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How Credit Put Spreads Can Boost Your Gains and Lower Your Risk

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Posted by LARRY D. SPEARS - Money Morning

on Tuesday, 06 March 2012 07:07

Last month, Money Morning showed you how to use a technique called selling "cash-secured puts" to generate a steady flow of cash from a stock - even if you no longer own the shares.

It is a highly effective income strategy that can also be used to buy stocks at bargain prices.

But selling cash-secured puts does have a couple of drawbacks:

•First, it's fairly expensive since you have to post a large cash margin deposit to ensure that you'll be able to follow through on the transaction if the shares are "exercised." ­Thus the name, "cash-secured" puts.
•Second, if the market - or the specific stock on which you sell the puts - falls sharply in price, you could have to buy the shares at a price well above their current value, taking a substantial paper loss.

Fortunately, there is a way to offset both these disadvantages while continuing to generate a steady income stream.

It's called a "credit put spread" and it strictly limits both the initial cost and the potential risk of a major price decline.

I'll show exactly how it works in just a second, but first I have to set the stage...

The Advantage of Credit Put Spreads
Assume you had owned 300 shares of diesel-engine manufacturer Cummins Inc. (NYSE: CMI) and had been selling covered calls against the stock to supplement the $1.60 annual dividend and boost the yield of 1.30%.

Let's also assume that back in mid-January, when the stock was around $110 a share, you sold three February $120 calls because it seemed like a safe bet at the time.

However, when CMI's price later moved sharply higher, hitting $122.07/share, your shares were called away when the options matured on Feb. 17.

That means you had to sell them at $120 per share to fulfill your call option. That might leave you with the following dilemma.

Thanks to the recent rally, the stocks you follow are too high to buy with the proceeds from your CMI sale. On the other hand, you also hate to forfeit the income you had been getting from the CMI dividend and selling covered calls.

You also decide you wouldn't mind owning CMI again if the price pulled back below $120.

In this case, your first inclination might be to use the money from the CMI sale as a margin deposit for the cash-secured sale of three April $120 CMI puts, recently priced at about $4.90, or $490 for a full 100-share option contract.

That would have brought in a total of $1,470 (less a small commission), which would be yours to keep if Cummins remains above $120 a share when the puts expire on April 21.

That sounds pretty appealing, but...

The minimum margin requirement for the sale of those three puts - and, be aware, most brokerage firms require more than the minimum - would be a fairly hefty $8,190.

[Note: For an explanation of how margin requirements on options are calculated, you can refer to the Chicago Board Option Exchange (CBOE) Margin Calculator, which shows how the minimum margin is determined for a variety of popular strategies.]

Your potential return on the sale of the three puts would thus be 17.94% on the required margin deposit ($1,470/$8,190 = 17.94%), or 4.08% on the full $36,000 purchase price of the 300 CMI shares you might have to buy.

Either of those returns is attractive given that the trade lasts under two months - but you also have to consider the downside.

Should the market plunge into a spring correction, taking Cummins stock with it, the loss on simply selling the April $120 puts could be substantial.

For example, if CMI fell back to $100 a share, where it was as recently as early January, the puts would be exercised.

You'd have to buy the stock back at a price of $120 a share, giving you an immediate paper loss of $6,000 - or, after deducting the $1,470 you received for selling the puts, $4,530.

And, if CMI fell all the way back to its 52-week low near $80, the net loss would be $10,530. (See the final column in the accompanying table.)

All of a sudden, that's not such an attractive prospect.

creditspreads

And that's where a credit put spread picks up its advantage.

But selling cash-secured puts does have a couple of drawbacks:

•First, it's fairly expensive since you have to post a large cash margin deposit to ensure that you'll be able to follow through on the transaction if the shares are "exercised." ­Thus the name, "cash-secured" puts.
•Second, if the market - or the specific stock on which you sell the puts - falls sharply in price, you could have to buy the shares at a price well above their current value, taking a substantial paper loss.

Fortunately, there is a way to offset both these disadvantages while continuing to generate a steady income stream.

It's called a "credit put spread" and it strictly limits both the initial cost and the potential risk of a major price decline.

I'll show exactly how it works in just a second, but first I have to set the stage...

