THE 4 PILLARS OF INVESTING Risk Management: Module 3 · If you want to pay the premium. Can you insure your diamond ring for more than it’s worth? If you want to pay the premium

Risk Management: Module 3THE 4 PILLARS OF INVESTING

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The 4 Pillars of Investing | Risk Management : Module 3

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Now this is a good example, this is called RIM, Research in Motion. They make electronics and stuff like that. And I want you to notice something here; this sucker will gap, especially on earnings. This sucker has a tendency to gap, see these big gaps right here? So what if you’re in this thing, you shouldn’t ‘cause it’s a downtrend, but what if you’re in your stop is here, and then it gaps down? Now you’ve lost five bucks. This one went from what would you say, about 64 to whatever it is here, so it’s about a five dollar difference right there. When I get something with gaps, another one you’ll see a lot of gaps in is your pharmaceuticals with that FDA approval that comes out. Your Google will gap a lot.

So, kind of look at the history, and if it gaps a lot, and you don’t wanna have it gap down, or if you have a good tax basis. Let’s say you’ve got a good cost basis going, you’ve got a stock that’s been going up and it’s got no gaps, pretty smooth, but then you’re worried about something and you think, “Gee, if I get stopped out, bam, I have to pay my taxes. Maybe it’s just a little glitch.” So what can I do in that scenario? Well I could use what’s called a protective put option.

And we talked about put gives you the right to sell something, gives you a choice, right? So this guy right here is paying for the put option. So he’s going to have a choice to sell. This guy’s gonna have the choice to sell. It’s in stone. This guy over here, remember what he’s gonna do; he’s gonna make a promise, peaceful promise. So this guy is going to make a promise to buy, and this guy’s gonna have the choice or option to sell, if you remember that from last time. So if we bring up the option chain here on research in motion, we got the October. So it’s September now, yeah looks like it’s September 4th here, so we’re looking at the third week. So we’ve got, it’s the first week of September, we’ve got another two weeks to go to September expiration. Then we got another month to go ‘til October expiration. So we’re looking at about five, six weeks here, closer to six.

So if I wanted to ensure this for the next six weeks, ‘cause I think there might be a gap because of earnings or something, I can go and what are they asking? They’re asking $3.40 for this option. Looks like the last guy got it for $3.34. So for $3.34, I can ensure $30 worth of stock for the next

RISK MANAGEMENTMODULE 41 2

A transcription of

The 4 Pillars of Investing

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two months. Now that’s 10%, why so much? Well, look at the gaps, right? Look at these gaps. These gaps are $5; that’s more than 10%, right? That’s more than a 10% drop. So we can ensure this for $3, and it looks like most of these gaps are around $5. Here’s one from $35 to $30. This one’s from $55 down to $50. So yeah, it gives us insurance against the gap, and you can still own your stock, it’s just this will increase in value. So very very cool stuff.

$3.40 for the choice to sell RIM at $31 here, it’s at $30.97 before expiration. So that’s an example of a protected put. And you know what, if it gaps clear down here, you can still sell it at the $31. If the gaps clear off the screen, you can still sell it, ‘cause you have that choice. Again, this is used because again, if I have a stop clause in here, and it gaps down below, I want to be able to sell it at this strike price. So that’s one of the reasons we can buy a protective put; not just to make money on something we don’t own, but to protect an investment that we do own.

Real nice story about this; this is called hedging. Some people buy insurance, and if you say, “I have insurance” someone might use the word ‘covered’, right? And one of the things I tried to do last time in our cash flow, is I showed you an example of some of the billionaires that use these strategies. For example, Warren Buffett was selling put options because he wanted to buy something anyway, remember? Well, there are other billionaires that buy put options to protect themselves. Here’s a billionaire, not exactly a Warren Buffett personality, more of an entrepreneur in a different way, kind of a fun; I like him, he’s a renegade, Mark Cuban.

Now look at this, here’s Yahoo stock; we’ve gone back in time a little bit, and this has had some reverse split several times, because that stock was actually at one time over $100 a share. But it’s split and it’s got it scaled down to $20 now, and in this point it would have been scaled to $1.96. I think it actually went from $100 to $5, which is a 95-90% loss. And here it’s gone from $25 to $1, so it’s all working out. But that’s a 90% loss. Imagine having a million dollar home, and it’s lost 90% of its value because of this fire. You would insurance a million dollar home wouldn’t you? If you have a million dollar stock portfolio, you’d ensure that wouldn’t you? See, it just kills me. What’s more likely to burn down in the next six weeks from now? Your 401K or your house? Which are you insuring?

