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.

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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.

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Part 3: How To Choose A Specific Oil and Gas Drilling Venture To Invest In

Third and final article in the series:
This is the third article in this series about how to make the choice on a specific oil/gas well drilling project to invest in. Click here to read the first article.

Focusing specifically on an investment in drilling for oil and gas:
In the previous article, we covered many ways of investing in oil and gas. From this point forward, we will address those investors who have decided to invest in domestic drilling ventures for oil and gas.

Choosing a specific oil developer to invest with:
After you have clearly defined your investment strategy (see the first article in this series), you need to look for oil producers that offer the type of investments that fit your strategy. However, there are many inexperienced and questionable oil producers out there trying to get your money.

Once you decide to invest in oil and gas, where do you go to find viable projects?
Your best bet would be to find someone who is currently a successful oil and gas investor and find out what they are doing. Ask everyone you know if they know such a person. After you exhaust those sources, ask professionals who deal with high net people such as financial advisers, the local Chamber of Commerce, accountants, lawyers, etc. The most risky place to look for these investments is over the Internet, magazine or newspaper ads, and investment chat rooms.

Be cautious before investing with a oil producer.
You must be very cautious and check these producers out. A previous article provided provides information to conduct due diligence on oil producers to narrow your search to reputable candidates. Part of your elimination process should be understanding the various oil and gas investments they have to offer and matching those against your investment strategy.

How much should you invest?
When you finally chose the best project and associated oil producer, then consider how much you want to invest. Another past article covers a strategy for systematically creating debt free wealth through oil and gas investing. Spread your available investing capital across several projects to mitigate the risk of any one project being bad. This also ensures you have capital to invest when a true opportunity presents itself. If you are always fully invested, then you may be tempted to borrow funds for investing. Don’t start on that path with oil and gas investments. There are too many risks and you could end up in lots of debt with little cash flow to cover the payments.

Continually learn.
Eventually you need to start with one investment in oil and gas drilling. Don’t research so much that you never take this first step. Know that you will make mistakes and there will be dry holes (a term used to describe a drilled hole that will not produce oil or gas). You will lose money. However, if you never risk your money then you will never have the chance to participate in the very productive wells that can return 20 or more times your money over the life of the well. The rewards can be significant for productive wells, especially at today’s high prices.

Do your homework.
Don’t pass on the opportunity to participate in oil and gas well investments based on negative things you may hear about those companies that give the industry a bad name. Research the companies you want to invest in. Understand whether they are using the latest technologies. Continually learn as much as you can about the oil and gas industry. Find one or more successful oil or gas investor who will mentor and guide you. Learn from them to not repeat the mistakes they may have made. Find out what makes them successful. What is their investment strategy? They may get you into deals you would otherwise not be made aware of. In any case, make a decision and move forward systematically with your investment in oil and gas. Be sure to follow your investment strategy to help make good decisions and avoid those “investments” that do not get you closer to your investing goals that follow your strategy.

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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. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for information on what projects we are invested in.

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.

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Part 2: How To Choose A Specific Oil and Gas Drilling Venture To Invest In

Second article in the series:
This is the second article in this series about how to make the choice on a specific oil/gas well drilling project to invest in. Click here to read the first article.

Understand there are many ways to invest in oil and gas:
There are so many different types of investments out there today. A few include:

-- Simply purchasing stocks in oil and gas related companies. Your investment loss is limited to the amount you invest so the risk is manageable. You do need to watch these stocks over time to make sure the underlying company isn’t doing things that may cause it to go into bankruptcy or other problems. Also, the stocks tend to fluctuate with whether oil and gas are in or out of favor at the time.

-- Purchasing an oil Exchange Traded Fund (ETF). You can invest in a fund that buys and sells oil or gas. This way you are not dependent on the underlying company, but only on what direction the price of oil and gas moves. Therefore, these ETF will also fluctuate with whether oil and gas are in or out of favor at the time. However, you only have the risk of price movement from the oil and gas and not from a company as you do with stocks.