The Advantage of Credit Put Spreads
Assume you had owned 300 shares of diesel-engine manufacturer Cummins Inc. (NYSE: CMI) and had been selling covered calls against the stock to supplement the $1.60 annual dividend and boost the yield of 1.30%.

Let's also assume that back in mid-January, when the stock was around $110 a share, you sold three February $120 calls because it seemed like a safe bet at the time.

However, when CMI's price later moved sharply higher, hitting $122.07/share, your shares were called away when the options matured on Feb. 17.

That means you had to sell them at $120 per share to fulfill your call option. That might leave you with the following dilemma.

Thanks to the recent rally, the stocks you follow are too high to buy with the proceeds from your CMI sale. On the other hand, you also hate to forfeit the income you had been getting from the CMI dividend and selling covered calls.

You also decide you wouldn't mind owning CMI again if the price pulled back below $120.

In this case, your first inclination might be to use the money from the CMI sale as a margin deposit for the cash-secured sale of three April $120 CMI puts, recently priced at about $4.90, or $490 for a full 100-share option contract.

That would have brought in a total of $1,470 (less a small commission), which would be yours to keep if Cummins remains above $120 a share when the puts expire on April 21.

That sounds pretty appealing, but...

The minimum margin requirement for the sale of those three puts - and, be aware, most brokerage firms require more than the minimum - would be a fairly hefty $8,190.

[Note: For an explanation of how margin requirements on options are calculated, you can refer to the Chicago Board Option Exchange (CBOE) Margin Calculator, which shows how the minimum margin is determined for a variety of popular strategies.]

Your potential return on the sale of the three puts would thus be 17.94% on the required margin deposit ($1,470/$8,190 = 17.94%), or 4.08% on the full $36,000 purchase price of the 300 CMI shares you might have to buy.

Either of those returns is attractive given that the trade lasts under two months - but you also have to consider the downside.

Should the market plunge into a spring correction, taking Cummins stock with it, the loss on simply selling the April $120 puts could be substantial.

For example, if CMI fell back to $100 a share, where it was as recently as early January, the puts would be exercised.

You'd have to buy the stock back at a price of $120 a share, giving you an immediate paper loss of $6,000 - or, after deducting the $1,470 you received for selling the puts, $4,530.

And, if CMI fell all the way back to its 52-week low near $80, the net loss would be $10,530. (See the final column in the accompanying table.)

All of a sudden, that's not such an attractive prospect.

And that's where a credit put spread picks up its advantage.

Here's how it works...

How to Create a Credit Put Spread
Instead of just selling three April CMI $120 puts at $4.90 ($1,470 total), you also BUY three April CMI $110 puts, priced late last week at about $1.90, or $570 total.

Because you have both long and short option positions on the same stock, the trade is referred to as a "spread," and because you take in more money than you pay out, it's called a "credit" spread.

And, in this case, the "credit" you receive on establishing the position is $900 ($1,470 - $570 = $900).

Again, that $900 is yours to keep so long as CMI stays above $120 by the option expiration date in April.

However, because the April $110 puts you bought "cover" the April $120 puts you sold, your net margin requirement is just $2,100 - which is also the maximum amount you can lose on this trade, regardless of how far CMI's share price might fall. (Again, see the accompanying table for verification.)

That's because, as soon as the short $120 puts are exercised, forcing you to buy 300 shares of CMI for $36,000, you can simultaneously exercise your long $110 puts, forcing someone else to buy the 300 shares for $33,000.

Thus, your loss on the stock would be $3,000, which is reduced by the $900 credit you received on the spread, making your maximum possible loss on the trade $2,100.

On the positive side, if things work out - i.e. CMI stays above $120 in April - and you get to keep the full $900, the return on the lower $2,100 margin deposit is a whopping 42.85% in less than two months, or roughly 278.5% annualized.

Plus, as is the case with most option income strategies, you can continue doing new credit spreads every two or three months, generating a steady cash flow until you're ready to repurchase the stock at a more desirable price.

In this case, we say "ready" to repurchase because you're never forced to buy the stock; you can always repurchase the options you sold short prior to expiration.

This strategy has substantial cost-cutting benefits when trading higher-priced issues like CMI, but it's also a very effective short-term income strategy with lower-priced shares.

For example, with Wells Fargo & Co. (NYSE: WFC) trading near $31.50 late last week, an April credit spread using the $31 and $28 puts would bring in a net credit of 75 cents a share, or $225 on a three-option spread.

