Stocks: Understanding the use of margins

Overview
Buying stock on margin is a way of leveraging your available investment cash to buy more stock than cash alone would buy. The hope is that the stock price will continue going up so the investor gains from appreciation of additional stocks purchased on margin than the lessor amount would have bought with cash alone. This can be great when the stock price goes up. However, when the price goes down, margined stock will work very quickly against you. We’ll cover more about buying stock on margin, along with the pros and cons.

Buying stock on margin
For qualified investors, many brokers offer the option of buying stock “on margin” by borrowing funds from the broker to pay for part of the purchase. Not all stocks are marginable and those that are maginable vary in the amount of margin authorized. Typically these stocks have a 50% margin requirement, which means you only need 50% of the stock price in cash to buy a share of stock. Another way of thinking about this is to say you can buy twice the number of stock shares than cash alone could buy. Some highly risky stocks have a higher margin requirement, meaning a higher percentage of cash is required to purchase a share of stock. In any case, a monthly interest will be charged for all borrowed funds until these funds are paid back.

Consider an example of buying stock on margin
For all examples, the cost of trading stock will be ignored. For this example, Joe investor has $1,000 cash available to buy stock in XYZ corporation. Shares of XYZ stock are trading at $10 per share. In this case, Joe can buy 100 shares of XYZ stock for his $1,000 ($10 per share x 100 shares = $1,000). Now assume that XYZ stock is a marginable stock with a 50% margin requirement. This means each $10 share of stock can be purchased with $5 in cash and the other $5 borrowed from the broker ($5 cash + $5 borrowed = $10 purchase price of a share). Now Joe only needs $500 for the same 100 shares since he borrows the other $500 from the broker to make up the full $1,000 needed to purchase the 100 shares. Alternatively, Joe could use his full $1,000 cash to buy twice the number of shares on margin. In this case, 200 shares at $10 requires $2,000 for the purchase. Joe uses $1,000 of his cash and borrows the other $1,000 for the margin purchase. In both cases, Joe has used leverage to control twice the number of shares that cash alone would purchase.

Why use margin?
As we’ve seen, buying stock on margin allows you to use less cash to purchase stock. If an investor determines there is a strong possibility the stock price will go up, the investor can chose to buy twice the number of shares (for 50% marginable stock) for the same amount of money. The investor then benefits from price increases on twice the number of shares. However, there is now a higher risk of loss if the share price should go in the opposite direction.

An example of margin leverage working in the investor’s favor
Continuing the previous example, Joe purchases 200 shares of XYZ stock (a 50% margin requirement stock) for $1,000 cash. The stock goes from $10 to $15 per share, a 50% price increase. Joe now has $5 profit in 200 shares of stock for a total profit of $1,000. Joe has a $1,000 gain on his original $1,000 cash, a 100% increase. Joe has doubled his money from a 50% increase in stock price. Leveraging with margin has allowed him to have twice the percentage of return than the stock price increased by.

Alternatively, if Joe had used his $1,000 cash to buy only 100 shares without margin, then he would have a $5 profit on 100 shares for a total profit of $500. He then has a $500 gain on his original $1,000 cash, a 50% increase. His investments have increased the same percentage as the stock price increased.

What can go wrong?
The danger in using margin is you now have a much higher risk exposure to loss than using cash. If the stock price drops with stocks purchased on margin, your loss will increase at a much faster rate. At some point, the broker will issue a “margin call” when the value of the stock goes down enough to require you to put additional money into your account to bring the percentage of cash back to 50%, or whatever margin level your stock is at. Lets look at an example.

An example of margin leverage working against the investor
Continuing the previous example, Joe bought 200 shares of XYZ stock with 50% margin for $1,000. Remember that Joe used $1,000 cash and borrowed $1,000 on margin for the $2,000 purchase of 200 shares at $10. Therefore, he is at 50% margin. Now assume the price goes from $10 per share to $8 per share. In this case, the total value of the stock is now $8 x 200 or $1,600. Joe still owes $1,000 against this $1,600 total value so he would only get $600 cash by selling all of the stock today. This means his margin level or ratio of cash to the total value is now at a 37.5% ($600 cash remaining divided by $1,600 current value = 37.5%). Typically a broker will ask for more cash when the ratio gets to 30% to bring the ratio back to 50%.

Notice that the $1,000 owed does not change, but the portion of cash remaining decreases as the price decreases. Now consider what happens if the price quickly drops by 50% from $10 to $5 per share. The total value of the 200 shares is $5 x 200 or $1,000, which is the same as the $1,000 still owed. Now there is no cash left since the sale of all 200 shares would go directly toward paying off the $1,000 debt (assuming interest owed is ignored). Joe has just wiped out all of his investment cash. He will be asked to put in another $1,000 to bring the margin level back to 50% ($1,000 cash and $1,000 debt) or be forced to sell some or all of the stock until enough of the debt is paid back to bring the ratio back to 50% (perhaps sell 100 shares at $5 to pay off $500 of the $1,000 debt).

Consider an even more severe case where the price drops quickly to zero (perhaps the company goes bankrupt and all stock shares are wiped out by bankruptcy). In this case, the investor lost all of the initial $1,000 investment funds and now owes $1,000 borrowed on margin for a total $2,000 loss. Had Joe purchased only 100 shares with cash, he would only be out the $1,000. Using margin two buy twice the stock also caused him to have double the loss.
In any case, you can see that rapid drops in price can really work against the investor who uses margin.

Strategies
Personally, I only use margin for a few situations:
1. I might use margin when all my technical analysis of the recent stock buying and selling patterns (trends, volume, stochastics, MACD, and other indicators) indicate a strong probability of price increase in the very near future. I’ll buy twice the stock for the same investment funds to hopefully catch the increase and then either sell enough stock to pay off the margin and keep the rest or I’ll sell out before the stock drops again.
2. I might use margin against a stock already in my portfolio (borrow money against a stock I have) to purchase another stock or option. Again, I want to do this on short term moves to quickly pay off the debt.
3. I need to have enough cash or assets in my account to short a stock. Brokers usually require assets in an account before letting you short stock. See a previous article on shorting stock.
4. When I need a short term loan for other personal uses. Say I need $1,000 for car repairs. If there is marginable stock in my account, I could borrow the $1,000 against these stocks to pay for the repair. Then I’ll pay the debt off as soon as possible.

Summary
The use of margin is another tool that can help an investor manage his or her investment portfolio. However, recently we’ve seen articles about top managers of companies being forced to sell their shares of stocks due to margin calls (Wall Street Journal aticle on top managers losing shares to margin, New York Times article on Chesapeake CEO being forced to sell all of his shares of the company, and many others).