So Mark Cuban, if you know his history, he had a company called Broadcast.com, and it was making $10-$15 million in revenue, and Yahoo liked this technology and they offered to buy it from him. And they did an interview with him on 60 Minutes, Steve Kroft did. It was called “The Self-Made Maverick” by Steve Kroft. Here’s a little excerpt from it, says “He had a company worth $15 million in revenue and one year later it sold for $5.7 billion in stock.” That’s a pretty cool day. You take your $15 million company in the dot.com boom and you’re cranking out $5.7

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billion in stock. Notice he didn’t sell it for cash, he sold it for stock. That’s going to be a big deal coming up here.

He says, “Boy it’s as shocking to me now as it was then.” He can’t believe it happened to him. Now, he had employees at stock option, so they became millionaires on paper. But it says, “Cuban, he kind of senses here that the internet bubble’s gonna burst, and he makes his shrewdest move. He began unloading his stock,” what’s another word for that? “Selling his stock using a hedging strategy.” So here again, like we did the article with Warren Buffett, a lot of people don’t know this vocabulary. Unloading means he sold it, hedging means that he didn’t have stop losses in; he might’ve gapped over his stop loss. He had a hedge strategy.

In other words, chances are he had options to sell which are called put options. He had a chance to sell up here, even though the stock went down here in a very short time, in a month. And so, while this started to head down, he could sell up here. Very cool stuff. And notice this, it said it locked in his profits. In other words, he had the right to sell at $20 or whatever it was, because it was locked in. And notice the language, “I was covered” he says, “and then some.” So he was insured and apparently according to him, can you insure your home for more than it’s worth? If you want to pay the premium. Can you insure your diamond ring for more than it’s worth? If you want to pay the premium.

So looks like he actually made money, looks like he over-insured, and it’s very realistic he could wind up with more than this. This happened to me; I’m in a rock band, and when people can’t hire a good band, then they hire us. When they can’t afford a good band, they hire us. And my equipment was at my buddy’s place, he put it in his garage, and someone broke into his garage at night and stole all the equipment. He called me and said, “Oh man, I feel terrible.” I says, “Hey, we’ve been friends for twenty years, don’t worry about it. I have…” what? “I’m covered.” And when I talked to the lady about, I actually over-insured them, so I was covered and then some; we actually made money on the deal, went out and got even nicer equipment. Best thing that ever happened to us was when it got stolen. Isn’t that something?

So he did the same thing here. He was covered and then some. Now, I want to speak also about hedging in this way. Hedging will make you look like a genius, even though you’re not. We have this stuff in the media where we call, Warren Buffet is “The Omaha Oracle”, as if he could see the future. We have this false idea that people can what? Sense the future. What the heck’s that mean? He’s sensing something? Mark Cuban has ESP? Mark Cuban has a sixth sense? He can just sense things that are happening? No. I disagree with that. I really want to let you know that this makes people look like geniuses. Watch how having a simple hedging strategy makes you look like you

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can see the future. Makes you look as if this, we’re actually gonna show you that this was common sense by Mr. Cuban, at least in my opinion it was. Watch this.

Okay, first thing I would submit is this. What if it would’ve gone up? What if Yahoo wouldn’t have tanked and he had bought the insurance? Well again, it’s kind of like if your house goes from $100,000 twenty years later to $200,000; you still bought the insurance. So, look at this, it could have said this, “…but Cuban sensing that Yahoo stock shares were soaring to even new heights made his shrewdest move. He negotiated the sale of his company for stock instead of cash. ‘I was bullish’ says Cuban ‘And then some.’” He could have said that if it would’ve gone up, looked like a genius. Remember, insurance, if we look back here, doesn’t cost very much. This is pretty expensive stuff but even then, he didn’t spend $30, he spent a small amount.

Well if this thing soars to $70, who cares about the $3, right? Who cares about it? So if you buy this thinking that it’s going to get back up here to $70, great, spend your $3, insure it, no big deal. So that’s what Cuban’s doing here. If this thing would have gone up, he says “Oh yeah, I was shrewd because I negotiated for stock instead of cash. If it had just been cash, I’d have missed this big run, but I negotiated for stock.” If Yahoo would have gone to new heights, he’d of looked like a genius for negotiating for stock. It didn’t, it feel apart. “Sensing the internet bubble was about to burst.” He was, and I actually believe he thought it was doing this one, because why would, if Cuban was sensing the internet bubble was about to burst, then why did he want stock instead of cash? Why would you sell your company for something that you thought was going to be worthless? Make sense?

