Posted by: thenakedoption | September 22, 2008

Controlling your emotions

They say the markets are controlled mainly by two emotions: greed and fear. When you’re making good money on a stock, it’s tempting to say to yourself “this baby’s gonna skyrocket to the moon and I’m gonna ride it there!”. But then it pulls back and you’ve lost some of your profit, or worse you end up with a loss. Conversely, when you’re losing on a stock it’s easy to hit the panic button and pull out before all hell breaks loose. But then it turns around and you realize you’ve pulled out too soon.

To control the greed and fear monsters, you first need to determine how much you want to gain and how much you’re willing to lose before entering any position on a stock. For example, you buy a stock at $100 and you think 20% would be a fair return. So you place a limit sell order at 120. This prevents you from getting greedy if the stock rises sharply. Once you’ve reached your selling price, you exit your position and walk away with a nice profit. If the most you want to lose is 15%, you place a stop loss order at 85. Now if the stock drops to 88, you don’t panic (ideally) because you’ve allowed yourself to lose up to 15%. You should always use stops on every trade you make. This helps to remove the greed and fear factors out of the equation.

Posted by: thenakedoption | September 15, 2008

Misplays: Lehman Brothers Holdings Inc.

I think this is going to be my misplay of the year.

There were reports last Friday that Bank of America was in talks with investment bank Lehman Brothers about a possible takeover. I was quite confident that BoA would bail out the ailing, 158-year-old Lehman and offer a premium for their stock in the same way that Chase Bank bailed out Bear Stearns earlier this year. As such I choose to take a very high-risk, very high-yielding overnight long position on Lehman.

Lehman closed last Friday at $3.65. I took a small position at $3.50. I figured that BoA would come to the rescue with an offer of $6 – $8/share, or worst case scenario BoA would pass and Lehman would sink to $2. In other words, upside potential was greater than the down. I was in a good position to make a pretty profit. Well, a 3rd scenario occurred that neither I nor any other analyst predicted would happen over the weekend – Lehman filed for chapter 11 bankruptcy and the stock plunged to 30 cents.

Luckily, my position was relatively small. So while the outcome did hurt, I was not sent to the cleaners. I knew exactly that what I was doing was very risky, so there’s no real lesson learned for me here. My advice to you is that even if you think something is a sure thing, don’t put all your eggs in one basket. My personal rule of thumb is that no more than 10% of your portfolio should be allocated to any one particular security.

Posted by: thenakedoption | September 12, 2008

Beware the pitfalls of ‘saving your money’

I love those ING Direct commercials where the Dutch guy always says “save your money.” So I thought I’d examine how good ‘saving your money’ really was.

September has been a rough month so far for investors. Heck, the last few months have been rough for investors. The markets are extremely volatile right now and have been on a downward trend since June. One day your portfolio could be in the green, the next day it could very easily be in the red, and back and forth. So what’s an investor to do?

Investors looking to escape the turmoil of the markets are turning to cash as a safe alternative. At first glance, money market funds may seem like a good idea, but you must consider all factors – namely taxes and inflation.

Let’s say you buy a $1000 GIC (which is virtually risk-free) with an annual rate of 3.5%. So in a year you’ll have 1000 + 35 = $1035. Now the first to take a piece of that pie is the taxman. In Canada, interest income is fully taxable at your marginal tax rate. Let’s say your marginal tax rate is 40%. That leaves you with $1021, or an after-tax return of 2.1%. Now economics comes into play. Investors are more focused on real return or purchasing power. In other words, your return after the effects of inflation. So far this year, inflation has averaged about 2.3%. Now your real return actually turns out to be 2.1 – 2.3 = -0.2%. So your original investment of $1000 is really only worth $998 when you take into account taxes and inflation.

The rates I’ve used are always changing and your marginal tax rate will depend on your personal income, so don’t take my example as concrete. But the point I want to make is that you must fully educate yourself on all factors when making any investment decision.

