Over the past few weeks the volatility and downward trend of the share market has caused traders and investors alike to lose very large amounts of money not to mention sleep.

For those traders who were prepared for such an eventuality, they lost very little of either. They would have lost around 5-10% whilst the average trader lost in the vicinity of around 20% if not more.

The average investor was drawn to the last “Bull Run” like moths to a flame. Having unrealistic expectations of easy money plus they are also being influenced by the media hype which is prevalent in a high flying share market.

The “Flavour of the Month” for quite a while has been Margin Loans. They are easy to set up. The paperwork is minimal as is the setting up costs. So you can be up and running in less than a .fortnight.

The average amount borrowed is usually around the $100.000 mark for which the potential trader has to put forward a fifth. In this case $20,000.But you can buy up to the full amount of the loan i.e. $100, 000 worth of stock. This is called leverage.

Now leveraging is a two edged sword, you can make good profits but you can have big losses as well.

The average investor who decides on a margin loan as a “Sure Fire” guaranteed quick way to make money invariably has neither the experience nor the knowledge necessary to cope with a sudden downturn in the stock market when it occurs.

Using the latest downturn in the markets as an example where share prices dropped downwards drastically in the region of at least 20%.Investors who had margin loans of around $100,000 suddenly had a paper loss of $20,000

When this occurred they were placed in the dilemma of either putting in more money (This is called a Margin Call.) or to buy more shares. In a lot of cases being borrowed to the hilt they were unable to do neither.

So their stock had to be sold at a loss which only exacerbates the problem as other traders are in the same boat having to sell their stock also. With a flood of shares hitting the markets all at once this forces share prices down even further. Causing more panic selling.

In some extreme cases investors were left with no share portfolio at all and still owed money on their margin loans. Not a nice position to be in.

So what precautions can the investor or trader employ to make sure that in the case of a downturn in the market, losses can be kept to a minimum?

The first thing to remember that the only security you have is the shares themselves. You have to maintain a margin between the amount you borrowed and the current value of the shares

This is called your” Loan to Valuation Rate” or LVR

If the market falls below your LVR you then have the choice of putting more money in or buying more shares. To bring up your LVR back again. Of course if you cannot do either then your lender will force you to sell all or part of share portfolio.

Having a diversified portfolio which covers several areas is a good idea as it is invariably one area that is hit the worst.

I personally know several traders who had only BHP/RIO in their portfolio who suffered disastrous consequences for not diversifying.

Another option is to start off with a conservative LVR in place.

A worthwhile valuable idea is to have an unused “Line of Credit” option in position. This will give you cash quickly if the need ever arises.

Lastly is of course to have “Stop Losses” (Conditional Orders.) in place to so that you can minimise any losses to 5-10% depending on the percentage you choose. This also has the effect of locking in any profits that you may have made prior to the market downturn.

Also remember the lender also charges interest on average in the 10% area per annum. That plus brokerage has to be taken into consideration as well as capital gains tax. All of which eats into your profit margin.

So if you decide that a Margin Call is the way to go then make sure you are aware of the pitfalls that can trap the unwary investor.

Good trading!

Money market instruments are short term debt obligations generally regarded as low risk, low to medium return investment for the holder. They are essentially IOUs issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower risks than most other securities. They have maturities ranging from one day to one year.

Treasury bills

Treasury bills are issued by the Central banks such as the Bank of England or government treasury departments. The Treasury sells bills at regularly scheduled auctions to refinance government projects and obligations. It also helps to finance current government deficits.

Commercial Paper

Commercial Paper is short-term loan that is issued by a corporation use for financing accounts receivable and inventories. Commercial Papers have higher denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity period of Commercial Papers is a maximum of 9 months. They are very safe since the financial situation of the corporation can be anticipated over a few months.