Since the net margin deposit on the trade would be just $675, you'd get a potential return of 33.3% in only seven weeks if WFC remains above $31 a share.

As you can see, credit put spreads are a great way to boost your gains while lowering your risks, especially in stable or rising markets.

So why not give yourself some credit.

Source http://moneymorning.com/2012/03/05/options-101-credit-put-spreads-can-boost-your-gains-and-lower-your-risk/

Money Morning/The Money Map Report

©2012 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email:customerservice@moneymorning.com" target="_blank">customerservice@moneymorning.com

Here's how it works...

How to Create a Credit Put Spread
Instead of just selling three April CMI $120 puts at $4.90 ($1,470 total), you also BUY three April CMI $110 puts, priced late last week at about $1.90, or $570 total.

Because you have both long and short option positions on the same stock, the trade is referred to as a "spread," and because you take in more money than you pay out, it's called a "credit" spread.

And, in this case, the "credit" you receive on establishing the position is $900 ($1,470 - $570 = $900).

Again, that $900 is yours to keep so long as CMI stays above $120 by the option expiration date in April.

However, because the April $110 puts you bought "cover" the April $120 puts you sold, your net margin requirement is just $2,100 - which is also the maximum amount you can lose on this trade, regardless of how far CMI's share price might fall. (Again, see the accompanying table for verification.)

That's because, as soon as the short $120 puts are exercised, forcing you to buy 300 shares of CMI for $36,000, you can simultaneously exercise your long $110 puts, forcing someone else to buy the 300 shares for $33,000.

Thus, your loss on the stock would be $3,000, which is reduced by the $900 credit you received on the spread, making your maximum possible loss on the trade $2,100.

On the positive side, if things work out - i.e. CMI stays above $120 in April - and you get to keep the full $900, the return on the lower $2,100 margin deposit is a whopping 42.85% in less than two months, or roughly 278.5% annualized.

Plus, as is the case with most option income strategies, you can continue doing new credit spreads every two or three months, generating a steady cash flow until you're ready to repurchase the stock at a more desirable price.

In this case, we say "ready" to repurchase because you're never forced to buy the stock; you can always repurchase the options you sold short prior to expiration.

This strategy has substantial cost-cutting benefits when trading higher-priced issues like CMI, but it's also a very effective short-term income strategy with lower-priced shares.

For example, with Wells Fargo & Co. (NYSE: WFC) trading near $31.50 late last week, an April credit spread using the $31 and $28 puts would bring in a net credit of 75 cents a share, or $225 on a three-option spread.

Since the net margin deposit on the trade would be just $675, you'd get a potential return of 33.3% in only seven weeks if WFC remains above $31 a share.

As you can see, credit put spreads are a great way to boost your gains while lowering your risks, especially in stable or rising markets.

So why not give yourself some credit.

Source http://moneymorning.com/2012/03/05/options-101-credit-put-spreads-can-boost-your-gains-and-lower-your-risk/

Money Morning/The Money Map Report

©2012 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email:customerservice@moneymorning.com" target="_blank">customerservice@moneymorning.com



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Bonds & Interest Rates

Royalty Trusts: These Incredibly Rare Investments Pay 10% Dividend Yields

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Posted by Carla Pasternak - Dividend Opportunities

on Wednesday, 29 February 2012 00:00

Only about two dozen of these securities exist... but double-digit yields are common.

I first uncovered this asset class years ago, back when I started my High-Yield Investing advisory in 2004. In October of that year, I added one of these securities to my portfolio at $41.33. I sold it for $64.51 about two years later. Along with $9.93 in distributions, my total returns were just over 80%.

Another one of these rare investments has also done well for current High-Yield Investing subscribers. I added it to my portfolio in late October 2010. I've received $4.28 per unit in distributions and the price has soared. So far, total returns are more than 50% in just 16 months.

I like to return to investment ideas that have done well for me. So it comes as no surprise that I'm again looking into one of the highest-yielding, yet rarest, income investments on the market -- royalty trusts.

These trusts are designed for one thing: to pay out royalties, or a share of production revenues, from a field of existing oil and natural gas wells.