Using margin smartly can help increase returns, but the investor must be very careful since it can also magnify losses very quickly.

Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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Psychology of trading – how pros count on emotional amateurs

Overview:
Emotions are very hard to keep in check when trading investments including stocks, commodities, and real estate. It takes most professional investors years of investment experience before they learn to trade using a system vice using purely emotions. Taking the emotional element out allows the trader to use repetition of entry and exit point criteria for more consistency in results. Trading on emotions, as most amateur investors do, usually provides no consistency of entry and exit points resulting most of the time in more losses than wins over time. This article will explore how many pros count on these emotional traders when making buy and sell decisions. I’ll be using examples that focus on stock investing, but you could just as well have this article talk about investing in anything.

Greed and fear are part of our culture:
Think about when you were a kid. When you saw your friend with a newer bike or neater toy, you wanted one too. That was greed and envy at work – wanting more than you have. Also think about when you had something really nice like a new cool bike that you knew others wanted. Most likely you had a chain to lock the bike up when parked. When at home, you kept it in the house or garage. That was fear at work – the fear of loss. All our lives, we have been conditioned by advertisement and other influences to want more than we have and to fear losing what we do have. When trading investments, these emotions usually work against you, but do play right into the hands of professional traders.

Greed and fear work against trading investments:
When looking for stocks to invest in, amateurs will many times look at stocks that are rising fast and think the stock has to continue going up. Greed kicks in and they buy into the stock when the price has already risen significantly thinking something along the lines of “the price doubled in the past week so I just need to get in to double my money and then I’ll get out”. You know the rest of the story. Right after buying the stock, the price drops quickly. At this point, fear kicks in. The investor may feel he or she needs to keep holding onto the stock until it comes back to the purchase price to get out at break even. Some of these investors will let greed kick in again and buy more shares of the stock at the lower price. As the stock continues to drop, the investor gets more nervous. Many of these investors are 100% invested, meaning they put all of their money into stocks (or whatever they are investing in) at all time. Therefore, when the price drops even further, they begin to panic. Many times the stock eventually drops so far that these fearful investors give up hope in the stock and sell in a panic to prevent further loss.

What happens next? Again, I bet you know – the stock rises quickly. Now the investor is in a quandary. They lost so much money on the stock that their greed kicks in to make up the loss buy buying back into the stock “just long enough to get back to break even”. Some times this works, but many times it does not as the stock again may take another dramatic fall in price even further than when the investor bought in the second time. Again the investor eventually panic sells at another large loss. This cycle may repeat itself several times or even with other stocks as the investor looks for another fast rising stock to get in and make up the loss from the first stock with.

Doing this over time almost always ends up with the investor losing all of his or her available investment funds unless they are lucky enough to have a wife that eventually says “you will stop now! No more!”!!! Thank God for conservative wives to save us for utter ruin!!! Ha! Sorry, just had to get a little of my own past experiences during my amateur trading years into this article!

Pros count on the panic both ways – buying and selling:
If you watch these “high flying” stocks for a while, you will see they trade in wide price ranges. Also, you will notice that the volume of trades is usually highest at the point when the price changes direction (either up or down) from the direction it was going previously. Those high volume price change days are key trading days of greed (must buy since it is surely going higher) and panic (must sell to cut my losses). On those days, the pros are doing the opposite of what the amateurs are doing. When the price does dramatic drops that force the amateurs to panic sell, the pros are buying which usually drives the price back up again. As it rises, the pros are selling all along to get out before the amateurs buy in bulk. When the price gets high enough, the pros start selling in much large numbers that overwhelm whatever purchases the amateurs are doing. Therefore, the price start dropping. The amateurs panic as the price drops and sell all the way down.

Another tactic used by many pro traders is to short sell the stock when prices are high to drive it down (see a previous article where I cover short selling in detail). When the price gets low enough, these short sellers must buy back the stock. Therefore they are motivated to cause those high volume dramatic drop in price days when amateurs panic and sell out their shares. The short sellers are able to find stocks to buy back at these low panic prices to close out their short position. It is important that you understand this is only one of many tactics used by professional traders to help influence the price of stocks that works against emotional traders.

Professional traders use a system to determine buy and sell points:
Their system may include emotions as a guide, but most use data, facts, trends, trading patters, and other measurable information to trigger buy and sell points for investments. Personally, I like to first look at stochastic trends and the MACD to look for these key days of panic selling and greed buying to determine when I will either get in or out of a stock. I’ll also look at many other data to confirm my initial look at the stock. All of this information goes into my particular trading system to let me know when I should buy or sell a stock (or whatever investment I’m using a system on). Most professionals are also using a system that tells them when to buy or sell a stock. It is important to understand as an amateur that you are entering a market where there are many professionals that are also buying and selling using a system. It is important for you to educate yourself on all of the available decision supporting data to come up with a system of your own that works for you. Don’t forget to consider systems that make you money when the stock goes down, not just when it goes up. Making money both when the stock goes down and when it goes up will help your long term success as a trader.

Consistency of trading rules gives the best probability of success:
Consistently applying your system over time by taking out the emotions will give you the best long term success in most markets. However, in todays extremely volatile market where prices can change by very large percentages on a daily basis, it is very hard to apply a consistent system. It may make the most sense in those situations to wait out the market until it stabilizes before starting up your system again. This is so hard for many people since they get greedy and feel they must enter the market at the lowest price to get the largest potential gain when the market recovers on an upward trend again. Continually trying to buy into the lowest price in todays market conditions has repeatedly shown that we have not yet reached the low price. You end up getting in at a high price and getting out at another low price, repeating your larger and larger losses long the way. It is then tempting to continue trying for fear of not being able to make up those losses if you miss out on getting into a recovering market too late after prices have already increased. That is why the consistent use of a system without emotions in normal market conditions is so important to prevent rash buy and sell decisions.

So much more to learn:
This article was only meant to be a very top level overview of how psychology plays in the trading of investments. I will cover various specifics in future articles that I hope continue educating you on being a successful investor based on my own experiences and hard lessons. I certainly don’t claim to have reached the completely unemotional state, far from it. After all I am human, but always learning and applying those lessons in continually improving my system as markets change.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Understanding stocks: When the business ATM stops working

Overview:
In last week’s article I wrote about how a corporation can raise funds by issuing stocks for sale to investors – sort of like an ATM without the requirement to have funds in the account first. This article continues that discussion by addressing the question of what happens when the ATM breaks – the company can’t raise funds from the sale of stock?

