich investor who can afford to pay cash for deals, you are set. But most investors, especially new investors, don’t have a lot of cash lying around to fund their deals. In order to purchase properties, these investors have to use other people’s money (OPM), usually in the form of a loan originated by a mortgage broker or from a traditional bank.

Banks are still making loans to real estate investors, but they are getting harder and harder to get with acceptable terms. The rules have changed. Investors are many times required to come up with larger down payments; 25 percent to 35 percent down is not uncommon. No-doc loans and stated income loans are things of the past. LTVs (Loan to Value) are getting lower, and are usually based on the purchase price, not the value of the property. Even seasoned mortgage brokers are hard-pressed to get decent terms for investors.

We are all hearing a lot of talk from Washington about bailouts for banks and homeowners. No one knows what the outcome of such discussion will be, but one thing is certain: there is no talk of bailouts for investors. We are on our own.

So what must we do to be able to invest in these hard times? Well, the trusty hard-money lender may just be the “knight in shining armor” we are looking for. I can hear you saying it now, “Hard money? That’s too expensive! I can’t afford it!” “Those hard-money lenders are scary!” “I don’t know any hard-money lenders!” Well do you want to invest, or do you just want to make excuses? The choice is up to you.

First of all, it needs to be said that a hard-money loan is not the solution for all situations.You need to run the numbers and see what will work. The numbers never lie, and will tell you if you will make a profit based on accounting for all of the project’s costs, including the costs of a hard-money loan. Do your homework, and you will know if a hard money loan is even an option in your situation.

Next, let’s get rid of some myths about hard-money lenders.

Myth #1 – The hard-money lender mainly wants to get title to the property.

FALSE! Hard-money lenders are in the business of lending money to make a profit. Many, if not most, hard-money lenders were first successful real estate investors, and are now using their money to make a profit for them without having to find, fund, possibly fix, and finish properties. Many still own several properties, but they focus on lending rather than buying for their profits. They don’t want your property. They just want a return on their money based on the risk they are taking.

Myth #2 – The hard-money lender works for the local crime boss.

FALSE! Many people associate higher interest rate loans with loan sharks. A hard-money lender is not a loan shark. First of all, in the case of a loan default, a hard-money lender mainly looks to the property for restitution, rather than looking to you. The interest rates and points they charge are usually commensurate with the risk they are taking in making the loan. Having said this, you still have to be careful concerning with whom you do business. If you feel uncomfortable with a lender, don’t do business with him or her.

Myth #3 – Hard money is almost always too expensive for most deals.

FALSE! Look at the numbers for the deal. They will tell you if the cost of the money will still allow you to make a profit. Remember that some profit is better than no profit at all, which is what you will get if you don’t fund the deal. Don’t get hung up on the higher interest rate. A high interest rate over a short period of time is usually not a deal breaker. But keep in mind that hard-money loans are not long-term loans. If you’re going to buy, fix, and sell, the hard-money loan gets paid off with the sale of the property. If you get a hard-money loan to initially purchase a rental property, plan to refinance as soon as possible in order to get a long-term, fixed, lower interest rate loan. This is a requirement for maximizing your cash flow.

Getting at least one—and preferably, more—hard-money lender on your Power Team is one of the smartest things you can do as a real estate investor because it gives you one more funding option for your real estate purchases. The more ways you have to fund your deals, the greater are your chances for success.

However, don’t be like so many real estate investors who just do a Google search, get a name, call on the phone to ask their current lending criteria, and think they have a hard-money lender on their team. It takes much more than that to develop a good relationship, but the effort is well worth it. Here are some tips that will help you in dealing with hard-money lenders.

Find and work with a local hard-money lender. There are many national hard-money lending groups that you can deal with, but there are real advantages to dealing with a local lender. Once you find a local lender, call and introduce yourself. You can ask some basic questions about lending criteria in order to break the ice and become acquainted. If you feel that he or she is someone whom you would like to work with, set an appointment to go to his or her office. After the office visit, if every thing looks good, take the lender to lunch someday soon. At a relaxed lunch, you can talk about lots of things and get to know each other even better. Find out how he or she got into the lending business. Ask about his or her philosophy on hard-money lending. Equally as important as getting to know hard-money lenders is allowing them to get to know you. Share your goals and plans for your investing. Now you are really building a relationship with that lender.

