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Yahoo! Finance Columnist, Anya Kamenetz wrote a very interesting and in your face reality article about the danger of credit card debt.

What exactly is the problem with credit cards?

1. The aggressive, misleading marketing: “You are pre-approved” letters for your dog.

2. The fine print: Fees, penalties, and high interest rates.

3. It’s the debt, stupid!: Credit cards let you buy stuff you can’t afford with money you don’t have. They make you poorer in the long run, plain and simple.

Personally, I choose 4. All of the above.

Read the rest of Anya Kamenetz’s Yahoo! Column.

Credit Card Debt Statistics:

The survey was released in September 2007 by Nellie Mae, Graduate students now average $8,216 in credit card debt, according to a new survey, which also says students wish they had learned earlier about handling money.

The average graduate who borrowed for college leaves school with almost $20,000 in student loans and about $2,000 in credit card debt. About two-thirds of students borrow for school, according to Chicago Tribune. You’re in deep debt before you send your first resume to find a job.

“These credit card issuers circle the campus like sharks circling a fish,” says Elizabeth Warren, a Harvard Law School professor. “Companies are turning over every possible rock to find a live human being to take one of their credit cards and use it. The college-age student is a prime target.”

Each fall, concerns about young adults falling prey to aggressive credit card marketing resurface as 17 million college students flock to campuses across the USA. Nearly a dozen states, including New York and California, have made it harder for card companies to market on public campuses. And a growing number of colleges, on their own, have begun to impose restrictions.

But these steps belie a stark reality: Credit card marketers today are as aggressive as ever — just more creative — about reaching students. Some solicit students by phone or e-mail, and flood their mailboxes with credit card applications. Other marketers set up tables around heavily trafficked campus areas, hawking free sandwiches or pizzas to hungry students to get them to sign up for a credit card.

At universities that restrict credit card solicitation, marketers legally bypass the rules by moving across the street from campus. It takes about five minutes to fill out a credit card application. In a few months, students can fall deep in debt, charging beer and designer jeans, as well as school supplies, to these cards.

“Graduate students are apparently doing what the rest of the nation is doing: using credit cards to sustain their lifestyle,” says Gail Cunningham, vice president of business relations for Consumer Credit Counseling Service of Greater Dallas.

The study, “Graduate Students and Credit Cards in 2006: An Analysis of Usage Rates and Trends,” suggests that:

• The more time spent in graduate school, the more likely a student is to grow his or her credit card debt level. On average, older graduate students (aged 30-59) carry $12,593 in credit card debt, almost twice as much as their younger counterparts (aged 22-29) who carry an average debt of $6,479.
• Only 20 percent of all grad students pay off their monthly balances.
• The average outstanding balance on credit cards held by graduate students rose 10 percent since 2003 from $7,831 to $8,612.
• Ninety-four percent of graduate student survey respondents used credit cards to pay for some portion of their direct education expenses, primarily textbooks. Twenty-eight percent admitted paying for part of their tuition with credit cards.
• Ninety-three percent of grad student respondents would have liked more information on financial management topics before they started school and would like financial management education now.
• The percentage of graduate-level students who have at least one credit card decreased only slightly in the past three years (from 96 percent to 92 percent).

Who is Anya Kamenetz?
Anya Kamenetz is a freelance writer living in Brooklyn, NY. She is a contributing writer for Fast Company magazine and a columnist for Yahoo Finance. She is the author of the popular book “Generation Debt” and Generation Debt Blog

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Popularity: 3% [?]

I often get queries about my approach to fundamentals in choosing a
stock. First, let me say that if there is one fundamental that is head
and shoulders above the others, I believe it to be earnings. The old
adage “follow earnings, follow earnings, follow earnings” says a great
deal. One of the failings of so many participants in the dot com
debacle in the late 90’s, early 2000’s was that many companies whose
stock prices were soaring simply had no earnings. When considering
earnings, it is important to compare like periods of time. While I
would like to see earnings increasing quarter over quarter, that simply
is not going to be the case in some sectors. Retail, for example, is
not a sector where we would ordinarily expect 1st quarter earnings to
exceed 4th quarter earnings. In retail, the huge earnings season is
ordinarily the 4th quarter so it is important to compare the most recent
4th quarter to the previous 4th quarter as well as to compare year over
year.

I should also point out that simply because a company has good
fundamentals does not assure that its stock will perform especially well
in the short or even mid-term. I consider Microsoft (MSFT) to be a
great fundamentally sound company with loads of cash. However, if we
look at price performance over the last 4 years, we find that it has
essentially traded between $20 and $30 a share. That is not to say that
a trader cannot make money on the up and down moves, it is simply to
point out that a good company does not necessarily mean it will have an
upwardly moving stock. Compare MSFT to Google (GOOG), for example.
From its IPO in 2004 to the present, GOOG has jumped from $100 to over
$500 a share.