Corporate Bonds

A corporate bond is an IOU issued by a public company, such as BT, ICI or Marks & Spencer. When you invest in a corporate bond, you are lending money to the company. In return you will receive interest at a fixed rate and the promise that your capital will be repaid at a certain date in the future.

Certificate of Deposit

A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. CDs offer a slightly higher yield than Treasury Bills because of the slightly higher risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. (Northern Rock Plc being the exception of course).

Repurchase Agreements

The Repo or the repurchase agreement is used by the government security holder when he sells the security to a lender and promises to repurchase from him overnight. Hence the Repos have terms raging from 1 night to 30 days. They are very safe due to government backing. Due to this short turnaround time, these agreements are the most liquid of all money market investments, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically.

Its is however important to note that Although securities purchased on the money market carry less risk than long-term debt, they are still not entirely risk free. After all, as we all know banks do sometimes fail, and the fortunes of companies can change rather rapidly. But it has to be said that the range of possible outcomes is less for short-term investments than for conventional equity and fixed income investments.

No one thinks they’re doomed.

I’m talking about the Canadians, of course.

See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts prompted a search for a way for you to make money as the Canadian banks go down.

In the last 18 months, my readers had the chance to make 432% when Lehman failed, 162% when Allied Capital came clean, and 220% on PNC Financial… This month they’re poised to make money on the next bank drop.

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall.

A Primer on Put Options

As you may know, an easy way to play the downside of stocks is through put options. Here’s a quick primer on how they work…

Put options are a limited risk, leveraged way for you to make money when stocks drop.

For example — when a stock falls 5% in a day, put options may go up 50%. When big drops happen, puts can go up hundreds of percent in hours.

And since they’re limited risk, if you’re wrong, you’ll never lose more than you put up.

My point is — there’s no easier, safer, and faster way to grab huge gains from downward stocks than through put options.

Having said that, let’s take a look in on how you can use them to make money on the Canadian banks. First, the “macro view…”

The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.

The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:

“Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]

Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.

But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.

They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.

Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.

Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.

But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.

For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital… sending the worst of the Canadian bank stocks down.

So how do you play it?

First, I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates. Then, simply visit Yahoo! Finance, enter in their symbol and click on “options” on the top left hand side underneath “Quotes.”

You’ll see all of the put options available on that stock. Pick a good one and you’ll be able to double your money as these stocks go down.

Regards,

Dan Amoss

The first technique is called over writing, so let’s take a look see how it works. Before we start there is one difference between UK equity options and US equity options. In the UK one option contract relates to 1000 shares, but in the US one option contract relates to 100 shares of stock.

Imagine you have a portfolio of shares that you have held for some time and these are mainly UK ‘blue chip’ companies. One of your shares is British Airways which you have held for some time, and you have 1500 shares bought at 200p. The market price at the moment is 365p per share. It is June and you decide to look at the current option chain for the next expiry period which is September. The option expires on the 15th September. You look at all the strike prices available and see that there are contracts at 330p, 360p, and 390p. You check the premium of the contract at 390p and see that the premium is currently 16p. You decide to sell ONE contract for which you receive a premium of 1000 x 16p = £160. (the premium is multiplied by the number of shares for one contract i.e. 1000). Please note – you still have 500 shares left in your portfolio as you do not have enough to write a second contract. You have now sold 1 contract which obligates you to supply 1000 BA shares at 390p on or before the 15th September (Amercian Style Contract) to the owner of the contract if exercised in the period. In return for this you have been paid a premium of £160 which is yours to keep whatever the outcome of the contract. OK – lets look at the possible outcomes of this contract as follows:

Outcome A – the company becomes a takeover target and shares jump to 520p

In agreeing to the contract at 390p per share, you have lost out on the takeover news and have missed the opportunity of ‘making’ 1300 (130 x 1000) on your share holding. This is the downside of writing a call option on your shares, that you could miss out on a rise in prices during the contract period. This is undoubtedly true, however there is no guarantee that you would sell your shares at this point, in other words it is only a paper profit had you kept them. The £1300 lost ‘opportunity’ profits are offset by the premium you have received to £1140.