When you have a deal that you want the lender to look at, take a detailed plan that spells out the specifics of the project and why it is a good deal (cost and potential profit). Show the lender that you know what you are doing and have a plan for the duration of the project, including a clear exit strategy. Most importantly, show the lender how and when he or she will be getting his or her money back.

Another advantage of working with local lenders is that once you have a good relationship, you can call them in the morning, meet them at the property midday, have a loan approval later that same day, and have documents and funding at the title company the next day. Cash and speed of funding will allow you to close lots of deals that would be lost if you only had traditional funding sources to call on.

A good relationship with a local hard-money lender has other advantages. Remember, the hard-money lender makes a good share of his profit on points, so the faster the money turns (meaning the loan gets paid off and a new loan is originated), the more money the lender makes. If you get the reputation as someone who gets things done fast, the lender will want to deal with you. You can also start negotiating reductions in points and interest rates, which could save you quite a bit of money and will put additional profit into your deals.

Now that you know that working with hard money really isn’t so hard, go out and get your share! Find your hard-money sources now, and cultivate those relationships before you need them for a specific deal. That way, when you get that frantic call from a distressed homeowner who is losing his home to foreclosure in five days, you will be able to help!

March 19, 2009

Deal or No Deal - How to Win Big in the Real Estate Investing Game

On the hit television game show, Deal or No Deal, there are 26 different briefcases, each representing various amounts of money ranging from $0.01 to $1,000,000. The contestants choose which of the briefcases is opened next, and the last briefcase opened reveals the amount of money the contestant wins. The ultimate goal is to open all of the briefcases except the one representing the $1,000,000. If the last briefcase opened is the $1,000,000 case, the contestant wins that amount, and is a very happy camper indeed!

While it is a fun show to watch if you have nothing better to do, most would not see a correlation between real estate investing and this popular game show. However, every time an investor makes an offer on a property, they are essentially playing real life deal or no deal. Unlike the television show, which is purely a game of chance, real estate investors can have substantial influence over whether the seller says “Deal,” or “No deal.” Improving your sales and negotiating skills can definitely increase your chances of winning big in the real estate investing game.

As you already know, finding motivated sellers is key to the success of your real estate investing success system. However, just having a motivated seller to deal with doesn’t guarantee that your discounted offer will be accepted. If the seller doesn’t say yes, you have a “no deal,” and you don’t make any money. So what can you do to change a lot of those “no deals” into “deals?”

First of all, you need to realize that identifying good deals is just one part of real estate investing. Your numbers may look great, but in order to finalize the investment, you need to deal with people. Successfully dealing with people takes good selling and negotiating skills.

If you’re like a lot of people, you have less than positive feelings about sales people. The word “salesperson” may even make you think of someone who is dishonest and will take advantage of you just to make a sale. It is critical that you get rid of any preconceived notions you have about being a salesperson. You need to realize and accept that as a real estate investor, you are a salesperson; realize your mind will not let you be good at something you don’t believe in. True selling is about solving problems and creating win-win situations. It’s about building lasting relationships with people by being honest and having integrity. Nothing is accomplished that isn’t first conceived in the mind. So purge your mind of those negative feelings about selling, and train yourself to be a selling superstar!

As an investor, your first product is yourself. You’ve heard it before and you’ll hear it again, “People do business with people they like and trust.” This means your job is to show people you are trustworthy, honest, and likable. You are not only going to be selling yourself to potential sellers, but to potential buyers, tenants, funding sources, real estate agents, attorneys, other investors, and everybody else you deal with. In the process of investing, remember that it’s all about finding out what the other person needs and discovering a way to meet those needs. If you can’t find a way to solve a problem, be honest and let the other person know right away. If you deal fairly with people, your reputation as an honest individual will spread quickly.

Selling involves learning the techniques of positive communications. Essentially, whenever two people are communicating, elements of the sales process are occurring. Just think of the last time you tried to convince someone to do something: your young child to eat their spinach, your teenager to clean their room, your wife to go see the Monster Trucks. Yes, you were selling.