The first trust debuted in 1979. Amazingly, even after more than 30 years there are still only about two dozen publicly traded oil and gas royalty trusts. And between 1999 and 2007, no new royalty trusts were created.

But in the past year, there has been a small renaissance in royalty trusts. I count four new trusts that have come to market in the last two years alone.

For income investors, the sudden surge of interest is good news. Routinely providing yields of about 10% or more, royalty trusts can seem too good to be true. Why, then, are oil and gas companies spinning off properties into publicly traded trusts?

Money.

Trusts allow the parent company to get full value for their reserves while also raising money, without diluting their common shares or going further into debt.

But there is one potential hang-up. By definition, these new trusts don't have an established track record of generating cash flow from their reserves. Instead, you must rely on the company's production projections and price assumptions, as stated in the prospectus.

That's the downside. But it's offset by at least two benefits.

02-12-PER

First, recent trusts are being formed for a set life or "term" of 20 years. For example, SandRidge Permian Trust (NYSE: PER) was formed on May 12, 2011, and will dissolve by March 31, 2031. The parent company or sponsor endows the trust with proven reserves that have high-probability development opportunities to ensure the term is fulfilled. 

In contrast, many older trusts formed in the early 1980s have consumed much of their original reserves. Although new production technologies have allowed them, in some cases, to draw more production from their reserves than originally anticipated, they still have a much shorter remaining reserve life. The average reserve life for older royalty trusts is about 8.3 years, versus 20 years for some of the newer trusts.

Once the reserves are used up, a trust expires and any remaining assets are distributed to unitholders. It can't issue equity or debt to acquire new reserves. 

A second benefit is some new trusts have created "subordinated units." (Royalty trust shares are called units.) These units, which are held by the trust's sponsor, support the distribution rate to common unitholders. 

They work like this. When SandRidge Permian was created, sponsor SandRidge Energy (NYSE: SD) set aside 25% of the outstanding units for itself as subordinated units. These units are also entitled to receive distributions... with a catch.

The trust forecasts target distributions for several years in advance, based on projections of production volumes, commodity prices, the effect of hedges, expenses and taxes.

Then a subordination threshold is also established. For the SandRidge Permian Trust, the threshold is 20% below the target distribution. If the distribution ends up being less than the subordination threshold, the sponsor will make up the difference by reducing or foregoing the distribution on subordinated units. This way, there is some assurance that distributions will reach a pre-determined level should commodity prices fall. 

In return, if the distribution is substantially higher than the target, the subordinated shares will receive an extra share of distributions.

These subordinated shares don't last forever. The parent company retains these subordinated shares until new wells that the trust is also required to drill are completed. Then, a year later, the subordinated shares convert to common shares.

Now before you dive into any trust, there is plenty more to know. Taxes are a little trickier than with a common stock, and trusts will perform differently based on their hedging programs and their production mix of oil and natural gas (I detail all of this in my March issue of High-Yield Investing).

However, if you're looking for a place to still capture high yields when interest rates are near zero, this sector may be small, but also holds plenty of promise.

[Note: If you're interested in royalty trusts, be sure to learn more about StreetAuthority's Top 5 Income Stocks for 2012 report. One stock we've selected is a royalty trust yielding double digits... another yields 8.8% and returned 13% during the bear market (when the S&P 500 fell -57%)... and a third holds stakes in dozens of infrastructure monopolies and has has paid more than 90 consecutive dividends. Visit this link to learn more.]

Good Investing!

 
Carla Pasternak's Dividend Opportunities

Disclosure: Neither Carla Pasternak nor StreetAuthority own shares of the stocks mentioned above. In accordance with company policies, StreetAuthority always provides readers with at least 48 hours advance notice before buying or selling any securities in any "real money" model portfolio. Members of our staff are restricted from buying or selling any securities for two weeks after being featured in our advisories or on our website, as monitored by our compliance officer.



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Bonds & Interest Rates

Interest Rate Outlook a Life – and Death Proposition

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Posted by Bill Gross - Pimco

on Thursday, 23 February 2012 06:18

Debt vs Interest Rates

  • Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
  • Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
  • We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration.

The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter. A multitude of liability structures dependent on a certain level of nominal GDP growth require just that – nominal GDP growth with a little bit of inflation, a little bit of growth which in combination justify embedded costs of debt or liability structures that minimize the haircutting of or defaulting on prior debt commitments. Global central bank monetary policy – whether explicitly communicated or not – is now geared to keeping nominal GDP close to historical levels as is fiscal deficit spending that substitutes for a delevering private sector. 

Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions. Most observers, however, would agree that monetary and fiscal excesses carry with them explicit costs. Letting your pet retriever roam the woods might do wonders for his “animal spirits,” for instance, but he could come back infested with fleas, ticks, leeches or worse. Fed Chairman Ben Bernanke, dog-lover or not, preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse. At his November 2011 post-FOMC news briefing, for instance, he noted that “we are quite aware that very low interest rates, particularly for a protracted period, do have costs for a lot of people” – savers, pension funds, insurance companies and finance-based institutions among them. He countered though that “there is a greater good here, which is the health and recovery of the U.S. economy, and for that purpose we’ve been keeping monetary policy conditions accommodative.” 

My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began. My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. 

 

....read the full article HERE



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Bonds & Interest Rates

Insanely Low Interest Rates & Your Opportunity

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Posted by Danielle Park: Juggling Dynamite

on Friday, 17 February 2012 08:59

Analyst and author of Grant’s Interest Rate Observer offers some historical trends on interest rates, monetary policy and what is still strong in America.  Here is the direct audio link.

This chart since 1790 ties in nicely with discussion of the generational cycles in interest rates and underlines just how insanely low rates are today.  Best advice to those still in debt:  don’t use current rates to borrow more–use them to become debt free. History assures us that this-low-rate-time too shall pass. I personally look forward to the next phase where Central Banks are taken out of the driver’s seat, budgets are balanced, and markets are left to freely find fair value again. It is not a question of if–centuries of history tells us this will happen. The question is just how much mess and pain must intervene before they do.

Click on the Chart or HERE for a Larger Image

Screen shot 2012-02-17 at 8.00.24 AM

 

About Danielle & Juggling Dynamite:

Portfolio Manager, attorney, finance author and a regular guest on North American media, Danielle Park is the author of the best selling myth-busting book “Juggling Dynamite: An insider’s wisdom on money management, markets and wealth that lasts,” as well as a popular daily financial blog:www.jugglingdynamite.com

Danielle worked as an attorney until 1997 when she was recruited to work for an international securities firm.  Becoming a Chartered Financial Analyst (CFA), she now helps to manage millions for some of North America’s wealthiest families as a Portfolio Manager and analyst at the independent investment counsel firm she co-founded Venable Park Investment Counsel Inc. www.venablepark.com.  In recent years Danielle has been writing, speaking  and educating industry professionals as well as investors on the risks and realities of investment behaviors.

A member of the internationally recognized CFA Institute, Toronto Society of Financial Analysts, and the Law Society of Upper Canada.  Danielle is also an avid health and fitness buff.

 



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Bonds & Interest Rates

Obama: Massive Tax Hikes & still $1.33 Trillion Deficit

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Posted by Mike Shedlock - Mish's Global Economic Trend Analysis

on Wednesday, 15 February 2012 08:33

stock-vector-wheelbarrow-of-cash-retro-clip-art-59394709

Obama Proposes Massive Tax Hikes, Still Comes Up With $1.33 Trillion Deficit


President Obama made a pledge to cut the deficit in half by the end of his first term. Instead it exceeded a trillion dollars for four straight years.

Indeed, the president could not even make a pledge made in September to reduce the deficit to $956 billion. Finally, just to keep the deficit at $1.33 Trillion, look at the tax hikes Obama proposes.

Details below summarized from the Bloomberg article Obama Sends $3.8T Budget to Congress

Obama Proposed Tax Hikes

  • Expiration of Bush-era tax cuts for couples earning $250,000 or more a year
  • Limiting the value of itemized deductions to 28 percent couples earning $250,000 or more a year
  • Imposing a minimum tax for individuals with annual incomes of at least $1 million
  • Raise taxes on dividends received by the wealthy to 39.6 percent from the current 15 percent
  • $61 billion "Financial Responsibility Fee" imposed on banks
  • Increase in the terrorism-security fee charged to airline passengers

It takes all that just to hold the deficit to $1.33 Trillion. Chance of passage would appear to be about zero percent.


....read more : Republicans Miss Golden Opportunities on "Hard Choices"






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