In my view, fundamentals help us determine what to buy but do
little in telling us when to buy it. Technicals, on the other hand give
us information that assist us in determining when to buy and when to
sell. In the Microsoft (MSFT) case, for example, while the stock may
become a bullish trade when it bounces off a support in the $20 range,
the expectancy is that it will likely remain range bound and the trader
may want to tighten stops as it approaches resistance in the $30 range.
At the moment, it does not look like a great buy in the $29 to $30
range. However, if it breaks up out of the range, it may engender a
great deal more interest from a bullish player.

Fundamentals encompass a wide array of factors. Earnings, as I
suggested are very important and should be compared to past performance
of the stock as well as to other stocks in the same sector. I also
believe debt is the enemy of corporations as well as of individuals so,
after earnings, I like to see debt within reasonable bounds and
certainly within proximity to other companies in the same sector.
Again, P/E (price to earnings ratio) in general should not be too far
out of whack with the market and sector within which the company
trades. I also like to see a fairly low price to book value ratio since
the break up value of the company is an important factor to consider.

I consider it important to realize that fundamentals can, and
sometimes do, change within the blink of an eye. What would happen to
Berkshire Hathaway, for example if Warren Buffet decided to step down?
Have you seen the affect of the prosecution of a high corporate officer
on the price of a company’s stock. What if a competitor comes out with
a new and better product? As many of you know, I edit a $10 and Under
service where I send alerts concerning cheap stocks I like. Rarely do I
expect great fundamentals on cheap stocks. Generally they are cheap for
a reason so I make most of those plays on a purely technical basis.
That does not mean I can’t make money as profits can be realized on companies
without particularly great fundamentals.

Bill Kraft, Editor

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Eric Aafedt

Popularity: 2% [?]

While many of our readers only trade stocks, I thought it might be
helpful to write a bit about options, specifically call options. I
often use call options in my Option Trader trades and my own portfolios,
so I thought it might add some clarity if I provide some explanations
of certain basic options strategies. At the risk of boring some of the
more sophisticated traders, I’ll start by defining options and call
options in particular. I’ll then take a look at buying calls as a
directional strategy. If the readers are interested, I’ll look at other
strategies using calls and, later, puts in subsequent articles.

Options are quite simply *contracts*. One party to the contract
pays a premium and obtains some kind of right. That person is the buyer
of the option. The other party to the contract receives the premium the
buyer pays and takes on some kind of obligation. In the case of a call
option, the buyer pays a *premium* and, for that premium, the buyer
obtains the right (but does not have the obligation) to buy the *stock*
at the agreed price (the *strike price*) anytime before *expiration* (in
the case of American style options). We can see several terms in the
preceding sentence that require some explanation.

An option *contract* usually controls 100 shares of stock. Note I
said “usually.” Sometimes it may control a different number so the
trader always needs to check.

The *stock* is also known as the underlying. Options deal with a
specific underlying so one of the elements in buying or selling an
option is what is the underlying.

The *strike* price (also known as the “strike” or the “striking
price”) is the price at which the buyer of a call has the right to buy
it and the price at which the seller of a call is obligated to sell the
stock if called (also known as assigned). In other words, if the owner
of a call *exercises the option *(calls the stock) he is buying the
stock at the agreed strike price and the seller must sell him the stock
at that price if the option is exercised before expiration. For American
style options (most stocks with options are American style), expiration
is noon on the Saturday following the third Friday of the month. For
practical purposes that means they expire at close of trading on the
third Friday of the month since we can’t trade on Saturdays.
As you can see, options *expire.* That means that the buyer no
longer has the right to buy the stock at the strike price and the seller
no longer has an obligation to sell at the strike price. The call buyer
who did not exercise his options and buy the stock at the strike price
before expiration loses the premium he paid and the seller of the call
keeps the premium and no longer has any obligation after expiration.
The *premium* is the amount paid by the call buyer to the call
seller (for the right obtained by the buyer and the obligation
undertaken by the seller). Premiums consist of one or two elements. One
of those elements is *time value*. Since the buyer of our call option
is obtaining the right for some period of time, he will be paying for
that element. Generally, the more time one buys (the farther out the
expiration), the higher the time value will be.