Lets look at what is currently happening to General Motors
If you do a stock symbol lookup for General Motors on any of the financial websites, you will find many preferred stocks as well as the common stock “GM”. Many of the very large DOW listed companies have issued preferred and common stocks over the years to pay for things like new factories and/or tools to produce new products. Selling preferred stock gives the needed funds without diluting existing common shares. GM is no exception. When its stock was trading at over $50 per share five years ago, it could have sold 10 million new shares of stock at $50 per share to gain nearly $500 million in funding for some new project. Today, the stock is less than $5 per share. They would have to sell 100 million shares of stock to generate the same $500 million. However, since they are on the brink of bankruptcy, there are very few investors who would buy those shares in a public offering. Therefore, GM is no longer able to raise much needed funds through offering of stock to prevent filing for bankruptcy. This is why they are now asking the government to provide a bailout of some kind for enough funds to stay in business. In a sense, their ATM is now broken.

Magnify GMs situation with many fallen stocks of today
You can find many GMs out there today. Many stock prices have been driven down severely during the recent stock market drop to fractions of their previous highs. As a result, these companies are not able to sell stocks to raise funds. Many companies are scrambling to redefine their business model. Some are using layoffs, selling off assets, receiving “bailouts”, finding big pocket investors, rethinking their products/services, going bankrupt, or taking other tough actions.

Summary
I find this a very interesting time and am keenly interested in how this all plays out. It seems to me that we are in the middle of another shift in business and economic fundamentals. Businesses and governments around the world are trying to define the new economic and business models that will work globally as they work to come out of the current crisis. Eventually new models will be defined and institutionalized. Changes will be made by businesses, governments, and people. Change means opportunity for those who can see the direction things are moving and are able to get ahead of the curve. Never be afraid of change, use it to your advantage and be a leader who arrives before others even start their change.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -
Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Understanding stocks: an ATM for business funds

Overview of stocks:
Stocks are issued by a corporation to spread ownership of that corporation proportionally to those who own the shares. Usually a corporation will issue shares of stock to investors who purchase the stocks at a set price, usually during a public offering. In this way, a corporation with strong revenues/earnings or prospects of strong revenues/earnings can generate working capital by selling shares of stock. Thus the simple analogy of selling stocks acting similar to an ATM machine for businesses to get access to working capital funds.

Two types of stocks – common and preferred.
Corporations can offer two types of stocks to investors – common and preferred. Both have their pros and cons. Generally, common stock owners have voting rights on Corporate matters while preferred stocks do not, however, preferred stocks usually pay a defined high dividend and are first to get paid before common shares. There are variations to these two types of stocks including convertible preferred which can be traded for a certain number of common shares at a set price on a future date

What are additional pros and cons of each stock type?
Here are some general comparisons between common and preferred stocks:

- Common stock holders share a percentage ownership of the corporation and therefore a share of the corporation’s earnings. For this reason, the price of a stock usually increases as earnings grow. As a quick example, if there are 1 million common shares issued by the corporation and it earns $1 million in earnings, then each share of stock represents ownership of $1 in earnings. If the same corporation later earns $5 million in earnings, then each share of stock represents $5 in earnings. For this reason, you would expect to pay more for the stock when it represents $5 in earnings than when it used to represent only $1 in earnings.

- Common stock tend to increase and decrease in value as the underlying corporation’s earnings increase or decrease for the reasons explained above. For this reason, they are more risky that preferred stock. However, they can also experience much more increase in price for corporations that have strong earnings growth over time.

- Preferred stock is not as susceptible to variation in corporate earnings since they are guaranteed a set dividend payment first before common share holders can receive a dividend. For this reason, there is less risk for preferred stock owners and the stock price does not tend to fluctuate as much unless the corporation is losing money and in danger of paying the preferred dividend. Also, if the preferred stock has a future option to transfer into common shares, then those preferred stock prices do tend to more closely follow the price changes in the underlying common stock price while continuing to pay the set preferred dividend until converted to common stock.

- If the corporation sells more shares of common stock to the public, then this is considered a dilution of the existing stock owner’s percentage of ownership in the corporation. As an example, if the consider the same situation described above where the corporation has $1 million in earnings, if there are now another additional 1 million shares of stock issued (sold to the public), then there will be a total of 2 million shares representing a proportional ownership in the same $1 million earnings. In that case, each share of stock represents only 50 cents ($1 million in earnings divided by 2 million shares of common stock). In that case, the price of each common stock usually goes down when new shares are issued to the public in large quantities.

- Continuing the above thought, there are situations where issuing new common shares to the public actually increases the price of existing common stock. If the corporation is going to use the resulting funds from the sale of the new stock to further expand business and do other proactive things that will result in increased business and growth, then the fact that the corporation is able to generate these new funds quickly from the sale of stock and use those funds for growth can cause investors to want to buy more stock. The increased demand then can result in an increase in stock price, even though there could be a significant increase in the number of shares that dilutes ownership. Consider the situation mentioned earlier where the corporation first earned $1 million and later grew to earning $5 million for the same 1 million in common stocks. Assume the corporation sells another 1 million shares of stock at $10 each resulting in a total of $10 million in new funds to use for investment in growth (new plants, new products or services, perhaps purchase of a competitor, etc.). The result could mean the corporation grows from $1 million in earnings to $100 million in earnings over the same time period it would have only earned $5 million in earnings without the $10 million in new funds for investment in growth. If investors see this huge potential for new growth, they may want to pay more for these stocks, even with the large increase in new common stock shares being issued.

- Preferred stock owners usually have no vote in corporate matters since they don’t have any ownership in the corporation, only rights to a set dividend. For this reason, many corporations desire to sell preferred stock instead of common stock. The existing common stock owners do not have their percentage of ownership diluted while the corporation has access to the resulting funds from the sale of preferred stock to use for business needs. However, they are then on the hook to pay a high dividend to these preferred stock owners. Many corporations therefore issue these stocks with the right to buy them back in the future. In that case, they no longer need to pay the dividends.

Issuing stocks can be very expensive to the corporation.
There are many laws and regulations that must be followed very closely by corporations when they issue (sell) stocks to the public. For this reason, most of these corporations use firms that specialize in issuing stocks. These firms will take care of the legal aspects as well as marketing the stock to perspective investors. Also, these investors usually have to be accredited investors since the Securities and Exchange Commission (S.E.C.) assumes only accredited investors can understand the risks involved and have access to enough excess risk capital to use for investing in these types of offerings.