-- Trade commodities futures contracts. Here you buy contracts on oil or gas in the futures market. You can put very little money down in order to control a significant amount of oil and gas. If the price moves only a little, you stand to either gain or lose many multiples of that movement. Since the risk of loss is much more than your investment, these are extremely risky investments. Professionals know tricks to control these risks, but most individual investors do not. As a result, these investor have to watch these prices, at a very minimum, once per day to consider readjusting their positions. Again, if the price moves in the opposite direction the investor bets, then the losses can be very large, very quickly. Many times the price of oil and gas moves very big overnight in foreign markets and opens in U.S. markets sharply higher or lower. You will not have control to sell your position (in many cases) and may wake up to a significant loss. You must be very careful when playing the futures market. There are many professionals in the market who trade them all day, every day. They can drive the price against you very quickly.

-- Purchase of land where oil or gas may be drilled. The hope is that oil or gas will be drilled and productive on the land to provide a portion of the revenues back to you as the land owner. However, if you buy land in an area that is known to have productive wells, then the price of the land may already be inflated to a point the revenues may not be that significant after paying payments on the land. Be careful.

-- Purchase of a lease that covers the right to drill on a specific piece of land. In this case, since you are not the land owner, you don’t have to worry about covering payments on the land. You can receive a portion of the revenues from the wells, but will also share revenues with the land owner, the developer, others involved in drilling and servicing of the well, and with investors in the wells that are drilled on the leased land. For a small fee to lease the land, the revenues from productive wells can be significant, while the risk is only the funds you pay for the lease. The lease purchaser should secure land that is known to be productive or has a high probability of being productive. The lease should provide the rights to conduct seismic and other studies of the land to verify the potential for good wells. Also, leases usually cover the right to drill several wells on the land, which reduces the risk to the investor/owner of the lease since hopefully not all wells will be dry (bad or non productive). Smart leases are low risk and have the potential for huge returns. For these reasons, most leases are only offered to large institutional investors and not to individual investors. Many large oil companies like Exxon will own these leases while, in some cases, letting small oil producers with their associated individual investors fund the drilling of each well.

-- Participation in drilling one or more oil and gas wells. As a participant, you are usually a general partner with all the associated tax advantages granted by congress for domestic wells to reduce our dependence on importing foreign oil. However, the oil producer and investors in the well take the risk of the well either being productive or dry. However, with all the associated tax advantages (tax free income, writeoff of invested funds against all income types, reduction of up to 40% of your alternative minimum tax income, etc.), and with most of the revenues generated form a well going to these investors, the overall returns can be very significant for good productive wells. However, due to the high risks that go with the potentially high rewards, investors should only consider investing in wells with a high probability of returning all invested funds in 6 to 18 months. That makes the risk to reward ratio reasonable against the risk assumed with drilling oil and gas wells. The probabilities for a productive well can be increased by using the latest seismic technologies, conducting thorough research on other wells in the same area, using reputable oil producers and well operators, etc. Most of the articles posted on this blog are centered around these investors in specific oil and gas projects. Visit the blog site for additional articles.

-- Participate in funding the transportation of oil and gas. Some companies offer partnerships to fund placement of a pipeline to oil and gas wells for transporting the oil or gas to a buyer. As an investor, you usually receive a percentage of revenues resulting from the oil or gas flowing through your funded pipeline.

-- Participation on a off-shore oil platform. These types of investments usually involve tens or hundreds of millions of dollars. Due the the significant funds required, these investments are almost always only offered to very high net investors and/or institutional investors. Once a platform is placed, there can be many wells drilled from one platform. The result is increasing revenues from multiple wells without the additional significant investment of a new platform each time a well is drilled. The revenues generated from a platform can be significant if many productive wells are drilled from it.

Next article in this series:
The next article in this series will continue thoughts on what an investor needs to do when considering investing in an oil/gas drilling venture.