Now that we’ve seen the elements that make up options, let’s look at
a concrete example to try to gain some clarity. As I write this piece,
Waste Management (WMI) is trading right around 35. Suppose I am bullish
on WMI. Of course, I could buy the stock and profit if it went up. I
could also consider buying some call options since I would expect the
price of those options to go up as the stock went up. I am writing this
in June and I see that the *October* (that means they expire on the
third Friday in October) *35* (that’s the strike price) calls are
trading at $1.80 x $1.90. So, for example, I could buy 1 contract of
the Oct 35 calls for $190 (that’s 100 shares times the $1.90) plus
commission. That is what is known as an “at the money” call. I am
buying the strike that is the same price at which the stock is currently
trading, i.e. 35. All I am paying for is time. If the stock stays at
35 until the third Friday in October would my option be worth anything?
No, I have the right to buy the stock at 35 but that’s all it is selling
for on the market so there is no advantage. However, let’s say the
stock went to $50 early October. What would my 35 call option be worth
then? Well, I have the right to buy the stock for $35 a share and I
could turn around and sell it for $50 so my option would be worth at
least $15 plus some time value until expiration. That $15 is *intrinsic
value* and the option is then what is known as “in the money.” So now we
can see that call options that are “in the money” are options whose
strike price is less than the price at which the stock is trading.
Those options have both intrinsic value and time value. An option is “at
the money” when the price of the stock and the strike price are
essentially the same. Premiums for “at the money” options are all time
value. Finally, one can also buy out of the money options. In the case
of a call, “out of the money” options are those whose strike is greater
than the actual price of the stock. Again, when buying “out of the
money” options, the trader is paying for only time value. “Out of the
money” options are always cheaper than “in the money” options or “at the
money” options because there is less liklihood that they will have any
intrinsic value at expiration. In fact,one of the common mistakes novice
traders make is to buy short term out of the money options because they
are cheap. Folks, they are cheap for a reason.

Many novices believe that traders buy call options with the
ultimate intent of exercising them by purchasing the stock. Ordinarily,
that is not what is done. The call buyer is looking for a move up in
the stock price. If the stock price moves up, the price of the call is
also expected to move up. If that happens, the call buyer can profit
simply by selling the call. Let’s take a theoretical example of XYZ
stock trading at $35 a share. Suppose it’s June now and we think XYZ is
going up so we decided to buy the Oct 35 calls for $1.50. We buy 10
contracts and pay $1500 (10 contracts x 100 shares per contract x $1.50
a share) plus a commission. We want the stock to go up. Let’s say it
runs up to $40 in a couple of weeks. Now, our Oct 35 calls are $5 in the
money and have that $5 intrinsic value, but there is also time left so
they will have some time value in addition. Suppose the time value is
$0.80. Now we can sell our calls for $5.80 and bring in $5,800 (selling
10 contracts x 100 shares per contract x $5.80 a share) less a little
commission. Now we have a profit of $5,800 minus our original $1,500
investment or a profit of $4,300. That’s a 286% return. What was our
risk? It was our original investment of $1,500. Even if the stock went
to zero, we couldn’t have lost more than we paid for the calls in the
first place plus commissions. Compare that to the stock purchase. If
we bought 1000 shares of the stock at $35, we’d have $35,000 invested
(half that on margin) and our whole $35,000 would be at risk. If the
stock moved $5 to $40 a share and we sold it, we would make $5,000 less
commission, and that would only be a 14% return. Let’s see, which is
better, risking $1,500 and getting a 286% return or risking $35,000 and
getting a 14% return? Of course, it isn’t all that easy or clear. When
we bought the call option, we knew it would expire. Time is running
against us. We need the stock to go up and to go up fairly soon,
certainly before expiration, if we are to profit.

Buying calls is a bullish strategy. The following is reprinted from
the CutLoss Level One Training Manual © with the permission of the
author (me):

“Instead of buying stock if we are BULLISH, we might buy CALLS on the stock.
Some of the advantages of buying CALLS:

-If we’re right on the direction and the stock moves fairly quickly,
we profit quickly

-Risk is limited to what we paid for options

-We can play higher priced stocks without committing so much money
to the trade

-If successful, our percentage return will be higher

-We can control more shares of stock with less money (leverage)

Some of the disadvantages of buying CALLS:

-We can lose some or all of our investment if the stock doesn’t move
in the direction we anticipated in a relatively short period of time

-The time value of the option erodes as time passes making the
option less valuable

-We will lose money if we are wrong about the direction of the
stock’s movement.”

As time goes on, I plan to include articles on various other option
trading including writing covered calls, vertical credit and debit
spreads, selling naked puts, and horizontal and diagonalized spreads.
I’m not going to make this an options column so these will be
interspersed with other articles of a more general nature.

Bill Kraft, Editor

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Eric Aafedt

Popularity: 2% [?]

Last week I wrote a little about calls. I defined them and showed how they could be used in place of a stock to try to profit on a rising stock. The article generated quite a lot of interest so this week, I’ll address another bullish strategy using calls.