Summary:
Offering stock for sale to the public is a great way for a corporation to quickly get access to working capital funds to pay off debts, buy out competitors, invest for growth perhaps in developing and/or deploying new products or services, or to use for other business needs. As mentioned before, this can seem like a ATM for cash since it looks like the corporation simply prints stock certificates on paper and sells it to the public for cash. For companies with a strong future outlook, that is not too far from the truth. Sharing ownership in strong and growing companies is the root of capitalism and free enterprise at its best.

Next article in the series:
Next week, the next article will cover what happens when corporations are not able to sell stocks to raise funds - their ATM is broken.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -
Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Options: Understanding leaps – controlling the level of risk toward buying (or selling) a stock

Continuing the series on options:
This is another in a series on understanding options. Previously I wrote about put options and call options (click on each to read the previous articles). I also wrote an article last week on using puts to limit losses when owning a stock that is going down. This article describes leap options, also known as leaps. Leaps allow you to buy a stock at a fraction of the cost and still benefit from the same rise (using a call option leap) or fall (using a put option leap) in price.

What is a leap?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock (click on the links above to learn more about call and put options). A leap is nothing more than a call or put option that has an exercise date many months or years into the future. It is a way to participate in a stock’s price move without paying full price to own the stock outright.

Critical things to know as an investor in leaps:
1) Leaps are exercised in the same way as call and put options since they are call and put options with a long timeframe before their exercise date. Therefore, each leap controls 100 shares of the underlying stock.

2) Leaps cost the most since the odds of reaching the exercise price over a long timeframe are greater, especially if the current stock price has a lot of variance.

3) Call (and put) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option - the broker may exercise it automatically. Be careful to know your call option’s value on or before expiration day to prevent buying the stock automatically.

Understanding the leverage associated with leaps:
If you are interested in owning shares of stock in a company, but either don’t have the funds to buy 100 shares or don’t want to risk those funds, leaps are a great investment vehicle to consider. Leaps let you participate in stock price changes over a long period of time without the risk of paying funds to buy 100 shares of the stock.

An example showing how a call leap option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I do research to find the stock of a company – xyz corporation - with a high probability of going up in price. On October 1, 2008 the price of xyz corporation stock is trading at $50 per share. I decide to purchase a January 2010 call option with a $75 strike price that expires the third week of that month. This call is trading at $10 which means I pay $1,000 ($10 price x 100 shares of underlying stocks) to buy the call option.

By January 15, 2010, the price of xyz stock rises to $125 and I tell my broker to exercise the option. The call option forces the call seller to sell these 100 shares to me at $75 each for a total cost of $7,500 ($75 x 100). I can then sell these 100 shares of xyz stock on the market for $12,500 ($125 price x 100 shares of stock) and have just pocketed a $5,000 profit ($12,500 - $7,500 purchase cost). However, I paid $1,000 for the call option so my net is $5,000 - $1,000 = $4,000. This is a 400% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the call option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.

The leveraging comes from only paying $1,000 to get a $4,000 profit, which equates to a 400% return on investment. The alternative would have been to pay $5,000 on October 1, 2008 to buy 100 shares of stock and then selling them for $12,500 on January 15, 2010 for a profit of $7,500, which equates to only a 150% return on investment. If the stock has risen much more over the long period of time, then the return against the $1,000 purchase price of the leap would be even more dramatic since every $10 increase in the price of the stock equates to another 100% return on my investment in the option ($10 per stock x 100 shares is $1,000 increase in those stock verses the $1,000 investment in the leap).

What is the potential loss with a leap?
The main benefit of using a call option leaps to make money on stocks with rising prices instead of buying the stock is that your maximum loss of investment is limited to the total purchase paid to buy the call ($1,000 in the above example). If the stock price never went higher than $75, then the call would expire worthless and the investor would loose the $1,000 investment. If I had bought the stock instead, my full $5,000 investment would have been at risk verses only $1,000 to buy the leap. Similarly, the use of a put option leap limits your investment loss only to the purchase of the leap.

The other benefit was the ability to participate in the increasing price of 100 shares of a $50 stock by only paying $10 per share through the leap to get the associated increase in value. I paid 1/5th of the stock price to control the same 100 shares of stocks over a long period of time.

Summary:
The use of a leap (call or put) is another way of making money when the stock price is going up or down over a long period of time without having to put the full amount of funds at risk that would be required to actually purchase and hold the stock. However, the price of leaps tend to be much higher than shorter term options due to the potential of a stock to reach the strike price over the longer period of time. Don’t invest too much on leaps in any one company. Diversify and use leaps as one investment tool among many as part of your investment strategy.
Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -
Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Options: Using put options to insure stock from loss

Refresh understanding of a put option:
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. A previous article described what a put option is. As a summary, a put option forces someone to buy stock at a set price from the buyer of the put option if that option is exercised. The desire of a put holder who chooses to exercise the option is that the price has dropped. In this case, the put holder buys stock at the current lower market price and sells it at the higher put option price to the seller of the put. Read the previous article for more details.

Holding a stock can be very scary these days.
With all of the tremendous volatility in stock prices recently, it is no longer safe to hold stock of big strong companies long term. Who ever thought GM and other large corporate stocks would return to prices not seen since the 50’s and 60’s. That means fifty years of appreciation has evaporated in only a matter of weeks.

How can I insure my stock from large losses due to big price drops?
If you own the stock of a company where you are worried about the price dropping, put options can act like an insurance policy protecting you from loss. Since the put forces the seller of the put to buy stock at a set price, you can buy a put option that has an exercise price at or near the current market price for the stock. If the current market price drops through your put option exercise price, then it makes sense to exercise the put option forcing the put seller to buy your stock at the exercise price. Alternatively, you can sell the put option at a profit to someone else before the exercise date, allowing you to continue holding your stock. Either way, the put becomes more valuable as the stock price drops, which compensates you for the associated loss in price on the stock you continue to own.

An example showing how a put option protects you from the drop in price of your stock
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I own 100 shares of xyz corporation stock that has been going down in price lately. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November put option with a $45 strike price that expires the third week of November. This put is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the put option.