Posted by: thenakedoption | September 6, 2008

Plays and Misplays: Oil and Mosaic

Play of the Week
ProShares UltraShort Oil & Gas ETF (AMEX:DUG)

The big news Tuesday morning when markets opened after the long weekend was that oil was tanking (pun intended), along with gold and almost every other commodity. Oil has tumbled more than $40 from its peak of $147 earlier this summer over fears of a global economic slowdown.
DUG tracks twice the inverse daily performance of the Dow Jones U.S. Oil & Gas Index. It closed last Friday at $34.61 and ended this week at $40.47 – an increase of 16.9% over just 4 sessions. This play gave me desperately needed relief from the carnage in the markets this week.

Misplay of the Week
Mosaic Company (NYSE:MOS)

Mosaic is a producer of phosphate and potash used as fertilizer in the agriculture industry. Shares of fertilizer companies like Mosaic have soared over the last year because of rising world demand for food. And how do you get food? You grow it. And how do you grow food? With fertilizer. I chose Mosaic over its main competitor, Potash Corporation, because 500 of their employees are currently on strike. That one’s a no-brainer.
So I figured tumbling oil prices would simply contribute to Mosaic’s bottom line, which is heavily influenced by fuel costs. Wrong. It turns out Mosaic, along with other fertilizer companies, is still on a downward correction course since peaking in mid June.
Conclusion: I still think Mosaic is a good buy and most analysts would agree. Even with a slowing global economy, people still need to eat. Perhaps we should wait to buy back once this correction has finishes its course.

Posted by: thenakedoption | September 5, 2008

3 Ways to profit in down markets

This week was a brutal week for the markets. The TSX lost close to 1000 points. The S&P 500 and DJIA were also down, and so was almost every sector – especially commodities. Now in general terms, it is easier to profit in a rising market, but you can still profit in a down market. Here are several ways:

  1. Short Selling
    Short selling (or shorting) is basically selling a stock now with the expectation that the price will go down, at which time you buy. It’s the same principle as ‘buy low, sell high’, except in the reverse order. Shorting can be very risky because it essentially involves selling something you don’t have. Your brokerage firm will require you to maintain a certain level of cash to buy those shares. If the price rises substantially, you may be forced to add more funds to your account (called a ‘margin call’) or even be forced to buy those shares at a loss. I have never shorted a stock due to the margin requirements.
  2. Put Options
    A way to control a stock without owning it outright is to purchase an option. A put option is the right, but not the obligation, to sell a stock at a predetermined price, by a specified date. If the underlying stock price falls, you profit. My view is that buying short term options (having an expiry of 9 months or less) based purely on speculation, is extremely risky. You may be able to generate large, leveraged returns, but you also have a real risk of losing your entire investment. However, if you own the actual stock, then I think using a put option as a hedge against a drop in price is a smart move.
  3. Bear/Inverse ETFs
    My preferred method of investing in a down market is to buy bear ETFs (more commonly referred to as ‘inverse ETFs’ in the US). Bear ETFs track the downward movement of an index, commodity, currency, etc. For example, if the price of oil drops, the price of a bear ETF that tracks oil will rise. Bear ETFs and ETFs in general offer the advantages of a diversified, managed fund for a low fee.

    Here are some Bear ETFs to check out:

    S&P/TSX 60 Bear Plus ETF (TSE:HXD)
    NYMEX Crude Oil Bear Plus ETF (TSX:HOD)
    Short S&P500 (AMEX:SH)
    UltraShort Oil & Gas (AMEX:DUG)
    UltraShort FTSE/Xinhua China 25 (AMEX:FXP)
    UltraShort Basic Materials (AMEX:SMN)

On one last note, the above mentioned ways will be more expensive in a down market and cheaper in a rising market – thus making them good hedging instruments in a rising market. If you’re still awash with what I just said, then think of it this way – insurance is much more expensive when your house is on fire.