One of the biggest parts of selling is listening and comprehending, and then constructing the deal based on what you have learned. Gather information by asking questions, hearing what is said, and understanding what isn’t said. Keep asking questions until you are sure you understand what the other person has said. Then repeat to them what you think they mean and ask, “Is that what you mean?”

If the other party is receptive to your proposal (your offer to purchase their property, for example), but not entirely satisfied with your terms, you need to know how to negotiate so you can work out the details. Too many people think that in any negotiation, you must have a winner and a loser. That’s just not true. Your goal is to communicate clearly, consider all your options, and come up with a solution that benefits everyone. Both parties have to be able to give and take to some degree, but it is usually possible to come up with a win-win solution.

Here are some helpful negotiating tips:

• Before you begin negotiating, set your limits. Run your numbers, know what you are willing to pay for a property and what concessions you are willing to make, and don’t go beyond those limits!

• Don’t allow your emotions to override your common sense. Set your limits and be prepared to walk away from the deal if you can’t get it for a price that allows you to make a profit.

• Early in the negotiation process, clearly state that you want to do the deal, but that the numbers must make sense. Let them know that you are an investor, that this is your business, and that you must make a profit or you can’t do the deal. Let the seller (or buyer) know you also want them to be satisfied with the deal. By setting a goal by which everyone walks away a winner, you are establishing a positive tone for the negotiations.

• Don’t start off with your best and highest offer. If you do so and the seller says no, you have nowhere to go. Always start with a lower offer and allow the seller to negotiate you to a higher price.

• In your initial offer, ask for things that you really don’t care whether or not you get. This gives the seller something to refuse. Feeling as if he or she is getting you to give up things may make the seller more willing to make his or her own concessions in order to get the deal to work.

• If the seller rejects your initial offer because it’s too low, you can expedite the negotiation by asking, “What is the lowest price you would accept for your property?” With that number, you can decide how (or whether) to proceed with the negotiation. If the price they give you is substantially higher than you can afford to pay, then you can say, “According to my research, I can afford to pay $X for your property. I’m not saying that you property isn’t worth more, but $X is all I can afford to pay at this time.” Then be silent and wait for an answer.

• If the seller still rejects your offer, start to gather up your papers and prepare to walk away. The seller will then realize that you are serious and may call you back for further negotiation. If not, leave the seller with an open-ended offer. Tell the seller, “I wish I could pay more for your home, but $X is all I can pay at this time. Please, continue to try to sell your home. I hope you can get more for your property; you deserve more if you can get it. But know that I will buy your home for $X. So if you can’t sell it for more, please call and we can talk again.” Be friendly and concerned about them and their situation and leave on good terms. Ultimately, you will buy a lot of properties from people who told you no to start with! It is important to follow up with these folks every few weeks to see how things are going with the sale of their property. That way, they know you really care and will be more likely to do business with you in the long run.

• If you are dealing with people who are not that familiar with selling or buying property, explain all the details of the transaction and walk them through the sequence of events leading up to the final closing. Keep them updated as the process moves along. This will give them more confidence in dealing with you and your team.

• If the seller or buyer seems to be confused and unsure about your offer, you could use what is known as the Ben Franklin or balance sheet close. Tell the client when Ben Franklin had an important decision to make, he would get a piece of paper and draw a vertical line down the center. On one side he puts the positive (for) reasons and on the other side the negative (against) reasons. Then you get a sheet of paper out for them. You fill in the positive side with all the good reasons for the decision to move ahead with the deal (i.e. gets them out from under the payments, allows them to move on with their life, etc.) and then slide the sheet over and let them fill out the negative reasons. If you have listened carefully and asked lots of questions during the initial conversations, you will have lots of positive reasons to put down on the paper.

• Another technique to help with negotiations is the “higher authority” approach. If the seller comes back with a counter offer that is reasonable, but still too high, simply tell them you will have to run it by your partner, your associate, the board of directors, or some other higher authority. You can say something like, “I will run this by my partners but I don’t think they will go for it. Is that the best you can do?” The seller may just come down enough to make the deal work, creating a win-win situation.