This strategy is bullish and is one of the more common uses of call options. It is known as writing covered calls. In stock lingo writing means selling. Covered means you own the underlying stock, and you already know what a call is from last weekend’s article.

Let’s use an example that existed during the past week. When NYSE Group (NYX) was trading around $62.90, the Jul 60 calls were trading at $4.50 x $4.80 while the Jul 65 calls were trading at $1.95 x $2.10. If we’re going to write covered calls, we need to own at least 100 shares of the stock since a single option contract controls 100 shares of stock.

In case you are unfamiliar with option quotes, you’ll see that there are two prices, the bid and the ask. The bid (lower number) is what someone (often the market maker) is willing to pay for the option and the ask (higher price) is the price at which someone (often the same market maker) is willing to sell the option. The difference between the bid and the ask prices is called the spread. In our example on NYX, you can see that the spread on the July 60’s is 30¢ and the spread on the 65’s is only 15¢.

Back to covered calls. Suppose it looked like NYX was moving up. We could buy the stock for $62.90 a share and simultaneously sell calls against the stock (known as a buy/write when we do both at the same time). Suppose we decided the stock looked very strong and we decided to buy the stock at $62.90 and simultaneously sell the Jul 65 calls for $1.95. Since option contracts usually control 100 shares of stock, we would have to buy at least 100 shares of stock to sell 1 contract of call options. In this case, let’s say we decided to buy 100 shares of the stock for $6,290 and sell 1 contract of the July 65 calls for $195 (100 shares x $1.95) our net debit would be $60.95 ($62.90 minus $1.95) so we would only have $6095 out of pocket since the market is giving us $1.95 a share for the calls. Now what is the situation? Well, we own 100 shares of NYX, but since we sold the Jul 65 calls, we are obligated to sell our stock at $65 a share if called anytime before July expiration. Since the stock price is less than the strike price of the call we sold, we sold an “out of the money” call in this example. If the stock doesn’t get above $65 before expiration what happens? Well, we get to keep the stock because no one is going to pay us $65 a share if they can buy it cheaper on the open market, and we also get to keep the $1.95 a share premium we got for selling the call. What if the stock is more than $65 at expiration? Well, we’ll most likely get called out (assigned) since the call buyer can now buy the stock from us for $65 and immediately turn around and sell it for whatever price the market is then paying. Of course, we still got to keep the $1.95 a share call premium AND, we have sold a stock we bought at $62.90 for $65 thus adding another $2.10 a share to our profit. If we don’t get called out, we made $1.95 a share on our $62.90 stock or about 3% for less than a month. If we do get called out, we make the $1.95 premium PLUS the $2.10 a share profit for a return of about 6.4% for less than a month. Of course, commissions are paid on the transactions so we need to be aware of that cost.

Instead of selling the “out of the money” call, we could have chosen to sell an “in the money” call. For example, with NYX at $62.90, we could have bought the stock and simultaneously sold the Jul 60 call for $4.50 a share. Now, our out of pocket would be $62.90 - $4.50 = $58.40 or $5840 for the 100 shares. Suppose the stock stays above 60 (the strike we sold) to expiration. Well, we’d be called out at $60 a share, wouldn’t we? But we paid $62.90 a share so we’re going to lose $2.90 a share. So what, the market gave us $4.50 to sell the call and now, we’re only giving back $2.90 of that $4.50. We KEEP $1.60 a share even if the stock drops almost $3 from where we bought it. That’s less than a one month return of 2.5%!

Buying stock is always risky. The risk is what we pay for the stock because theoretically, at least, the stock could go to zero. So, when we buy a stock and also sell a covered call, our risk is always less than it is if we bought the stock alone. The market has paid us to sell the call and our risk is reduced by that amount. Some traders and investors sell calls against their portfolio quite regularly and can thereby enjoy reduced risk and a monthly return on their investment. Of course, if we sell a covered call, we are obligated to sell the stock at the strike price we sold. In our example, suppose NYX went to $100 a share and we had sold the 60 call. Unless we had taken some action to buy back our call, we’d have to sell the stock at 60 if called (and we certainly would be). So, when we sell covered calls, we are giving up some opportunity to the up side if the stock runs. If we’re afraid to lose that chance, writing covered calls isn’t for us. If we want to reduce risk and create monthly income, it is a strategy worth learning.

Bill Kraft, Editor

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Eric Aafedt

Popularity: 2% [?]