Posted by: thenakedoption | September 2, 2008

Profit in declining markets: bear etfs

In my very first blog entry, I touted a new crude oil etf as the best thing since sliced bread – and who wouldn’t. HOU went from $19 in January to $48 in early July, but has gone downhill since then.

You can find many reasons as to why oil has been on a downward spiral since early July, but there are two explanations that I can agree with.

  • The first is that the speculators are closing out their positions. In other words, the hedge funds and pension funds (those who don’t actually need oil the way say, refining companies do), have poured billions of dollars into oil futures contracts for purely short term gain. With worries of the global economy slowing down, those guys are now getting out and taking some profits with them.
  • The second explanation which is more objective is that oil is priced is US dollars – which has made a comeback over the last several months. As the US dollar rises, fewer dollars are needed to buy a barrel of oil and hence the price of oil decreases.

So now that oil is on the decline, you can check out Horizons BetaPro Crude Oil Bear ETF (HOD) which tracks the inverse performance of crude oil futures contracts on the NYMEX.

One major point I must make note of is that back in June when oil was nearing US $150/barrel, top energy analysts from the banks, asset management firms, and oil companies were all predicting $200 oil by year’s end. Well, that’s probably not going to happen. This just goes to show that the guesses of individual investors like you and me are just as good as the big wigs at major financial institutions.

Posted by: thenakedoption | August 18, 2008

Picking stocks: easy. Picking good stocks: not so easy

Choosing high quality stocks that will generate a positive return is no easy task. No one can pick stocks that will rise in value with certainty. If they could, they would be instant billionaires, and they probably wouldn’t tell you how to do the same.

However, there are some basic fundamental guides you can make a part of your investment strategy.

1.    Don’t put all your eggs in one basket
We’ve all heard this saying at one time or another and it definitely holds true when choosing investments. You’d be a fool to bet your entire portfolio on one particular investment, unless that investment is virtually risk free like Canada Savings Bonds. These days, you don’t even need to pick and choose individual stocks because there is a wide selection of fully managed funds. Mutual funds and ETFs offer low-cost alternatives and offer varying degrees of diversification.

2.    No risk, no reward.
Risk and return are positively correlated. The more risk you take on, the higher the potential return (and loss). Your ultimate goal should be to choose investments with the lowest possible risk, for the highest potential return.

3.    Don’t choose stocks you think will rise in value. Choose stocks you think everyone else thinks will rise in value.
Now things get a bit more complicated. This is more of a theory than a practical guide, but I really like it. I first heard this from a professor of management strategy back in university. It is partially derived from game theory, for those of you familiar with economics.
Essentially, it means that as individual investors, we cannot influence prices on the stock market. For example, my order of 100 shares of XYZ will not cause an increase in price of XYZ. But a bank that buys 3 millions shares of XYZ will certainly cause a price movement. So if a particular company is making headlines and you think the insurance companies, pension funds, and banks will start snapping up their stock, you need to jump on that train and ride it home!

Posted by: thenakedoption | July 31, 2008

That cuppa joe is the first to go

Starbucks Corp. posted its first ever quarterly loss today. Starbucks recorded a net loss for Q3 of $6.7M or 1 cent per share. Over the last year, shares have plummeted 45% and they recently announced the closure of 600 U.S. stores.

I’ve always been fascinated with the revenue model of Starbucks. Here’s a company that managed to find a way to brew a cup of coffee for about 20 cents (maybe less), and sell it to you for 5 dollars! Those are some juicy margins. From a business standpoint, it’s pure genius!  And best of all, they convinced those too embarrassed to order up a “small” cup anywhere else, to pay a ridiculous amount for a “tall” cup instead.

So what’s happening to the retail coffee industry? Is it on a downward spiral? No one can say with certainty, but all signs do point to trouble. The U.S. is in recession, despite their government’s reluctance to officially declare one. So if your family’s home just got foreclosed and is now struggling to make ends meet, a 6 dollar “Venti” becomes a low priority. In addition to recession, there’s lots of competition and low-cost alternatives like Tim Horton’s here and Dunkin’ Donuts there. There’s also Blenz, 7-11, McDonald’s etc.