• “He who speaks first loses.” Silence is a powerful negotiating tool. Use it often. Simply make your offer or counter offer and then shut up. Don’t run off at the month trying to convince them to accept your offer. As difficult as it may be, just wait. If you start talking again and give too much unasked-for information, it can kill the deal. Just wait, and wait. They will eventually speak, and hopefully, will accept your offer. The silence technique can be used very effectively when first inspecting a property you are looking to buy. If you go on and on about all the defects in the home, you risk insulting the owners. Better to look closely at that water stain on the ceiling, take a few notes, and say nothing. If something like a counter top is somewhat uneven, take a marble out of your pocket, put it on the counter top and let it roll to the edge. Catch it in your hand and say nothing. Silence is golden!

There are many other negotiating techniques that can be used. Entire seminars are taught on the subject, and you should continually study and improve your skills. But at the end of the day, if you are honest and deal fairly with everyone, and really try to solve your clients’ problems, you will have a lot of deals accepted and will make many friends along the way. Now, go out and make lots of offers so you will have the opportunity to use your negotiating skills!

March 16, 2009

Give Your Children the Gift of Financial Literacy

By Jacquelyn Lynn

The recent subprime meltdown and the resulting increase in foreclosures has been an educational experience for the entire country, but one important lesson that isn’t getting talked about much is this: Kids need to be financially literate. Report after report describes people signing mortgage documents they didn’t understand and buying houses they couldn’t afford—two clear indicators of financial incompetence in action. What might these people have done differently had they been given the gift of financial literacy as a child

While it is never too late to acquire financial education, it is best to start early, and preschool is not too soon to start talking with your children about financial concepts. Yet some adults find it as hard to talk to their kids about money as they do about sex—and maybe even more so. Here’s how you can help your children become financially literate:
Set a good example. Children naturally mimic their parents’ behavior, so set a good example by becoming financially literate and using positive money management skills. Your words and actions should be consistent—for example, don’t tell your children not to make impulse purchases they can’t afford on credit cards and then do exactly that.
Talk about money. Whether it’s during meals, while driving in the car, or while engaging in a leisure activity with your kids, talk about financial issues. Keep the conversation at an age- appropriate level, but introduce subjects such as the economy, investing, interest rates, debt management, saving, charitable giving, and more. In addition to talking, listen. Encourage your youngsters to share their thoughts and feelings about money without fear of criticism.

Be honest. Kids should know the truth about the family’s financial situation. It’s not necessary to send a message of constant doom and gloom, but don’t paint a picture that’s rosier than reality. If you’re financially secure now but have made mistakes in the past, share that experience with your kids—let them know that you struggled, and that they may have to as well. It doesn’t mean they’re failing, it just means they’re learning some lessons the hard way.
Explain saving and investing. When children are young, you typically teach them to set aside a portion of their money for savings—first in a piggy bank, then in a commercial bank. As they get older, teach them about investing and how they need to learn to put their money to work for them, not just earn a pittance of interest in a savings account.

Require your kids to keep financial records. Have your kids keep a diary of the money they receive, whether it’s their allowance, from work, or gifts, and what they do with it. At least once a quarter, sit down with your child, review their financial records, and talk about what they’ve done with their money. This is a good way to introduce the concept of keeping records and balancing your accounts.

Use everyday events to teach the value of money. A trip to the grocery store can be a great learning experience. Take advantage of this mundane chore to teach your kids about value, quality, and how to make unit-price comparisons. When buying other consumer items, involve your children in the evaluation of issues such as quality, performance, reparability, warranties, safety, and other consumer concerns. Let them learn how planned spending reduces waste and increases value, in contrast to unplanned spending which usually results in poorer value and therefore wasted money.

Let your youngsters make spending decisions. Once you’ve taught them the basics, give your kids a chance to practice what they’ve learned. Chances are they’ll do some things right and do some things wrong. Let them learn that their decisions have consequences, both good and bad. When they make a mistake, don’t scold or punish, but do let them live with the result—no matter how tempted you are to rescue them. Guide and advise, but don’t direct and dictate.

Teach your children about advertising. Consumers are bombarded with hundreds of advertising messages every day, and children are often the targets of those messages. Show your children how to evaluate an ad and figure out if a product will really do what the commercials say, if the price is reasonable, and if there are alternative products available that might do a better job and/or cost less. Be sure they understand the advertising strategy of appealing to emotions and that they know how to separate the emotional appeal that could drive them to make financially unwise decisions from logic, economy, and utility.