I’ve never met anyone who has read “Rich Dad, Poor Dad” by Robert
Kiyosaki who didn’t agree with the premise that in order to become rich
it is necessary to have your assets working for them (unless they
inherited wealth or won the lottery, etc.). Most of us work for a
living and we, ourselves, are the only money producing asset. That is a
very rare way to wealth yet it is what we are taught to do. I recommend
Mr. Kiyosaki’s “Rich Dad, Poor Dad” to you. Hopefully it will inspire
you to learn to utilize assets in addition to your own time to produce
wealth for you.

I teach seminars and mentor students concerning stock and option
trading. One of the common misconceptions I see when students begin
taking our seminars is that they think it is a way to get rich quick.
That is definitely not the way I see it. Stock and option trading can,
indeed, lead to great wealth, but it also has risk. Sometimes the risk
is relatively slight and sometimes the risk is enormous. I’ve seen
traders “bet it all on black.” In other words, I’ve seen people take
all their money and put it into a single play. That’s scary to me.
I’ve seen them lose all their trading money in a single day. That’s not
investing, it’s gambling. I don’t mean to say that money can’t be made
gambling, it can. Over the long haul, however, the gambler in the
markets usually goes broke. One of my own mentors told me not to try to
get rich quick, but rather to try to get rich steady and that made a lot
of sense to me.

In this series of articles, I’ve written about a number of things
that I believe are extremely important to successful trading. Subjects
I’ve touched upon include having a business plan (I set out a beginning
outline to construct a basic business plan), money management, some ways
to cut losses and let profits run, and various strategies. All of those
things are important, but, most important of all, in my view, is
knowledge. The more advanced trader can sometimes transform a losing
position into a winning position if she knows some countermeasures or
she can at least reduce the loss in a position that has turned against
her. The beginner just doesn’t know what to do. Where do you fall in
that continuum?

I don’t care who it is, your money is more important to you than it
is to anyone else. You probably work very hard to earn it. Isn’t it
every bit as important to learn how to preserve it and how to grow it?
Only you can motivate yourself to do it. Is it easy? Is it get rich
quick? Is success going to be handed to you? Probably not. Like almost
everything that is worthwhile, it is going to take work. I think we’ve
been schooled to believe that trading is too hard for most of us and we
must rely on someone else. Horsefeathers! How well did the experts
running the mutual funds do when the market crashed in 2000? How well
did the analysts pushing Enron do? With a little knowledge and the
willingness to keep learning you have the opportunity to place yourself
in a financial position you never thought you could achieve. The catch
is IT’S UP TO YOU. I’ve heard it said that if you are willing to do
what others won’t for 6 months or a year, you’ll be able to do what
others can’t for the rest of your life. Wealth is not just about money,
it is about quality of life. It is a wealthy man who can enjoy and
spend time with his family. It is a wealthy woman who can devote time
to what she loves. Money can help achieve the independence necessary to
live the quality of life we seek; it can help free our time for the
things that are truly important to us. Family, charity, activities that
may be beyond our means now are within our reach if we choose to make
the effort. It isn’t for everyone, but if it is for you, start now.

One of the first things that deter students is vocabulary. “I’m
going to open a diagonalized calendar spread” or “I think I’d like to
adjust my bullish put spread since the stock turned bearish” may have
little meaning to you at the moment, but with a little study you’ll
become fluent. Did you ever study a foreign language? Remember the
first couple of days in class when you thought you’d never get it?
After a couple of weeks, you were beginning to converse and understand
some basics. It took some effort, but you gained ground rapidly. The
same thing is possible in studying trading. Chances are you can do it.
You just have to want it. If you don’t go after it, I doubt you’ll get
it. If you do go after it at least you’re giving yourself the chance.

Let me suggest that you set aside some time each day or each week
or each month to study. Set aside the time and do it regularly. Use
your subscriptions to see what I am doing. See if it makes sense to
you. Learn from my mistakes. Trade on paper without real money until you
see how you are doing with any particular strategy. Don’t trade with
real money until you have personally practiced a strategy and understand
the risks and nuances. Keep learning, it’s worth the effort.

Bill Kraft, Editor

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Eric Aafedt

Popularity: 2% [?]

Following publication of my Article on calls and writing covered
calls, I received a thoughtful and helpful letter from a subscriber.
After thanking me for the article, the subscriber suggested that I may
not have emphasized the risks associated with the covered call strategy
strongly enough. He suggested that the inexperienced trader could “put
the cart before the horse” and just look for calls with high premiums so
he could then buy the stock and write the high priced calls.

My subscriber noted that my article did point out that buying stocks
is always risky and was concerned for the neophyte that the idea of
buying a stock just because the call premiums were high could prove
disastrous. He then, quite correctly, noted that the risk graph for
writing covered calls was the same as for selling naked puts. He
suggested that no one would ever suggest a novice sell naked puts. As an
aside, I should note that brokerages apparently see a risk distinction
between writing covered calls and selling naked puts since they will let
almost any client write covered calls, but require the trader be level 4
and have a defined minimum account balance before selling naked puts.
Does that make sense when, as my subscriber pointed out, the risk graphs
for the two strategies are exactly the same?