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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. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for information on what projects we are invested in.

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

Part 1: How To Choose A Specific Oil and Gas Drilling Venture To Invest In

Know your investment strategy/goals:
Most investors do not have a lot of spare time to spend managing their investments. However, every investor should take time periodically to initially define and periodically reevaluate their investment goals, where they are currently toward reaching those goals, and what strategy they have to get there. This strategy needs to consider the investment risk tolerance of the investor, the timeframe needed to reach the goals, what assets the investor currently has and in what form, and many other factors.

What are your goals? What timeframe do you need to reach those goals? What is your risk tolerance? What assets do you have and in what form (home, stocks, cash, bonds, etc.)? How much cash do you have to invest? What percentage of your cash is available for higher risk investments? What amount of time do you have to watch/manage your investments? How are you investing (self, with others, corporation, partnership, trust, fund, etc.)? What purpose do you have for investing (retirement – when?, tax advantages, freedom, etc.)? What freedom do you have to invest the funds - Do you need permission? - From who and why?

Only after you have given serious thought and effort toward clearly defining your investment strategy and goals, then consider if investing in oil and gas drilling ventures is and appropriate investment for you. Don’t jump in because you think it is a quick means to wealth with the current high price of oil and gas. High prices alone do not mean lots of wealth for investors. There are many things that can go wrong with a oil and gas drilling venture where you will lose all of your investment. Only use risk capital that you are willing to lose after first building a successful investment base that continually generates the risk capital you need to consider oil and gas drilling ventures, again, only if it fits your strategy.

Typical investment strategy/goals associated with oil and gas drilling investments:
Investment goals you should have when considering investment in oil and gas drilling ventures should include:
- Rapid return on invested funds (look for projects with expected 6 – 18 month return on investment)
- Very low time commitment requirement
- Tax deductions against both ordinary income and capital gains
- Reduction of alternative minimum tax (AMT) and investment income that does not put you into an AMT situation
- An income stream with significant tax free components
- Limited loss to only invested funds
- Very low to no liability risk
- Investment in something that most everyone uses regularly with rising prices (increasing returns for the investor)

Many of these goals are due to the unique tax advantages provided by Congress for direct investment in domestic oil and gas drilling ventures (tax free income, deduction of each invested dollar against all income types and capital gains, up to 40% reduction of alternative minimum tax income –AMT, etc.). You can read more about the various benefits of oil and gas investments in past articles at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html.

Take your time finding the right oil/gas drilling venture to invest in:
You do not want to risk your money without taking the time to evaluate several oil developers and projects they are offering. I’ve noticed investors in a field they are not familiar with will try and get their information only from the oil developer selling interests in a project. The developer tells them everything they want to hear to make the project seem absolutely a “sure thing”. They then give all kinds of “proof” that you will believe if you don’t know the business. In this case, the investor then tends to throw lots of money into the project without much hesitation. They give more thought and research into buying their HDTV than in researching the right oil developer and project that fits his/her investment strategy.

When buying a TV, Car, or house, we spend hours, even days researching on the Internet, talking with people who have recently bought, reading reviews, etc., before ever making the final decision to buy. By the time we purchase, we have done enough research to make an educated decision. Why then can’t a new investor in oil and gas do the same level of research before investing? If you don’t know the business, then learn all you can about oil and gas investments first. There is a danger her of over analyzing as well where you never make the decision to invest because you never feel like you’ve learned enough. There is a fine balance that you need to find for yourself. Having a clearly defined investment strategy and associated set of goals is absolutely critical in helping you understand where oil and gas drilling ventures may or may not fit. You will be able to consider each drilling project to know how it does or does not fit within your plans. All of these play together in helping you come to a decision either to invest or not in a specific oil/gas project.

Next article in this series:
The next article in this series will continue thoughts on what an investor needs to do when considering investing in an oil/gas drilling venture.