Explain the truth about debt. Teach your children about the difference between good debt and bad debt, about how using debt to build wealth is good but using debt to buy depreciating consumer items is bad. Make sure your kids know that simply pulling out a credit card does not mean that something is paid for, and that they shouldn’t charge consumer goods they can’t afford to pay for at the time of purchase.

Have your children participate in the bill-paying process. Let kids see how often you have to sit down and pay bills—and let them see the bills. Show them how to write a check or use your online bill paying system, and let them actually pay a few bills every month. They should know how quickly the balance in your checking account declines after the mortgage, utilities, and credit card bills are paid each month. Show them how to check bills for accuracy—especially how to review a credit card statement and be sure all the charges are legitimate and accurate.

Teach your children the value of giving. Help your children develop the habit of giving to charity from an early age, whether it’s giving to a church or other charity. You might suggest that they set aside 10 percent of whatever income they receive for this purpose. As you teach the value of financial giving, also stress the importance of giving of themselves.

Have your kids set financial goals. Talk to your kids about what they want in the future such as going to college, owning a car, or owning a home. For younger children, it may be things such as a bicycle, a game, or an electronic toy. Each child should write down their goals and put together a plan to achieve them, then periodically review the plan to see how they’re doing. Encourage them to maintain this habit throughout their lives.

What’s most important to keep in mind is that there is nothing mysterious or difficult about financial literacy. Children who are not taught these valuable lessons pay an expensive price for the rest of their lives. Get your kids on the right track as soon as possible and watch them blossom into financially secure, independent adults.

March 10, 2009

Trading Journal

Are You a Serious Trader?

By Tim Justice

Trading is considered a business for a professional. But not all people who trade the markets treat it as a business. Do you want to know if you are a serious trader? Here is a simple litmus test: Can you tell me the entry date, price, size, total profit and loss, exit date, and the reason behind why you made your last five trades? If the answer is no then you have a lot of room for improvement in getting organized.

I have coached hundreds of students over the past few years and one constant remains: The students I work with who keep good records do better on average than those who do not. Record keeping can include many different areas, ranging from tracking your equity curve month to month, writing out your trading rules, and keeping a trading plan for each and every trade you enter.

Discipline is an absolute requirement if you expect to do well in the markets. Intelligence, education, common sense, and a good approach help too. But you must be disciplined. In fact, if you stay disciplined and outlast the initial learning curve, you are destined to succeed.

Let’s define discipline the following way: It is disciplined trading if you refrain from emotional trading, overleveraging, and trading against your trading system. The first step is to create a trading plan, write it down, and follow it. The old adage of “plan your trade and trade your plan” fits perfectly here. So what information do you need to keep, and where do you keep these records?

Let’s deal with where you keep records first. I prefer to keep my records on my computer in a spreadsheet. It is easy to enter and keep organized. You can keep them in a notebook as well, but if you do, I recommend you get a notebook that you set aside and only use for this purpose.

Some traders like to keep their records in the trading software they use or their brokerage account. You can make that work, but a word of caution: Being able to go back and look at your trade fills and executions is not the same as keeping a trading journal and writing out a trading plan for each trade. There are very real differences. First, it takes time to track down the old trades and figure out when and where you made the trade. Second, even when you do find them, you may not remember the details of the trade and why you made it. Lastly, it just screams of laziness.

Once you decide where to keep the records, the following information will be needed. Keep in mind that this is just a basic model, and you can chose to track other information as well. However, these are the basic components of each trade log:

1. Trade Number
2. Entry Date
3. Long or Short
4. Ticker
5. Size
6. Entry Price (Including commissions.)
7. Total Cost Basis (The price multiplied by the size of the trade adding in commissions.)
8. Stop Loss/Risk Management Plan
9. Trade Target (What is your goal in profit, pattern, or underlying security price? How are you going to manage the trade as it moves?)
10. Pattern of the Stock. (Basic technical characteristics. This is kept for your own benefit so that when looking back in review, you will remember some of the things you were looking at.)
11. Reasoning Behind the Trade (Why did you enter the trade?)
12. Exit Date
13. Exit Price
14. Total Gain or Loss
15. Final Analysis (Did you execute the trade based on your trading rules? Did you learn anything from this trade?)