Finally, my subscriber suggested that the strategy of writing
covered calls “…applies only to writing calls on investment grade
stocks that the reader already owns…” I believe all of his points are
worthy of discussion, but I don’t necessarily agree that covered call
writing be reserved for only “investment grade stocks” already in the
portfolio.

Truth is, I thought I had made the point that stock buying is
risky. It seemed obvious to me that writing a covered call involved
buying a stock so the strategy is risky. Of course, it is less risky to
buy the stock and write the call than it is to buy the stock alone. If
we buy the stock alone without taking in a premium, our risk is the
price we paid for the stock. If we write the covered call, our risk is
the price of the stock less the amount we took in for writing the call.
The real point the subscriber makes is that writing covered calls can be
risky and that traders shouldn’t just go out and buy stocks to write
covered calls simply because the calls have a high premium. There is
usually a reason for the high premium — and it’s usually high risk.
That’s a valid point. The strategy is bullish so we usually don’t want
to buy a falling stock just to write a call. I write calls on stocks
that are flat to uptrending. Of course, the largest premiums are often
found on the falling stocks. That is the danger about which my
subscriber is rightly concerned.

I don’t agree that calls should *only* be written on stocks that
are considered to be “investment grade” since a stock is only
“investment grade” in hindsight once the profit is realized. For
example, was Cisco an “investment grade” immediately before it dropped
90% over 2-1/2 years; is it today? Or GE that dropped 65% in 2 years? Or
Qualcomm that was down 88% in 2-1/2 years? Or Amazon when it was down
95% in less than 2 years? That list goes on and on.

I often buy stocks that are nowhere near what one would think of as
“investment grade” (even though that is a suspect category, see above)
and sell calls against them. If the stock is bullish in a bullish
sector in a bullish market and has a good return on its call premium,
why not? If it turns, I can generally undo the play for what is
normally only a slight loss. Knowledge makes a big difference in what
strategy to use and how to use it. Anyone who trades is taking on
risk. In my opinion, common sense dictates that anyone entering any
trade has an obligation to himself or herself to understand that trade
completely before they ever even consider putting real money at risk.

The fact is, I do teach novice traders how to trade naked puts as a
strategy and, as I have repeatedly said in my Articles, I encourage them
to paper trade the strategy (as any strategy) before ever putting real
money at risk.

I really don’t expect people to go out and utilize strategies I
mention in my Articles without doing the other things I repeatedly
mention including creation of a personal business plan, formulation and
use of a money management strategy, paper trading each strategy until
they can trade it successfully before putting real money at risk, and
continuing their education. Trading is a business. If one were going to
open a computer technician business or a greeting card store, they would
have a business plan wouldn’t they? Well, it is every bit as important,
if not more so, to have a business plan for trading. As part of that
plan, it is critical that the trader develop a money management plan.
As I have discussed in earlier articles, without a proper money
management plan the trader is likely doomed from the beginning. So, too,
I believe it is foolish to trade a strategy that one does not understand
completely. In order to understand a trade completely, one must not
only study it, one must also practice it. The initial practice needs to
be done without using real money, without putting real money at risk.
The would-be trader needs to paper trade the strategy until he can
successfully repeat it over and over. Only then should he even consider
putting his toe in the water.

This business of trading is just plain risky. It is not get rich
quick! It requires study, patience, practice and EFFORT. It can pay
off handsomely, but like any other successful business it requires
understanding of the business, understanding of the risks, knowledge of
what one is doing, proper management of money and continuing education.
Only then does the trader begin to give himself a chance.

Bill Kraft, Editor

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Eric Aafedt

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In recent weeks, I’ve devoted some space to basic information
about calls. I’ve written a little about buying calls when a trader
thinks a stock is going up and I’ve written about selling calls against
stock the trader already owns (writing covered calls) and I’ve discussed
risks of entering those types of trades. While calls may be used in a
number of additional ways, I’ve tried to give the reader a beginning
understanding of some of the uses and risks of certain strategies using
calls.

This week, I’m going to turn my attention to the definition of put
contracts and one important use that can be made of puts from the put
buyers’ perspective. If you’re new to the Newsletter, you may want to
check the archives for the June 24th Newsletter “A Little About Call Options” where I covered
terminology such as expiration, contract size, strike price, etc.