By November 15th, the price of xyz stock drops to $30 and I tell my broker to exercise the option. I then force the put seller to buy my 100 shares at $45 each for a total of $4,500 ($45 x 100). Since the stock was at $50 per share on October 1st and were sold for $45 per share on November 15th, I have limited my loss to only $5 per share ($50 October 1st price - $45 received per share = a $5 loss per share). My total loss for the 100 shares is $500 ($5 per share x 100 shares). Had I not purchased the $45 November put option, my loss would be a much higher $20 per share ($50 October 1st price - $30 November 15th price = a $20 per share loss). In that case, my loss would be $2,000 ($20 per share x 100 shares). Again, using the put option, I have limited my total loss to $500 instead of what would have been a $2,000 loss. If the stock price had dropped lower than $30 by November 15th, then the put option would have protected me from a much larger loss.

Why doesn’t every stock owner always buy put options for protection?
Put options cost money. The closer the exercise prices to current market prices, the more it will cost to buy the put option since the probability of the option “going into the money” is high. If you were to continually buy put options close to market prices, then the cost of all the put options you buy will themselves cumulatively act like a loss against your stock’s value. However, in uncertain times or before earnings or other news announcements where there is a strong possibility of bad news coming out on your stock, it may make very good sense to buy a put option. Another strategy could be to buy a way out of the money put option with a strike price far below current market prices. These type of put options will be very cheap, but you will have a much higher vulnerability to loss for the difference between current market prices and the much lower put option strike price. That strategy would be good for protection against a dramatic drop in stock price.

Summary:
The use of put options is one strategy used by seasoned, sophisticated, and some accredited investors to protect their portfolio of stocks against large price drops in uncertain situations. If you own stocks and worry about price drops, consider purchasing put options as a form of insurance protecting you from large losses.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -

Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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Options: Understanding Calls - making money when a stock price goes up

Options: Understanding Calls - making money when a stock price goes up

Setting up for future option strategy articles:
Last week I described put options. This article describes call options. I must establish what these two options are before discussing various strategies used by sophisticated investors to control and sometimes eliminate most risk from the movement in the price of a stock. Now, lets get into understanding what call options are.

What is a call option?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. There are put and call options (I covered put options in last week’s article). When exercised, call options force the seller of a call to sell stock at a set price. As the buyer of a call, you hope the stock price goes higher than the call exercise price. If it does, then you can buy the stock at the call exercise price and sell at a higher market price or keep the stock.

A call (or put) option controls 100 shares of the underlying stock:
Critical things to know as an investor in options:
1) One call option controls 100 shares of the underlying stock. Therefore, when one call option is exercised by the call buyer, the call option seller must sell 100 shares of the underlying stock at a set price (an example below will help explain this).
2) Calls (and puts) are priced on a per share basis or 1/100th of the actual cost to buy or sell a call. So, if you see a call trading for $5, it will actually cost $500 to purchase that call option ($5 call option x 100 shares = $500 total cost). These two things can throw new option investors off until they get used to the leveraging inherent with trading options.
3) Call (and put) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option - the broker may exercise it automatically. Be careful to know your call option’s value on or before expiration day to prevent buying the stock automatically.

How can you make money with call options when the stock price goes up?
As mentioned above, a call option can be exercised to force the seller of the call to sell the underlying stock at a set price for the buyer of the call option if he/she chooses to exercise the option. The desire is to force the call seller to sell 100 shares of a stock to you at a lower price than the current market price you would have had to pay to buy the 100 shares of stock.

An example showing how a call option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I do research to find the stock of a company – xyz corporation - with a high probability of going up in price. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November call option with a $55 strike price that expires the third week of November. This call is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the call option.

By November 15th, the price of xyz stock rises to $70 and I tell my broker to exercise the option. The call option forces the call seller to sell these 100 shares to me at $55 each for a total cost of $5,500 ($55 x 100). I can then sell these 100 shares of xyz stock on the market for $7,000 ($70 price x 100 shares of stock) and have just pocketed a $1,500 profit ($7,000 - $5,500 purchase cost). However, I paid $200 for the call option so my net is $1,500 - $200 = $1,300. This is a 650% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the call option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.

Another example showing the tremendous leveraging potential in options:
An alternative to exercising the stock purchase would be to sell the call option before it expires to another investor at a profit. If xyz stock is trading at $70 per share on my $55 call option, then there is a $15 profit potential for each of the underlying 100 shares of xyz stock. Keeping in mind the price quoted for a call option is in reference to a single share of stock, then the call should be trading closer to $15 and possibly more if the stock price is continuing to rise. That means I could sell the $2 call for $15 and pocket the difference. In that case, I will have paid $200 to buy the call ($2 call price x 100) and sold the same call now worth $15 for $1,500 ($15 call price x 100) for the same profit of $1,300 ($1,500 - $200). Again, this would be a 650% return on the $200 investment to initially buy the call. In reality, there would be a broker fee to buy the call and again to sell the call. However, you don’t have the extra fees of buying and selling the underlying 100 shares of stocks that would be incurred if the call option was exercised as in the previous example.

What is the potential loss with call options:
The main benefit of using call options to make money on stocks with dropping prices instead of shorting the stock is that your maximum loss of investment is limited to the total purchase paid to buy the call ($200 in the above examples). If the stock price never went higher than $55, then the call would expire worthless and the investor would loose the $200 investment.

Summary:
The use of call options is another way of making money when the stock price is going up. They are especially good to consider when a stock has been unfairly beaten down in price and set to rebound. However, the price of such call option can be much higher since many investors likely expect the price to return back up and pay a premium for the option. You need to be careful since stock prices can change very quickly in the opposite direction causing your call to expire worthless. Don’t invest too much on calls in any one company. Diversify and use calls as one investment tool among many as part of your investment strategy.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -
Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Options: Understanding Puts - making money when a stock price goes down

Stock prices are dropping these days:
You would have to live in a remote village somewhere to not know about the dropping stock market. You hear about how there was over a trillion dollars of value lost from the 778 pont on day drop in the dow this past week. The media focuses on how much money was lost. What they don’t tell you is that many other investors made tons of money that day when prices dropped by using put options and by shorting stocks (see a previous article explaining shorting of stocks).

What is a put option?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. There are put and call options (I plan to cover call options in a future article). When exercised, put options force the seller of a put to buy stock at a set price.

Using leverage - a put (or call) option controls 100 shares of the underlying stock:
Critical things to know as an investor in options:
1) One put option controls 100 shares of the underlying stock. Therefore, when one put option is exercised by the put buyer, the put seller must buy 100 shares of the underlying stock (an example below will help explain this).
2) Puts (and calls) are priced on a per share basis or 1/100th of the actual cost to buy or sell a put. So, if you see a put trading for $5, it will actually cost $500 to purchase that put option ($5 put option x 100 shares = $500 total cost). These two things can throw new option investors off until they get used to the leveraging inherent with trading options.
3) Put (and call) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option - the broker may exercise it automatically. Be careful to know your option’s value on or before expiration day.