You can retool this list to fit your personality and trading system. For example, if you are an options-spread trader, you may want to include columns including maximum risk and margin requirements. But the basic framework above will work for most traders.

The most important thing to remember is that you are putting in this work for your own benefit. Learning from our mistakes is vital. In order to effectively assess where we are making mistakes, we need to log down our decisions in detail.

When you enter the trade, you will need to do some initial record keeping, like you have seen above. Two of the most important things to write out are stops and targets: where you are going to exit on profits or losses. This does not have to be a specific decimal point, but you better have a pretty good idea of what you expect to happen in the position.

A stop loss is an order that you place with your broker that tells the broker when to exit your position. Stop losses can be set on any instrument and traders traditionally use them to mitigate risk. They are very important in a trading system. Some traders tend to set a mental stop, while others write one down on paper, or put it in their trading log. This can work, but most (especially those who won’t be watching the market) will need to learn to place a stop on their trade through the broker.

Placing a stop loss is one way to mitigate risk as it gets you out before more losses occur. It’s not the only way. You can also control your risk through your position size, your strategy selection, and by using vehicles like options and futures creatively to create hedges. If you are new to trading, you will want to focus on stops and position size.

If you decide not to set a stop, you still need to write down in your trading log where you will exit the trade if it goes against you. In my experience, the types of trades that hurt accounts are those where a trader refuses to sell it on a loss. The best advice I have ever been given in trading is to cut losses short and let your profits run. Good trading requires that you sell losing trades. You can not just hold them and hope for the best. Hope is a wonderful thing, but it is not a trading plan.

Targets are set to have some picture of where we want to get out of trades on profits. You will not want to run away from successful trades. Letting your profits run and develop is a very smart thing to do. It will be important that you learn the signals to watch for that tell you when to get out. Setting an initial target is a starting point that can and will be adjusted as the trade develops.

Finally, remember that keeping records and being organized will help you become a better trader. It’s a sign of professionalism and will keep you focused on the task at hand.

Bears, Bulls, and Bailouts...Oh, My!

There has been much said and written concerning the current issue of bailing out certain companies and industries. It has become quite a hot topic for millions of Americans because it directly affects them in their chosen professions, let alone the ambiguous implications it can have on the financial markets!

The automobile industry and the financial holding/investment banking industry have been singled out in reference to the current bailout debate. Since these industries have been experiencing extensive hardships, we have been asked to consider bankrolling them into the future. True to form, other industries have now reserved their place in line for a government hand-out.

The repercussions of such a hands-on, interventionist strategy are extensive. One of the questions that we as traders should be asking is if such a bailout will promise success for both the industries in question and the markets in general, or would a more free-market solution be more effective? Investors, on the other hand, are wondering if these previously recognized blue-chip growth stocks, which are now slumbering in the financial basement, are a good buy, considering their currently inexpensive asking price. An investor/trader must always bear in mind, however, that they are the definition of a risk taker because any investment, after all, is a risk—one that hopefully yields a reward in the future.

A good way to analyze and understand the issues with this strategy of interventionism and fiscal manipulation is to look back to the first big bailout of modern times. Before A.I.G., Fannie and Freddie, and even before Bear Stearns, there was Chrysler.

In 1979, when it was still the tenth largest company in the country, Chrysler found itself on the verge of disintegration, largely because high oil prices had made its hefty, gas-consuming automobiles less appealing to the masses (much like today). Company executives, along with union leaders, came to Washington with their heads hung low and proceeded to argue that Chrysler’s dissolution would wreak unacceptable havoc on the American economy.

Congress and the Carter administration responded by arranging for $1.2 billion in subsidized loans, which was an extremely extravagant amount of money, and still is, even when adjusted for inflation. The Reagan administration helped further in 1981 by restricting Japanese imports in an effort to increase the ability and opportunity of Chrysler to increase their supply to meet consumer demand.

On paper, the Chrysler rescue was a big success. Under Lee Iacocca, the company came out with the original minivan, as well as the K-car line of smaller vehicles similar in design to the Dodge Aries. By the mid ‘80s, Chrysler had repaid the loans in full, with interest. Mr. Iacocca later appeared on the cover of Time Magazine as “Detroit’s Comeback Kid,” and his autobiography became a number one best seller.