Remember that options are simply contracts between a buyer and a
seller. When an option contract is opened the buyer always obtains a
right and the seller undertakes an obligation. In the case of a call,
the buyer obtains the right, but does not have the obligation, to buy
the stock anytime before expiration (in the case of American style
options) at the strike price and in exchange for that right, pays the
seller a premium. The seller of a call, on the other hand, receives a
premium and for that payment undertakes the obligation to deliver the
stock, if called (known as being assigned), at the strike price anytime
before expiration.

Now, let’s see what right the buyer of a put obtains and what
obligation the seller takes on in exchange for the premium. The buyer
of a put obtains the right, but does not have the obligation, to put his
stock to the seller at the strike price anytime before expiration and
for that right, pays a premium. Think about that for a moment. The
buyer of a put can force someone to buy his stock at the strike price
anytime before expiration. Suppose Mrs. Trader owns 500 shares of ABC
at $50 a share. If the company went down the tubes, the stock could
literally go to zero, couldn’t it? Mrs. Trader would lose $25,000 if
that happened, wouldn’t she? Now suppose it is July and that Mrs. Trader
owned the same 500 shares of ABC stock at $50 a share. Also suppose she
also bought 5 contracts of the Dec 50 puts on ABC for $5. Remember,
most option contracts control 100 shares of stock (always check) so she
would have spent $2500 to buy those puts (100 shares x 5 contracts x
$5.00 a share). Now what would her situation be if the stock went to
zero sometime before the Dec expiration? Well, she could exercise her
$50 puts and require someone (she wouldn’t know who) who sold $50 puts
to buy her now worthless stock for $50 a share. She would “put it to
him.” Now, she would sell her stock for $25,000 and would only have lost
her $5 premium ($2,500). That strategy is what is known as “buying a
protective put.”

Protective puts have been likened to insurance policies. Just like
when buying insurance, the buyer of a put pays a premium. The premium
buys the protection of being able to force someone to buy the stock at
whatever strike price the buyer has chosen. In our example with Mrs.
Trader, she bought the at the money put so anytime until expiration, she
could force someone to buy her stock for what she paid for it. If she
decided to do that, her loss would be limited to what she paid for the
put. Of course, Mrs. Trader could also have chosen to buy an out of the
money put which would have cost less. Suppose she chose to buy the Dec
45 put instead of the Dec 50 put because it only cost $3.00 a share
instead of the $5 for the Dec 50. Now, she would pay $1,500 (100 shares
x 5 contracts x $3). Though she is paying less for the puts, she is
also adding some risk. Instead of forcing someone to pay $50 a share if
she exercised her puts, she could only force them to pay $45 a share.
In effect, she is taking on an additional $5 a share risk herself. That
additional $5 risk is akin to the deductible in an insurance policy.

While you can probably see the reduced risk during the life of a
protective put, it is also necessary to be aware that buying protective
puts also increases the total cost of the position. When buying a stock
and a protective put, the cost is obviously greater than buying the
stock alone, but the risk of stock ownership is decreased during the
life of the put option. When we buy a house or a car we insure it
against loss (many times with a deductible). As long as the insurance
policy is in effect, we reduce our risk of loss if something happens to
the house or to the car, but, of course, we pay for that protection.
Buying a protective put is analagous.

Though a trader or investor can make a lot of money buying stock,
stock buying is always risky. Each trader as part of his or her business
plan should decide whether and under what circumstances protective puts
should be utilized. If someone considers themselves to be a “long-term
investor” who doesn’t want to babysit their positions, it might be wise
to consider protective puts. How about the investor who has all his eggs
in one basket, like the stock of the company where they work. Should
they consider some protective puts? Think of all the people who lost
fortunes with Enron or Worldcom. I’ll bet they wish they knew about
protective puts.

As you have probably gathered by now, the seller of a put is paid
the premium and, for that payment, undertakes the obligation to buy the
stock at the strike price if it is assigned to him at anytime before
expiration. In a sense, the seller of a put is akin to the insurance
company since the seller is taking on the risk in exchange for the
premium received.

While a complete exploration of put strategies is well beyond the
scope of this article, I do want to note that as the price of a stock
goes down, the price of a put generally goes up. Often traders won’t
assign their stock when it goes down, they will simply sell their
current puts for a profit and then, perhaps buy more. Puts also may be
used to profit when stock is dropping, but that is the subject of a
future article.

Bill Kraft, Editor

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I have written an Article for this Newsletter each weekend over the
past many months. Now, I’d like to indulge in a little review. I
wonder how many of my readers agree that trading is a business and that
most successful businesses have a business plan. I’d guess that most
everyone would agree that a business plan is a very helpful, if not
necessary, device to run a business successfully. Next I wonder how
many of you actually have formulated your own business plan. Darned
few, I’ll bet. I always question students who are availing themselves of
the free retakes of our basic seminars whether they have done their
business plan. It astonishes me how few have done their plan. Not
surprisingly, most who fail to do their plan usually just plain fail.