Besides that, it’s not a big deal to have insurance. What if this would have been about his home? “Cuban, sensing his home was going to burn to the ground…” What are you talking about? No one senses their home’s going to burn to the ground. You buy insurance anyway, just in case it does. So either way you look like a genius. If your house appreciates, wonderful, if it doesn’t, you had insurance. I think this is probably more about, is this really him predicting the future, or just common sense, right? Because I don’t think he was sensing the internet bubble was about to burst. If I thought that the Yahoo stock was going to get thrashed; I don’t buy insurance because I think my houses are going down in value, I buy insurance in case they do.

But the media wants to make it look like he’s shrewd. “The Omaha Oracle” it’s Mark Cuban, the “senser” here. And simply not the case, in my opinion. So great example of how good risk management makes you look like a genius, ‘cause he had insurance. And yet, I think it’s the other way around. If he hadn’t, he’d have been a fool. And think of how many people endured all this downward stuff in AIG, in the dotcom bust, no insurance. If someone’s house was to burn to the ground and you said, “Well, I have insurance”; you still feel bad for them, but inside you’ll kind of

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be thinking, “Well houses burn to the ground, they do that. Don’t you know that? Wouldn’t you want insurance in case yours does?”

Well guess what, markets burn to the ground, they do this. Wouldn’t it make sense to have insurance? So again, just kind of a plug for hedging. Another thing we oughta do, we oughta use the computer on this. I use, again this mock trade is one of the platforms I use. Heard from my buddy Tom Joseph, today as a matter of fact, sent me an email. And so we’ll get into this computer and I’ll show you how some of this works.

But let’s, very important to use software I think and get away from the freebie stuff, spend a little money on our software. This is gonna be, you know you’re an investor, that’s part of your overhead, it’s not a big deal. So more of using some options for risk management here. Let’s say, this is one of the coolest most conservative trades I know; let’s say you own some VXX, and you own 100 shares of this at $43, and you think it’s gonna go up because of more volatility in this time period or what have you. And maybe what you do is you say, you know what, I’m going to write a call on this. So if you remember from the cash flow, if you own this, you can also sell someone the option to buy this, and they would give you this money.

So you’re gonna make a promise to sell your stock for what you bought it for so you don’t lose any money. But you figure, hey, if I can make five bucks, for selling my stock right now at what I bought it for, I’ll take that right now man. I’ll take five bucks for you to buy it from me. Then I don’t have to wait and hope it goes up, right? It goes up to $48.17, I’ll just take my money right now and you can buy it at $43. But, this person’s gonna wait for the month here, and this is kind of an interesting thing. He has a choice to buy your stock for $43. So watch how this works, this is interesting.

You might have this go down during the month and lose money. That’s your problem with doing this, is yeah you’re getting the cash flow; what if this goes down to $30? It’s a pretty volatile deal. If we look at this thing, and we bring up the VXX here, this is a pretty volatile sucker. Here it gaps from $32 to $40, that’s eight bucks. Certainly it can go from $45, you know it’s at $42.72 right now. So you buy it at let’s say $42.72, and he’s gonna buy it from you at $43. So let’s just do that. Let’s just change that, that’ll work, I can do it on the fly. So let’s say you buy it at, I’ll just change it quick, I have the power to do that on the fly. So today it is $42.72, and we’ll just call it $43. But for the art of purposes here, $42.72 we’ll call it $43, and you’re willing to sell it at $43. So you’d make 28 cents if you’re willing to sell it here.

This guy wants the option, amazing option, I can’t believe it’s that expensive right now but it is. So, check this out. What if we did this though? What if we were concerned this was gonna drop eight bucks; what if we said the most we want to lose is a dollar to risk this? We don’t want to risk

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more than losing a dollar for doing this. So here we have a $42 strike, meaning that now we could sell a put option to where this guy can buy it from us at $43, but we can sell it to someone else at $42. That means our max risk now is a dollar.

So check this out. Let’s go, let me show you how you can do this automatically if this seems complex. Watch this, let’s go to the mock trader here. Here’s our VIC, and let’s bring up a risk graph. And what a risk graph does is it shows me what I’m going to gain or lose if I make a trade. There’s all types here. So what I do is I put in the VXX, and I’d hit ‘load.’ Okay, we’re not going to go through this, that’s more advanced stuff so we’ll put that down. And then I have these spread templates. And this particular one, like if I did a covered call, watch what I do. I put it in here, I’m buying today at $42.72, isn’t that right? $42.72, again this is a covered call, which it already says I’m going to buy 100 shares because that’s how many shares I need to sell, one contract; they’re giving me $5.17 on that, that is amazing. Gets that data right from the options chain in October 2010.