But all is not lost in the java war. The domestic market may be saturated (people always joke in Vancouver about how there’s not one, but two Starbucks on every corner), but there’s still plenty of room for growth in emerging markets and that’s where I think Starbucks will prevail. Let’s face it; Starbucks is still a very good company with a very solid brand and business model. I just don’t see them going downhill anytime soon, especially when there are enormous opportunities, albeit outside of the U.S.

The wealth of emerging markets is steadily growing and what better way to spend that new wealth than on a nice, steaming cuppa joe… even if does cost 5 dollars.

Posted by: thenakedoption | July 9, 2008

Stay away from airlines

Calgary-based WestJet Airlines announced today a partnership with Southwest Airlines. The alliance between the discount carriers means WestJet will gain access to Southwest’s U.S. routes in the 48 contingent states and Southwest will have access to WestJet’s vacation destinations such as Mexico and Hawaii.

WestJet shares were up more than 11% today to close at $14.10, but I’m not about to start snapping up their stock. While I strongly believe this is a good move for both airlines and should result in better service for consumers, I’m not convinced the airline industry is a place to start investing your hard-earned money. In the wake of sky-rocketing fuel costs, airlines have had to implement fuel surcharges, charge for services that used to be free (such as that second piece of luggage), and reduce or eliminate routes altogether. Combine that with excess capacity and a slipping load factor, and you have a shrinking bottom line for all airlines.

With carbon-reducing initiatives and rising fuel costs, the global airline industry is undergoing a massive overhaul that will most likely result in aggregate restructuring and consolidation. It is unlikely that people will stop flying, so only the smart and the strong players will survive, but it will be a long and bumpy ride. I wouldn’t touch airlines with a 10-foot pole right now. I feel the risk to reward factor is simply too high. If you insist on investing in transportation, take a look at the freighter and shipping industry.

Posted by: thenakedoption | May 21, 2008

Ride the TSX wave

Name: iShares CDN Composite Index Fund ETF
Symbol: TSE:XIC

The S&P/TSX Composite Index closed above 15,000 today, fueled (no pun intended) mainly by soaring crude oil prices.

The S&P/TSX Composite Index measures the value of the largest stocks on the Toronto Stock Exchange based on market capitalization. This index acts as a benchmark, meaning that you can compare the return on your portfolio to how the market did overall. For example, if the equity portion of your portfolio increased by 11% last year, and the TSX increased only 9%, then you outperformed the market. However, if your portfolio increased less than the market, then you would have been better off buying a mutual fund that simply matched the performance of the TSX. Now, I’m not a huge fan of mutual funds so I’m going to recommend an ETF that will do the job just as well if not better.

Barclays’ iShares CDN Composite Index Fund ETF (XIC) invests in shares of companies that make up the S&P/TSX Capped Composite Index. As with all ETFs, they can be traded on a stock exchange just like any other stock. The minor difference in ‘performance’ between the actual index and the ETF is mainly due to transaction costs and management fees – which are only 0.25%.

Buying an index fund ETF is a passive style of investing that is easy and cost-effective. I bought some shares of XIC at the beginning of May (less than 3 weeks ago) to, ironically, add some stability to my portfolio, and since then it’s soared 6%. Now before you accuse me of pumping a stock, keep in mind that the Index is heavily weighted towards energy and financials. Even though oil prices are breaking new records every day, they are still very volatile. If oil takes a nosedive next week, the Index with certainly follow. I’m also not convinced the banks are finished dealing with the U.S. sub-prime mortgage meltdown, not to mention the pending recession that will undoubtedly affect us here in Canada. I expect the Index to generate positive returns over the course of a year, but it’s going to be a bumpy ride.

By definition, it is impossible to outperform the market with an index fund, but if you want to ensure that a portion of your portfolio performs just as well as the market, then XIC is definitely worth looking into.

XIC performance over the last year

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