In the April 29th, 2006 edition of this Newsletter “Business Plans for Traders and Investors”, I set out 13
elements to help get started on creation of your own plan. Take a look
at that again if you’d like. All you have to do is fill in the blanks
as they apply to you and you have the foundation of your own plan. I
believe most plans are better than having no plan at all, and if yours
isn’t working, go back and see where the plan is failing and then fix
it. Making money in trading, like in almost anything else, requires
work, study, and knowledge. As you progress with paper trading (trading
without using real money), you’ll begin to see risks and pitfalls you
might otherwise miss and then you can adjust your business plan
accordingly. Remember that the business plan is always a work in
progress and can change as you grow in knowledge and experience or can
and should change as your own circumstances change. For example, you
may initially decide you only have time to look at the market on
weekends, but after some successes, you may decide to allocate more time
to trading and you might then change your plan to look at the market
each day.

Another critically important but little discussed factor is money
management. Proper money management keeps the trader in the game.
Failure to properly manage trading money can lead to very large losses
and can quickly make one an ex-trader. I wrote fairly extensively about
money management in the March 25th, 2006 edition of the Newsletter “Money Management and Reward to Risk”. In
that article, where I discuss ways to manage money, I demonstrate how a
trader who employs sound principles can lose 6 out of 10 trades; that is,
lose 60% of the time and still be profitable. Do you recall how to do
that? Isn’t it worth knowing?

What about emotion? I believe and have consistently written that if
one is making emotional decisions about their entries and particularly
about their exits, they are quite probably losers. How can we
discipline our trading in an effort to take the emotion away? Check out
the May 27th article “More About Disciplined Trading”. Have an exit plan in place before you ever enter a
trade and stick to it.

Aside from selling naked calls, what do you think is the riskiest
thing we can do in the market? How about buying stock? What is the risk
when we buy a stock? It’s the price of the stock, isn’t it? Or, how
often is my stock going to go to zero, you might ask. Do you know
anyone who owned Enron or Worldcom or United Airlines before the
bankruptcy? Was once enough for them? Would once be enough for you? If
we understand that the whole price of the stock is our risk when we buy
stock, shouldn’t we have an exit and/or hedges in mind before we ever
enter the position? Read, for example, last week’s Newsletter “What’s A Put and How Can It Help?” where I
discuss the protective put as a way to limit losses. Of course, there
are other ways to limit losses and that brings me to the most important
point of all. The money that you use to trade is yours. The risk is
yours. Isn’t it important to learn how to protect your hard earned
money? I submit it is critical for anyone who wants to trade to get
“real.” Trading isn’t a get rich quick endeavor (even though that has
happened), it is a business that requires the trader’s attention and
devotion to education. If you aren’t willing to obtain the education,
by all means, don’t trade. It’s that simple.

How can you get the education? You can read. There are many
excellent books and articles on trading. You can subscribe to services
such as Option Trader, Trend Trader, or $10 & Under Trader to see some
of the things someone who actually trades for a living does. You can
watch DVD’s. You can attend seminars. As some of you know, we are
putting on our SWAT (Stockmarket Weapons and Tactics) Seminar outside
Denver on the 26th and 27th of August. Subscribers to Option Trader,
Trend Trader and $10 and Under Trader get the full two days for $799,
others pay $1299. We give a full refund of the seminar tuition if any
attendee doesn’t like the seminar for any reason by lunch the first day.
We’ve never had anyone ask for the refund. There are many other
wonderful seminars available. Many cost much more, some a bit less. I
think the important thing is who is teaching. Is the instructor someone
who actually trades for a living or is it someone who makes their living
by giving seminars? Before you sign up for a seminar, find out who the
teacher will be and whether or not they trade for their own living. Ask
what percentage of their income comes from trading and what comes from
giving seminars. If they won’t tell you, you have the answer. Many
students seem to think that seminars are too expensive. I paid about
$3500 for the first two-day seminar I attended. It took me less than 4
days to make that back with the knowledge I gained and it ultimately
resulted in a fantastic change of career for me. I don’t mean to suggest
that just by attending a seminar you’ll suddenly become rich, or even
that you’ll make money. You may attend a seminar, read books, watch
DVD’s and still wind up losing. Trading is risky business. The one
thing I think I can assure any new trader is that unless they treat
trading as a business, learn money management, work on disciplined
trading and constantly strive to gain knowledge, their chances of any
long-term success fall in the slim to none category.

Bill Kraft, Editor

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