So today is September, so if I’m willing to hold this for six weeks, right, I can get $5 on it, that’s insane. That’s like 11% at the $43 strike. So someone’s going to pay me, if you can imagine this, $45 for the right to buy this at $43. Man, I don’t know, that’s just nuts. But they don’t want to spend the whole $42,000 right now maybe to get a thousand shares, or $4,200. They’d rather spend $500 to lock it up now, for the right to buy at $43 than spend the $4,000 it’d take to get a hundred shares. $4,200 it’d take to get a hundred shares. So my risk is though, here, over here on this side if you can look at where my arrow is; this is the amount of money I can make. And notice at this point, I’m only going to make a few dollars on the upside. Why? Because I’m buying it at $42.72 right here in this area, $42.72, and I’m going to sell it at $43. So I’m only going to make thirty cents on the upside.

And I’m capped on the upside because no matter how high this stock goes, from $45 to $47 to $50 to $52, no matter how high this stock goes, I’m selling at call, which means that person has the right to buy it from me at $43. So the most I can get is what I’m going to sell it for is $43. So why does it add this money here? Well, I’ve got a hundred shares and I’m selling each call for $5, so $5.17 times 500 shares is what? Look at this, $5 today, it’s about $517 isn’t it? Right here today. If I get the other thirty cents times my hundred shares, I’m going to get up here to about $545. So the most I can make is $500.

But look at this, if the VIC starts to fall between now and October, look, I can lose the $500, I can lose the $700, $1,000, ‘cause see I’m owning the stock, I bought the stock. So if this thing goes down, look how much I can lose here. I can really lose a lot of money, right? So maybe what I do is I change this from a covered call to a caller, and I click ‘caller’; it will automatically do it. See how sweet this software is right here? And so now, this line right here shows me at expiration, this line

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right here this black one, shows me on the third week of October how much money I’ll make, and then this line here tells me where the stock price will be on the bottom. We can spread this out a little bit. And we can see how much money I’ll make.

Well I’m going to take this $5.17 that I’m getting from selling a call, I’m going to turn around and I’m going to buy one put option here for $42. So that means, just as I had the covered call, let’s make this a zero, it’s not gonna let me do it, just put the caller back here. That means that instead of going down and down and down and down, the most it can go down is to what level? To this $42. And at $42 or lower, let’s even make this even bigger, at $41.90, $41.80, $41.70, all the way down, I mean, forever man, this can get down to $41, to $40. It can get down to $38, $37. In fact, this thing can get all the way down to $25. Look, the most I can lose is $27 bucks on this. That’s the most I can lose on this hundred shares is $27.

Why? Because I have a put option. I have the right to sell it at $42 right here, $42, bam, I have the right to sell it right here no matter how long it goes. Now this guy has the right to buy it from me at $43, so that’s the most I can make, but look at this. Now my upside, I can make $73, no matter how high it goes, I make $73. The most I can lose is what? $27. That’s a pretty cool trade if you ask me. Very cool trade. And this is called a caller. I think this is the most conservative thing that a person can do that even if it falls down here, I’m making $20, I’m making $10. And the more money I have, the more I can make.

If I want to do this on 200 shares or 300 shares and three contracts and apply that, I can apply that. So very cool stuff. I’m in one right now on a, I’m not in this one, ‘cause I’m just doing this live, but I’m in one right now on a silver company. And what’s cool is my technical analysis is sound, my fundamental analysis was sound, and I’m up in this range. I’m three or four dollars up here. Yeah, I capped my top, but I also limited my risk on the bottom. So hopefully you go through the video as many times as you need to to kind of understand how this baby works, but very cool trade.

In fact, before we get out of this, let me show you some other stuff you can do with these options. What if I want to do this; I kinda of prepared this one before. Bring this one up. This is an interesting one right here. I’ve got a whole bunch of stuff going on here. I sell a call, and I buy a call. That’s called a Bear Call Credit Spread. ‘Cause look at this, I’m selling one for $4.20, I’m buying protection at $3.95, so I make twenty five cents here on the top, right? And this is not one I would recommend you do, I just threw this up here. When I do these, lot more research; you gotta know what Delta is and Gamma is and Theta. You’ll need to understand these numbers and how the bid-ask spread works. Lot to know, how likely is it so stay in this range?