Outcome B – the share price falls to 295p as competition increases in the industry

The price has fallen during the period, and the contract expires. Whilst the price has declined by 65p, this is partly offset by the premium you have received, reducing your ‘paper loss’ to 49p per share. You still retain your shares and any future dividends.

Outcome C – the market is quiet and the share price closes at 390p

You have made a small ‘paper profit’ here, and a real profit of £160.You have kept your shares and any future dividends. The reason you would probably keep your shares is that with dealing costs etc it would not be worthwhile for someone to exercise, although you can never be sure. I have been exercised when the strike and market price close at the same price, but I have also been left unexercised with prices very slightly above the strike. It depends how your broker closes out positions and reconciles their contracts – sometimes you may be lucky, other times not.

Now, with B and C, you still retain your shares so what might you do? – write another call to earn some more income. You look to the next series (probably Dec) and write another option earning more income. With B, where the share is now trading at 295, you might look for a strike at 320 – 340, and with C, probably around 430 – 440. And so on, until on one contract you will be exercised. The most options I have written on the same block of shares is 4! Finally on the 5th contract the price went up and I was exercised. Please remember it is possible to write a contract so that you have built in a loss. Suppose you purchased some shares for 250p which then declined in price , and you wrote a contract at 225p with a premium of 10p. If it was exercised you would be receiving 235p (225+10) for shares you had paid 250p. Now, on occasion I have done this deliberately where I wanted to get rid of the stock for some reason. PLEASE DON’T DO THIS BY ACCIDENT. There are lots of packages around that will give you a graphical display of the breakeven point – most of these are free.

Finally, I mentioned dividends a couple of times above. Naturally, whilst you hold the shares you receive any dividend payments from the company. You should be aware when dividend payments are due for two important reasons. Firstly you may decide not to write an option as a dividend is payable in the next few weeks and you decide to wait. Secondly If you do write a call and a dividend is due shortly, the likelihood of exercise is much higher right before a dividend payment. The perfect outcome of course is where you keep your shares, your premium, and a dividend is paid during the contract ! – it does happen.

Your present financial situation

You need to begin by evaluating your current financial situation. Consider your assets, your liabilities, your total household income and the amount of discretionary income that you have available to invest on a monthly basis. Your discretionary income is the income that you have left over each month after you pay all of your household expenses. Next, you need to evaluate your current level of cash reserves. Cash reserves can be defined as the assets set aside in the case of an emergency or for an opportunity. An example of an opportunity would be a great investment, a real estate property that you want to buy or a great vacation discount that you want to take advantage of. It is recommended that you keep between 3-6 months of your total household expenses set aside as cash reserves. The other factor to consider is the level of your personal protection. Your most important asset is your ability to earn an income. Protecting yourself, your home, your vehicles and your family is important. Evaluate your levels of insurance coverage to determine whether it is sufficient to cover your present needs.

What are you saving toward?

Everybody saves for a purpose. Some people save to ensure a better retirement. Some people are saving to buy a car, home or a new boat. Some are saving to ensure that their children have a great college education. Before you begin to save, sit down and think about all of your goals, and then prioritize them based on personal importance. Ask yourself whether these goals pass the acid test. The acid test asks if you would be willing to do whatever it takes to achieve these goals. For example- Would you reduce your lifestyle and expenses to save more money if it would ensure that you reached your goal? If a goal does not pass the acid test then you should remove it from your list. Next, define each goal with a time frame and an amount. For example- I need to have $50,000 saved for my oldest son by 2010 to pay for his education, is a clearly stated goal. Once you have defined your goals, determine the dollar amount needed to save to achieve them and the length of time you have to save for them. These factors will be taken into consideration when making your individual investment selections.

Do you understand your investment options?