One can see a clear connection from the Chrysler bailout to the recent attempts to steady Wall Street. Back then, Washington “insisted on a few pounds of flesh, like a wage freeze for Chrysler workers, in exchange for aid. Mr. Paulson has done something similar by insisting that shareholders of the Wall Street firms benefit little from any bailout.” (Leonhardt, 2008) But why should the shareholders be kept from any perceived benefits when, after all, it is the shareholders who assume most, if not all, of the risk?

In 1979, the government structured the Chrysler deal so that taxpayers might earn a profit from it, which they did. This past year, the Federal Reserve effectively purchased securities from Bear Stearns that it hopes to sell for a gain when the financial markets calm down. Harvard economists have recently said of the matter, “While it’s way too early to know if the strategy will succeed as well as it did three decades ago, it’s certainly conceivable” (Leonhardt, 2008). Conceivable or not, many are certainly wondering when it became a viable fiscal policy for the United States government to purchase equity in private institutions.

The Chrysler bailout may have saved the company, but it did nothing to stop Detroit’s long, sad, and (some would say) inevitable decline. This begs the question as to whether or not we are doomed to repeat history until we finally find a way to learn from it. Is there something that investors can learn from the events of yesteryear regarding the fiscal decisions our leaders in Washington are making?

Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. “The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill¬overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead” (Summers, 2008)

Whether you are a fan of the actions taken by our political leaders or not, the constant in this equation is that the idea of bailing out industries as they experience wicked declines has consistently entered into the discussion.
This method of Keynesian macroeconomic maneuvering is becoming something of a phenomenon as political leaders look to bail companies out first in an effort to solidify voting bases, rather than allow the business cycle to follow through. We have essentially allowed our political leaders to create an economic precedent that may be extremely hard to rescind, if not impossible; and with this precedent comes an environment that carries with it some rather volatile conditions.

It may be difficult for our leaders to understand the realities of the business cycle. With the good comes the bad; with every retraction and contraction in the cycle, an expansion will gloriously follow. While it may be towards the expansions of the business cycle that our gaze is fixed upon, I would argue that it is during these gleeful expansions that we actually create the most damage in our market-based economy. It is when we are sitting on top of a newly created peak, with the recent memory of the trough eliminated from our consciousness due to the current good times that we allow fundamental rules and moral obligations to be broken in exchange for quick-and-easy cash, sturdy profits, electoral victories, or obscene performance-based bonuses. If history has taught us anything in the world of finance, it has taught us that greed can move the markets just as significantly as fear, the only difference being the speed by which these two emotions propel us.

While it may have worked for Chrysler, thus benefiting the company and the taxpayers who footed the bill, the question still remains as to whether or not this line of problem-solving is actually in the best interest of a capitalistic society. It may fall directly into the line of Keynesian economic theory, but it creates an economic atmosphere that could easily mute any opposing ideas. It creates an extremely ambiguous environment for traders to operate in because of the cause-and-effect status that politicians generate through their grandstanding and midnight voting sessions.

There are handfuls of examples that easily compare what Chrysler went through with what several large corporations and industries are going through today. Unfortunately, the automobile industry is right back where it started: in search of yet another government bailout. Is this perpetual trend something worth protecting in an apparent free and capitalistic economy? Or are we, through our leaders’ actions, choking the roots by which we have grown into a global economic behemoth?

One thing is for certain. A person who intends to trade capital in a system that is becoming more and more manipulated by government interaction and regulation needs to keep both eyes and ears wide-open in an effort to remain vigorously prepared for and updated on the day’s goings-on. It may take some time to become comfortable deciding which strategy will suit a given eco-political situation or event, but it is possible, and can certainly be profitable. The main ingredient to this recipe is a cup of practice, with a tablespoon of more preparation, and a pinch of constant observation and due diligence.

March 08, 2009

Stock Questions and Answers

Q: I’m just beginning to venture into options trading, and am wondering if you could shed some light on what a spread trade is and why it’s useful.

Good question! Let’s first define what an option-spread trade is. A spread is a strategy that involves buying at least one option, while selling another simultaneously. With spread trading, you can create virtually limitless combinations of risk and reward. When most novice traders are introduced to the options arena, they typically begin with simply buying call or put options. While these two strategies can be quite lucrative when you are right, they can also cause quite a bit of damage when you are wrong.