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But let’s say I believe a stock is going to stay in a range. Let’s say I believe this is going to stay in maybe a eight or nine dollar range here from $39 to $47. I actually don’t think this one would, it’s too volatile, the VXX, but let’s say I think this is going to stay in this range. Watch this. If I get twenty five cents here, meaning I’ve sold one for $4.20 and I’ve bought one for $3.95, what does that mean? Well, I sold the call which means someone can buy it from me at $46. So notice here at $46, they can buy it from me, and that’s where I start losing money. Notice here though, that I bought a call where I can buy it at $47, which means the most I can lose on this is $30 on the top.

Same with the truth on the bottom here. Down here, that’s also the most I can lose. So as the stock moves up and down, if it stays in this range, I simply let all of these expire worthless and I get cash flow off it. And that’s really a fun trade because often it’s easier to find a range than a direction. But this shows me, what’s cool about the risk graph is it shows me that if it stays in this range, wherever I have the cross-hairs; if this goes to $40, I’m making $70 here, $69. If it goes to $46, I’m making $69. Most I can lose on the trade is $30. So, kind of a cool trade right here. I don’t want you to really understand this; this bottom is called a bull put debit spread. You put them together you get an iron condor and now we’re getting into language that we don’t need to know just yet.

But how cool is that? I don’t even own the stock, notice that I bought no stock; I sell options for cash flow, I sell a call for cash flow, I sell a put for cash flow. My put I’m selling for $53, I’m buying one for protection. So the ones I sell are for cash flow, and the ones I buy are for protection. Notice at the $47 strike price, boom right here, that goes level. In other words, I can’t lose anymore because I’ve got an option where I can go buy that sucker. And over here I’ve got an option where I can sell it. So my max risk on this is $31 and my profit is $69. So pretty cool trade. Wouldn’t do it on this if the VIC’s too volatile, but I do it on indexes. I’ll do this on the Q sometimes, I’ll do this on the Russell 2000 cash settled European style index option.

But you’ll get there. What is the point here? Selling options for cash flow, but buying options to manage the risk, that’s called hedging. So many different ways to do this. In fact, if you look at all these templates, they’ll set you up with all these different ways you can do it. You’ve got calendar puts you can do, shows me my risk; that’s kind of an interesting one isn’t it? Shows me my risk. I can do straddles, shows me my risk, and it builds the trade for me which is really really cool, long put ratio backspreads. And it actually shows me my risk, my debit, my credit, my profits, all this type of stuff. I can adjust these, very cool software. In fact, if I want to, there’s something called a spread select, and I can put in what I want.

Say I want to trade some Q’s and I can simply take these different combinations that I’ve learn about; you’ve learned the covered call now, you’ve also learned the caller trade and stuff like this. I can pull these off. And on the Qs, there’s my caller, where I buy the stock, sell an option that’s a

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call, and buy an option for a protection that’s a put. Shows me my profit, shows me my risk, and I can click these and I can play with the expiration dates and how many strikes out I want. Really get leap with the covered right here, calendar call, bull put credit. And I can scroll down here and I can see my risk, my break even points, my max, my profit, whether I’m getting paid. This is a cash flow trade, this is a capital gain trade. Any time I’m paying, I’m hoping the stock moves to get a capital gain. Any time that I’m getting paid, I’m hoping it goes sideways in the opposite direction.

So very very cool stuff here that you can do with software. Isn’t that nice that it’ll just build all these trades for me? I can just build them however I want. If I want to see what it looks like, let’s say I want to see what this bull call debit spread looks like, I double click and it gives me the risk graph. If I want to see the chart next to it, it will give me the chart. I can see my candles and tilt it sideways and see where the range of this stock can go where I’m making money or losing money. Very fun stuff. So I highly recommend you learn software, go through this stuff, so much we can do with software.

I want to find the stock, go out and say hey I want to find all the ones that maybe had a MACD cross up today, and there they are. AGG and I say, okay show me the chart on this. Or maybe I say that one’s kind of bullish, and I say okay, well maybe I say give me the spread select and I can start seeing what kind of trades I can build with this fundamentally strong stock. And I say okay here’s this one, here’s my risk graph. So very fast, very cool stuff. You know I can even see, if I want to leave the trade early, let’s say twenty days in; it will show me what it’ll look like in twenty days, with more or less volatility I can adjust. Very cool stuff.

I’m getting too advanced now, but I get excited to show you all this stuff. It’s out there, and it becomes easier. I know it looks complex, but it’s like anything else, like driving a car. Once you learn to drive it, off you go. So there’s a little bit on using software, but again, the higher point is, I used an option. I sold and option for cash flow and then I bought an option for protection. This one right here is called a caller. Pretty impressive stuff.

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THE 4 PILLARS OF INVESTING Risk Management: Module 3 · If you want to pay the premium. Can you insure your diamond ring for more than it’s worth? If you want to pay the premium