Consider investing into mutual funds if you are a new investor into the stock market. Mutual funds are comprised of multiple individual stocks or bonds and usually offer a smaller initial investment amount to be contributed on a monthly basis. This smaller dollar amount makes it possible for a variety of investors to begin saving into the stock market without large sums of cash already set aside. Understanding stocks, bonds, mutual funds, real estate investment trusts, cash value life insurance, annuities and trusts is an important place to start when you are a beginning to invest. Research each investment option to determine which combination will best assist you in reaching your financial goals.

Define your Investment Risk Tolerance

Now that you have an understanding of the stock market, you need to determine your personal risk tolerance before you start to invest. Your risk tolerance refers to the amount of variance you are comfortable with in your portfolio, and is often defined by how far away the goals that you are savings towards are. Investors are typically categorized as Aggressive, Moderately Aggressive, Moderately Conservative and Conservative. Each investor type is characterized by their investment portfolio, their time frame to save, their expected portfolio returns and their overall tolerance to withstand portfolio value changes on an annual basis.

These are the most important things to consider before you invest into the stock market. Having a financial plan that you implement will increase your chances for financial success.

This is not investment advice. Before implementing any investment strategies, consult your financial advisor or financial professional.

With years of experience down in Mexico in ensuring safe real estate transactions through their services such as title insurance, escrow services and closing coordination activities, the Stewart Title group has now opted to include a strategically complimentary product being that of Mexico mortgages.  “Loans obtained by Americans, Canadians, and Europeans have represented less than 10% of the purchases for second homes in Mexico. If you include to this scenario the current U.S. credit crisis, the access to financed capital has reduced substantially across the board” states

Ivan Castillo regional manager of Stewart Title of the Yucatan Peninsula, but quickly adds “Financing in Mexico using the Mexican property as guarantee has become more readily available through the services that we offer, with interest rates that have become very accessible in the last several months.” 

The program has been designed to ensure a simple and efficient process for the American, Canadian or European to obtain approval for loans with clarity and with ease of mind.  Working with several lenders, the group is able to find various programs that best suit the borrower and his needs with an increased probability of qualification for the Mexico home mortgage.  “This is where our network of offices and years of expertise comes to play” added Ivan Castillo.

Mexico mortgage loan options

Mexico Home Purchase Loans

Refinancing your Mexico Property

Property cash out (raising cash on a percentage of the total amount qualified from your property)

Construction Loans

Lot loans are also available

The loans are offered against the collateral on the property in Mexico and the lenders are located in either the United States or from Mexico.  Fico scores of 680 or above with the requirement of making a down payment of 25%.   

There are estimates that nearly one million Americans have already purchased a home or future retirement property down in Mexico.  This amount is projected to increase as more Canadians and Americans begin retiring in the next decade.   New services and tools to help this expanding market obtain and maintain their Mexican homes will become more accessible with the years.  This can be seen with companies such as Stewart Title whose new program has been introduced with their adjustment to the market and projection of substantial increases in the amount of Mexico Real Estate property acquisitions that will begin utilizing these new channels and sources of financing. 

Jeff’s analysis is unique, at least among academic derivatives textbooks. I would definitely use this material in my derivatives class, as I believe students would benefit from analyzing the many dimensions of Jeff’s trading strategies. I especially found the material on trading the earnings cycle and discussion of how to insure against price jumps at known events very worthwhile.’

From the Back Cover

  ‘…a brilliant and thoroughgoing presentation. Five Stars, Highly Recommended.   John A. Sarkett, Stocks, Futures, and Options Magazine..  “Jeff’s analysis is unique, at least among academic derivatives textbooks. I would definitely use this material in my derivatives class, as I believe students would benefit from analyzing the many dimensions of Jeff’s trading strategies. I especially found the material on trading the earnings cycle and discussion of how to insure against price jumps at known events very worthwhile.” —DR. ROBERT JENNIN (more…)