How can you make money when the stock price goes down?
As mentioned above, a put option can be exercised to force the seller of the put to buy the underlying stock at a set price from the buyer of the put option if he/she chooses to exercise the option. The desire is to force the put seller to buy 100 shares of a stock from you at a higher price than the current market price you pay to buy the 100 shares to sell.

An example showing how a put option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I do research to find the stock of a company – xyz corporation - with a high probability of going down in price. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November put option with a $45 strike price that expires the third week of November. This put is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the put option.

By November 15th, the price of xyz stock drops to $30 and I tell my broker to exercise the option. I then buy 100 shares of xyz stock on the market for $3,000 ($30 price x 100 shares of stock) and force the put seller to buy these 100 shares at $45 each for a total of $4,500 ($45 x 100). I have just pocketed $4,500 income - $3,000 cost of the stocks = $1,500 from this transaction. However, I paid $200 for the put so my net is $1,500 - $200 = $1,300. This is a 650% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the put option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.

Another example showing the tremendous leveraging potential in options:
An alternative to exercising the stock purchase would be to sell the put option before it expires to another investor at a profit. If xyz stock is trading at $30 per share on my $45 put option, then there is a $15 profit potential for each of the underlying 100 shares of xyz stock. Keeping in mind the price quoted for a put option is in reference to a single share of stock, then the put should be trading closer to $15 and possibly more if the stock price is continuing to drop. That means I could sell the $2 put for $15 and pocket the difference. In that case, I will have paid $200 to buy the put ($2 put price x 100) and sold the same put now worth $15 for $1,500 ($15 put price x 100) for the same profit of $1,300 ($1,500 - $200). Again, this would be a 650% return on the $200 investment to initially buy the put. In reality, there would be a broker fee to buy the put and again to sell the put. However, you don’t have the extra fees of buying and selling the underlying 100 shares of stocks that would be incurred if the put option was exercised as in the previous example.

What is the potential loss with put options:
The main benefit of using put options to make money on stocks with dropping prices instead of shorting the stock is that your maximum loss of investment is limited to the total purchase paid to buy the put ($200 in the above examples). If the stock price never went lower than $45, then the put would expire worthless and the investor would loose the $200 investment. In the case of shorting a stock, the investor has no limit on the potential loss of the stock price should dramatically increase before the stock can be purchased back to close out the short (again – refer to my previous article on shorting stocks).

Summary:
The use of put options is making many investor very rich in today’s falling stock market. However, you need to be careful since stock prices can change very quickly in the opposite direction causing your put to expire worthless. Don’t invest too much on puts in any one company. Diversify and use puts as one investment tool among many as part of your investment strategy.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -

Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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A combined Oil & Gas and Real Estate Investment – The best of both worlds

Intro:
I get emails and phone calls resulting from reading this Accredited Investor Talk blog. One discussion I had this week was with an oil and gas (O&G) investor who combines these investments with real estate. I thought his strategy would be of interest to both the oil and gas investors and real estate investors who follow this blog.

Concept:
Most of my previous articles on oil and gas investments assume someone else owns the associated land where these wells are drilled, but the partnership funding the drilling projects secures the rights to a lease for drilling on the land. In the case of the investor I talked with, he first buys land near Texas cities with strong suburb growth that are also strong prospects for oil or gas. Once the land is purchased, he drills and puts the associated wells online to generate cash flow from the land. Later, when the value of the land grows from nearby homes being developed in the suburb, this investor starts also developing the land with homes to sell.

My thoughts on a plan for this type of investment:
- Create a detailed business plan and investment strategy before even starting this project: One of the first steps before starting this project must be a detailed business plan and associated investment strategy. The business plan needs to detail what the entry and exit strategies are for the various phases of this project (the O&G phases and real estate phases). It needs to detail all the key stakeholders in the project, their roles and responsibilities, and how they will be compensated. The plan should document the various probabilities of success (and failure) for each phase of the project which links to the level of risk involved. The plan should also discuss what the investment strategy is for this project which should relate to the probabilities and risk levels involved. There are infinite strategies that could be used throughout the project. Will other investors be brought in for various phases of the project or will all funds come from the initial investors only? Having a clear strategy identified and documented in the business plan for each phase of the project helps keep the focus and helps articulate the project to others. I’ve written a past article on an O&G investor’s investment strategy that provides an example of one O&G investment strategy.

- Buying the right land: This investment should include land with a strong probability of containing productive oil and gas deposits. One way to raise the odds of buying potentially productive land is to buy near other productive wells. The logs from these wells should be reviewed to see potential O&G deposits underground in this land. However, purchasing land near current producing O&G wells usually means the price of this land will be high. This must be considered in any revenue model used to support a business plan for this combined real estate and O&G drilling venture. If you over pay for the land, then the revenue from the wells won’t provide enough returns to make the project profitable enough to counter the high risks involved.

- Finding a good developer for the O&G drilling projects: My personal thoughts are a project of this size and cost should use the services of a very capable oil developer to ensure the highest probability of success with hopefully drilling many profitable O&G wells. Unless the investor has a very strong background with the associated experience to develop these wells, due diligence should be conducted to select the best developer for this project. The business plan should state whether outside investors will be used to fund these wells or if funds will come from the initial project’s investors. A good developer will be able to raise outside investor funding for these projects, if that is what the business plan calls for. As a side note, I have written a complete series of articles that covers all the steps needed to drill O&G wells.

- Managing the cash flow: The project needs to clearly document how cash generated from the O&G wells will be used. Will they be used to: 1) pay down debts including purchase of the land, 2) pay back investors, 3) fund additional O&G wells, 4) initiate development of the real estate, 5) paying ongoing expenses, etc. These wells will not provide income forever as the associated limited supply of oil and gas is pumped out. Therefore, a clear strategy must be defined on where the resulting revenues will be directed - leveraged/or not, reinvested, or otherwise spent. Once the revenues start coming in from he real estate development side of the project, this too must be defined and planned. In all situations, the resulting tax issues must be known and dealt with in the cash flow strategy.

- Finding a good developer of the real estate projects: Again, unless the creators of this project have the necessary experience developing successful real estate projects, a successful real estate developer should be used. This may cost more, but their ability to develop successful projects should reduce the risks involved.