There are two primary advantages to spread trades, the first of which is that spread trading allows us to reduce the cost of the trade, thereby reducing the risk. For example, suppose stock XYZ is currently trading at $60, and you want to establish a bullish position. Assessing the current option quotes, you see that the one month 60 call is trading at $6 and the 70 call is trading at $2. Rather than buying the 60 calls outright for $6, we could enter a call spread by buying the 60 call and simultaneously selling the 70 call. This would drop our cost (and max risk) from $6 to $4.

A second advantage of spreads is the ability to place multi-directional trades. In other words, it is possible to create spreads that profit if the underlying stock moves up or down, up or sideways, down or sideways, etc. This allows us to widen the range of profitability, thereby increasing the probability of success. Becoming more comfortable with options spreads necessitates the use of risk graphs. Risk graphs visually portray the risk/reward characteristics of an options trade while also allowing the user to examine “what if” scenarios to see the effects that a change in time or volatility would have on a specific strategy.

Q: What is the difference between an American-style and a European-style option?

The main difference between these two styles of options is when they can be exercised. Most option traders, whether they’re aware of it or not, are trading American-style options. If you’ve ever traded options on stocks such as Wal-mart (WMT), Exxon (XOM), or Microsoft (MSFT), you’ve traded American-style options. These options can be exercised anytime prior to expiration. For example, if I were to buy a 3-month, 50-strike call on stock XYZ, I have the right to buy 100 shares of XYZ at $50. I can exercise this right today, tomorrow, or anytime before options expiration. European-style options are much less common, and can only be exercised on the day of expiration. A lot of stock indexes, like the NASDAQ 100 Index (NDX), Russell 2000 Index (RUT), or S&P 500 Index (SPX) are European style. It may be important to mention that, although we can’t exercise a European style options prior to expiration, we can sell it whenever we want. In addition, American and European options have nothing to do with geographic location.

Q: I tried my first straddle trade, and it left me quite perplexed. I placed the straddle two days before a stock’s earnings announcement, and when the announcement came out the stock gapped down eight percent. Although I expected to see a tidy profit, I was losing money! I thought a straddle makes money either way a stock moves?! What gives?

Your explanation reminds me of the first few straddles I tried back in the day! Rest assured you are not the first trader that has experienced the disappointment of unfulfilled expectations with straddles. Let’s see if I can shed some additional light on your trade. A straddle involves the simultaneous purchase of an at-the-money call option and a put option. Because the trader is long both a call and put option, the trade is bi-directional, and will profit if the stock makes a substantial move to the up or downside, as you stated in your question. However, there is another variable that can drastically affect the outcome of a straddle trade: implied volatility. Remember, as implied volatility rises, option premiums rise; as implied volatility falls, option premiums fall. In addition, at-the-money options are the most sensitive to changes in implied volatility. Because straddles involve the purchase of two at-the-money options, they are very sensitive to changes in implied volatility. In general, we like to enter straddles when implied volatility is low, and exit when implied volatility is high.

It is well known that earnings announcements generally cause an increase in volatility in the stock price, thus producing up-gaps and down-gaps. In anticipation of this increased stock volatility, option premiums (implied volatility) generally rise prior to the earnings announcement. Think of the earnings announcement as a catalyst to cause a short-term increase in actual stock volatility. Once the announcement has been made and the stock has reacted, the stock typically reverts back to its normal level of volatility. Consequently, after an earnings announcement is released, implied volatility usually gets crushed back down from its lofty, pre-earnings-announcement levels. This volatility crush causes the extrinsic value portion of an options premium to deflate very rapidly.

This could be what happened with your straddle trade. Although the gap down resulted in a theoretical gain due to the stock movement (Delta), you lost more money due to the volatility crush (Vega) that so often occurs after the earnings announcement. One possible solution for mitigating this volatility risk is to make sure that you enter the straddle before the implied volatility has increased too much. You can consult a volatility chart to determine whether or not the implied volatility has begun to increase. Sometimes, this may require you to enter approximately three to four weeks prior to the earnings announcement. In addition, if the implied volatility has increased substantially prior to the actual announcement, it may be wise to exit the straddle before the announcement and ensuing volatility crush. Good Luck!