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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. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for information on what projects we are invested in.

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.

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Debt Free Wealth Generation From A Good Oil and Gas Investment Strategy

Only use risk capital when investing in oil and gas drilling ventures.
When considering investing in oil and gas drilling ventures, only risk capital should be used. As with any investment, if you are not comfortable risking the loss of money, then you are investing too much. This level of comfort differs for each investor. You need to decide what your comfort level is. Once decided, follow an investment strategy that maximizes your returns while minimizing your losses.

A basic strategy for oil and gas drilling investments:
· Don’t invest in only one or two wells. Reduce your risk by spreading the available funds over several wells.
· Invest approximately the same total funds in each oil and gas drilling project. Using the same amount of funding keeps you disciplined and consistent. You wont be as susceptible to an oil producer trying to more in one project since it is a “sure thing”.
· Only consider investing in wells that are projected to return your investment in 6 to 18 months.
· Develop a reinvestment plan into additional wells. Decide what percentage of oil/gas revenues from your wells to should be reinvested in additional wells. This way your income continues to rise from consistently adding new wells at the same time your older wells start dropping in production.

Consider an example of diversifying over several wells:
Let’s look at an example showing how diversification provides the best combination of risk verses return. In this example you have $100,000 total to invest. You invest approximately the same portion of this money across four wells. It is may be impossible to invest exactly the same in each well since the cost to participate may differ from well-to-well.

When the wells are complete and in production, we see the various monthly returns for each and further see that well #2 turned out to be a dry hole or non-producing well. The return on investment with the other three wells varies from a high of 200% to 67% with an overall combined return of 93% across all four wells.

Had you invested the full $100,000 in well #1, the total return would have been maximized. However, you would have risked losing all of your funds had it turned out to be a dry hole like well #2. Alternatively, had you only invested in two wells with the dry hole well #2 being one and either well #3 or #4 being the other, your combined returns would have been much less than the current diversified 93% across the four wells. Therefore, investing everything in one or two wells hoping for a 200% ROI Well #1 is not worth the risk, and misses out on the strong diversified 93% ROI.

A long term strategy for oil and gas drilling investments:
Every well runs dry at some point in the future with some wells only lasting a short time while others last for many years. It is important that you continually add to your portfolio of oil and gas wells to replenish lost income from the older wells as they slow down. As stated earlier, a portion of the income from your wells should be reinvested into additional wells. Beyond trying to maintain the same level of combined income, you should consider reinvesting even more so your resulting yearly income is always increasing. Over the long run, continued diversification will minimize your risk of loss while providing consistently increasing income. Another reason to continue reinvesting in additional wells is to take advantage of the tax write-offs against the income from these wells.

Consider an example of reinvesting oil/gas income into additional wells:
In the previous example we received a combined 93% ROI over four wells. This means we will receive $93,000 income from those wells in the first year. If we reinvest a little over half of that into two additional wells at $25,000 each, then the resulting income would be significantly higher while lowering our risk over more wells. This assumes the first wells continue to provide a strong payout after the first year.

Scale up your investments as income grows:
Continuing this strategy provides you with increasing income that is debt free. You are using income to buy additional income. This is a very powerful way of having your money work for you to increase your wealth. Eventually, as your income increases, you will be able to participate in larger projects while increasing your percentage ownership in the associated partnerships. You could scale up your average investment per well from $25,000 in this case to $50,000, then $75,000, etc. This may mean purchasing additional percentage ownership in these projects or participation in larger projects that require more funds per percent ownership. Also keep in mind that ongoing investment in additional wells provides associated tax write-offs against the growing income stream.

Your input is desired for future article topics:
We want to hear from you. What oil and gas investing related questions to you have that we have not already covered? Please email topics you would like us to consider at our generic email address MarcobeInvestmentsInc@gmail.com. Also, email us if you have any other thoughts or questions for us to answer. Thank 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. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for information on what projects we are invested in.

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.

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