- Define what real estate revenue strategy will be used: Will the land be sub-divided and sold off as homes/commercial sites are developed? This would provide large funds to the investors while also giving them an exit strategy as the real estate is sold off. Alternatively, will apartments and/or commercial buildings be built and leased or rented for ongoing revenues to the investors? This would generate ongoing income to the investors while also hopefully providing capital gains as these property values increase. Perhaps a hybrid strategy will be used that considers selling off some of the land while keeping other portions for ongoing rental revenues. That solution provides both large upfront revenues from sales and ongoing revenues from the remaining rental properties.

- Exit strategy: An exit strategy must be defined on how the investors will be able to sell out their interest in the project. Will the project be taken public (if it is large enough) where investors could sell out their shares on the market? Will other investors have the right to buy out an investor’s interest in some other way? An exit strategy needs to be defined and agreed to by all associated investors before the project is started. There should also be agreement between involved investors on what happens in special situations such as the death of an investor, divorce, law suit, etc. All of these things could severely impact the project without an agreed upon plan for each situation that ensures the remaining investors are able to continue moving forward with the project. To cover all of these issues, I highly recommend using a lawyer to draw up documents before investors put in a cent.

Summary:
This is an interesting way of getting the best from real estate and O&G investments, including all of the unique tax benefits provided to O&G investors and other tax benefits provided to real estate investors. However, there are many issues that must be understood and addressed before starting such a project. I don’t pretend to have all of those issues covered in this short article. Any project of this size should employ the best talented people available to ensure success in all phases. If that happens, any included investor would be very richly rewarded.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

- - - - - - - - - -

Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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Stocks: Understanding stock shorting – making money when a stock price goes down

Stock shorting is big in the news these days:
There are many news articles being printed these days about stock shorting. Also, Congress and others are looking at stock shorting and considering various new regulations on this investment tool. Many sophisticated and accredited investors use this means of investing to make a lot of money when the price of stocks move down. I hope to help better explain what stock shorting is, how it works, how it can work against you, and what the benefits and issues are with it.

What is stock shorting?
Most investors are familiar with investing “long” by holding a stock while it hopefully increases in value over time. The goal is for the stock price to continue increasing so there will eventually be a good profit (capital gains) when the stock is sold. However, sophisticated investors make money when the price of a stock goes down. This type of investing can be done by shorting the stock.

How can you make money when the stock price goes down?
As mentioned above - in the case of “going long” a stock, the investor purchases a stock and sells it on a future date hopefully at a higher price. The difference between the purchase and sales price (if sold at a higher price) is then the profit. In the case of “shorting a stock”, the investor borrows stock from someone else and immediately sells it on the market. Eventually the investor buys back the stock from the market - hopefully at a lower price than when it was previously sold by the investor - to give it back to whoever lent the original stock to sell. This is the opposite of going long. The investor first sells the stock at a high price and later buys back the stock at a lower price. The investor keeps the difference.

An ideal example showing how shorting works:
For this example, I’ll assume my broker does not charge to buy or sell stocks so those costs will not be included. Also, I am not going to talk about the broker’s margin requirement. This is a simplified example (as will be the other examples in this article).

On Monday September 15, 2008 I tell my broker to short 100 shares of Morgan Stanley stock (symbol MS). The broker finds 100 shares from someone to let me borrow and then sells them on the market. Assume all the stock shares sold at $34.00 for a total income to me of $34 x 100 = $3,400. Further assume I am a genius investor and happen to know the bottom of the price would be Thursday September 18 at $11.92 and tell my broker to buy back the 100 shares of MS. If I was lucky enough to get all 100 shares for $11.92 then I spent $11.92 x 100 shares or $1,192. The shares are given back to whoever lent me the original 100 shares and I pocket the difference of what I sold the stock for ($3,400) and what I paid to get them back ($1.192). In this case, I would make a profit of $2,208 ($3,400 - $1.192 = $2,208) in only four days without even owning the stock. Furthermore, I didn’t need money to buy the stock since the money was received when I initially sold the borrowed shares.

Where shorting can work against you:
First consider how you lose money when going long a stock. When going long, you lose if the price of the stock goes down. The stock was first bought at a higher price than when you eventually sell the stock with the difference being your loss. In the case of shorting a stock, you lose money if the price of the stock goes up. The stock was first sold at a lower price than when you eventually buy the stock back with the difference being your loss.

An example of how shorting can work against you:
Lets assume the opposite situation for MS than the above example. On Thursday September 19 I think MS is going to continue going lower and tell my broker to short 100 shares. Assuming the broker finds 100 available shares and sells them at the low $11.92 per share, I receive $1,192 at that time ($11.92 x 100 = $1,192). However, instead of continuing lower, the news announcement comes out that the government is working on creating an entity that will take all of the bad assets off of the financial institution books. The stock starts climbing very rapidly. On Friday I panic and tell my broker to buy back the 100 shares. At the time I am forced to buy the shares at a high price of $33.25 since many other short sellers are also quickly buying back shares of stocks to “cover their short”. I then pay $3,325 for these 100 shares ($33.25 x 100 = $3,325). The net result is that I lose the difference or $2,133 in less than 24 hours!

What is a naked short?
You hear a lot about naked shorts these days. In this case, the investor does not first make sure there are 100 shares of stocks available to sell or to buy back and sells the stock anyway. This can be hard to understand, so I refer you to a article on Wikipedia that goes into more detail.

Why is shorting allowed?
Shorting can be beneficial to a stock by helping curtail over-buying of a stock to the point of ridiculous prices above what the underlying company should be valued at. By shorting stocks that have run up in price, these investors can help bring the price back down to more reasonable levels. Therefore, shorting does play a beneficial role of helping to regulate the price of stocks that may otherwise reach very high levels and fall precipitously when the buyers dry up. The “long” investors would then be hurt very quickly as the price drops. By allowing shorting of the stock, hopefully it does not reach such a high level where the risk of dramatic fall is high. If the shorts bring the price too low, then eventually the “long” buyers start coming in to bring the price back up to a reasonable level. The cycle then repeats if the price again goes up too high to where the short sellers get the upper hand to bring the price back down.

How the current freeze on shorting financial stocks might hurt investors:
Currently there is a freeze on shorting many of the financial stocks due to the major financial crisis in our country. This is good in one way since it stops the runaway shorting of a stock where the price goes down and more shorts join in. As they join in the price drops even more attracting additional short sellers. The result is a compounding of shorts that overpower any attempts by the “long” investors to bring the prices back up. Also, many of these financial companies are good. The price drops are not in line with the actual strength of the underlying company, but are the result of these compounding shorts. So, the freeze allows this short upon short upon short to stop, hopefully letting the stock have a chance to rise back in a range reasonable for financial strength of the underlying company.

The danger here is that the price of these stocks could go the other way and be much higher than what is reasonable for the underlying company. Without short sellers to help regulate and bring the prices back down to reasonable levels, these stocks could be in for a dramatic fall at some future point when the “long” investors have all bought what they want. At that time, they start to sell in panic if the price drops. They want to get out at the high and not be caught in a rapidly declining price again. So, we will have to see if the prices of these stocks stop at reasonable levels on their own as they recover from this period of extremely heavy shorting or if they will get too high and be in for another round of rapid decline, even without short sellers. When the ban on shorting is eventually lifted, the short sellers will hit companies where the prices of the stocks have gone way too high. The drops could start a panic sale again as “longs” get out.

Summary:
Stock shorting is a legitimate means of investing and plays an important role in helping keep stock prices regulated. Many times, it helps prevent “bubbles” where prices go way to high and fall precipitously as the “long” investors panic out. Stock shorting is not well understood, but is definitely a tool used by some accredited investors, sophisticated investors, and other seasoned investors.

Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Almost everything you need to know about oil and gas drilling investments

Recap of past oil and gas investing related articles.
I though it might be good to recap on the various articles I’ve posted this year related to investing in oil and gas. Below is a list of the various topic areas discussed with links to the associated articles of interest.

Defining an accredited investor:
Accredited investor
You may be accredited and not know it

Tax advantage related:
Tax free income
Reducing up to 40% of AMT income
100% deduction against all income types
Eliminate/reduce 1031 capital gain tax burden

Learn about the oil and gas business:
Why do oil companies need investors?
Who makes money from selling a barrel of oil?
What to watch for when investing in oil and gas
Understanding oil and gas speculators – Why do we need them?

Steps involved in a typical oil and gas drilling venture:
Part 1: Finding the best drilling location
Part 2: Structuring and funding the partnership
Part 3: Preparing and drilling the well
Part 4: Putting the well into production

Examples of actual oil and gas investments:
A single well oil/gas project
A multi-well oil/gas project
Funding the purchase of a oil/gas drilling rig

Choosing a specific oil/gas project to invest in:
Part 1: Know your investment strategy/goals
Part 2: Many ways to invest in oil and gas
Part 3: Choosing a developer and project

Mitigating rising fuel and energy costs for business/owners:
Investing to mitigate the risk of these rising costs

Generating debt free wealth/income:
Using a good oil and gas investment strategy

Real estate vs. oil and gas investments:
Part 1: Time and liability exposure
Part 2: Wealth from cash vs. debt
Part 3: Regulation and liability
Part 4: Considering tax issues
Part 5: Comparison summary and final thoughts

Additional non-oil and gas related articles of possible interest:
The fallacy of buying a home for the interest deduction
Part 1: What differentiates a successful accredited investor
Part 2: What differentiates a successful accredited investor
Part 3: What differentiates a successful accredited investor

A Plug for our sister "Oil and Gas Investor Network" social site:
For those of you who are not aware, we have a sister site for oil and gas investors on Ning. It is the “Oil and Gas Investor Network” Site at http://oilandgasinvestornetwork.ning.com/. This site was originally started to support members of our LinkedIn.com group “Network for Oil and Gas Investors” at http://www.linkedin.com/groups?gid=87188.

Summary:
So there you have it, all of the articles published to date on this blog site. I hope this recap provides a single source of valuable links you can use many times in the future as you either consider investing in oil and gas or continue on your oil and gas investing journey.

Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on how we can help you be a better oil and gas investor or with other oil and gas related questions/topics you have that we can answer in future articles. Happy investing to you all.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles can easily be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

The fallacy of buying a home for the tax deduction

“You need a tax deduction”
Many income earners hear that phrase a lot. It makes good financial sense to find ways of reducing our taxes while still paying our fair share to maintain this wonderful country we are blessed to live in. Some advisors recommend buying a home for the tax deduction of interest on the loan. However, they should have a full understanding of the client’s financial status to make this statement only if it truly fits within his/her financial plan. Unfortunately, many other people hear this advice and feel it is a global statement for everyone.

Understanding the deduction of interest on a home loan:
The ability to deduct the interest paid on a home loan is one of the few deductions used by the ordinary wage earner. A few years back, they were able to deduct interest on credit cards and other expenses. No longer. Therefore, they try to buy the largest home affordable in order to have the most interest to deduct yearly. Once the original loan gets paid down to where most of the monthly payment toes toward principle rather than toward interest, they may get a new refinance loan or a 2nd on their home to have cash for “investing” and higher yearly interest to deduct. They stay in debt on their home to the maximum level possible for this tax deduction.

What does it really cost to deduct the interest on a home?
What these people may not realize is that they are paying out over twice the money than the benefits they are receiving from the deduction of interest. The following example will help illustrate this further.

Very simplified example:
Joe earns a yearly salary that puts him in a 40% combined state and federal tax bracket. Joe buys a house with a total of $25,000 interest the first year. This provides a $25,000 x 40% or $10,000 tax benefit. However, note that Joe spent a total of $25,000 to get this $10,000 benefit, or 1 ½ times more than the benefit.

If Joe was in a lower total bracket of 25%, then the benefit would only be $25,000 x 25% or a $6,250 benefit. In this case it cost Joe $25,000 for a $6,250 benefit or four times as much.

These examples are very simplified and don’t take into account all of the tax issues associated with a real situation. However, they do illustrate the point that Joe is spending much more money than he receives from reduced taxes. In addition, over a 30 year loan, the extra money spent is significant.

Must look at each person’s situation to determine what makes sense.
For some people, renting may actually make more sense financially than owning. For others, owning a home is the best option. However, care must be taken to buy a home that fits within an appropriate financial plan for that person. Don’t try to buy the largest home or get the largest mortgage just to have a big interest deduction. There are many other deductible investments you can make that will reduce taxes while providing income. In this way, the money spent actually generates increased income rather than extra expense. Also, consider the benefits of having your home paid off with the funds that once went toward the mortgage payment now available for investing in additional income generating investments. There are investments such as oil and gas drilling ventures that provide a 100% deduction of all invested funds against all income types while not counting in alternative minimum tax (AMT) income. Other tax advantaged investments include government bonds. In these ways, the investor can reduce taxes while increasing income without adding debt.

Summary:
The main point here is not to buy the largest house or maintain the largest mortgage for the tax deduction alone. Be sure to carefully consider your long term financial plan to determine what level of investment in a home best fits within that strategy. Work with a financial planner as needed during this process.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Past articles can easily be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content