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I'll just say flat out that I thought this was an irresponsible article. Never once did TMFJeff indicate how current valuation factors into the decision to write a put. This same topic has come up a couple of times, at least, on the boards. Here is a post that explains my position pretty well:

http://fireboards.fool.com/Message.asp?mid=18804323

In short, you can't earn a free lunch by selling puts on an overvalued security. If you think a stock is overvalued, you don't get to magically set up a good buying opportunity by writing a put. You're writing insurance on a stock - if you already think it's likely the stock will go down (more likely than the market believes, because you think it's overvalued) you won't be properly compensated for the risk you're bearing. If you disagree with that, why don't you write 50-year $5 puts on every stock in the DJIA?

This was a really incomplete article that I hope doesn't incent people to start writing puts on stocks they believe are overvalued.
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<<Never once did TMFJeff indicate how current valuation factors into the decision to write a put.>>


I don't understand how you reached this conclusion. The whole thesis behind the article was valuation. It said, "...run valuation models on a company, determine the price where you'd like to own it (if that price is lower than today's price), and then sell puts and get paid to wait for your price."

On what other basis would you sell puts on a stock -- other than valuation? You don't randomly sell puts, naturally. You value a company. If the price is too steep today, you run models to find a price that's attractive to you. Then you might consider selling puts with strike prices near that ideal price (assuming you're paid enough in the premium to make it worthwhile). It's all about valuation.

Jeff

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I don't understand how you reached this conclusion. The whole thesis behind the article was valuation. It said, "...run valuation models on a company, determine the price where you'd like to own it (if that price is lower than today's price), and then sell puts and get paid to wait for your price."

On what other basis would you sell puts on a stock -- other than valuation? You don't randomly sell puts, naturally. You value a company. If the price is too steep today, you run models to find a price that's attractive to you. Then you might consider selling puts with strike prices near that ideal price (assuming you're paid enough in the premium to make it worthwhile). It's all about valuation.


This doesn't address my point at all, which might be an indication that I didn't do a good job of presenting it. Your focus seems to be on calculating a valuation at which you would be willing to buy the stock, which is far less important than determining whether the current market value is over or under valued. If the current market price is overvalued in your opinion, you will not receive an appropriate premium when you sell the put, no matter if the strike price is above or below current price or above or below your estimate of fair value.

The bolded part from the above quote is really the crux of the matter: You posit a situation where the stock price is "too steep" and suggest that you might sell puts, given an appropriate premium. That can't happen! The fact that you consider the stock price to be too steep virtually guarantees that you will receive insufficient premium, regardless of the strike price you choose to sell.

You throw out, almost as a side point, the idea that you need to be "paid enough in the premium to make it worthwhile", but you give no indication on how you would actually determine if you're paid enough. In the article, you say "I'll add to this that you should have a valid reason for using any option -- a logical, "wholistic" strategy that includes stock ownership. Because if you're merely speculating on price movements, you will get burned." My complaint was/is that you are not offering any logical way to determine if the premium is sufficient to compensate the insurance you're providing.

You then go on to quote "Motley Fool Select's Foolish Guide to Options" and say, "It's best used for those stocks that are both low-priced and offer attractive enough premiums to compensate you adequately for the opportunity cost should you not get the stock you want at your price."

No! You're being compensated for the risk that the stock on which you've written a put will experience a permanent loss of value and you will pay in excess of what the stock is worth.

Just to be clear, I'll say it one more time: When writing put options, setting the right strike price (which is what your article focused on) is much less important than getting a sufficient premium. What determines whether you're getting a sufficient premium, largely, is the relation between current stock price and your estimated valuation.

Also, I forgot to provide a link to the original article, which is here: http://www.fool.com/news/commentary/2003/commentary030529JF.htm
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You wrote:

<<<The fact that you consider the stock price to be too steep virtually guarantees that you will receive insufficient premium, regardless of the strike price you choose to sell.>>>>


I disagree. The more "highly valued" a stock, typically the higher the premium on the puts, even if you're selling a far out-of-the-money put (as you should be in the case of a highly-valued stock). Steep prices and a high insurance policy (or put contract) go hand in hand.

You wrote:

<<<Your focus seems to be on calculating a valuation at which you would be willing to buy the stock, which is far less important than determining whether the current market value is over or under valued.>>>


Naturally determining a price where you'd be happy to buy the stock concurrently addresses the current valuation and whether that's reasonable or not (how could it not?). Perhaps I didn't make that clear enough in the column, though -- or assumed it's a given.

Jeff
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<<<The fact that you consider the stock price to be too steep virtually guarantees that you will receive insufficient premium, regardless of the strike price you choose to sell.>>>>


I disagree. The more "highly valued" a stock, typically the higher the premium on the puts, even if you're selling a far out-of-the-money put (as you should be in the case of a highly-valued stock). Steep prices and a high insurance policy (or put contract) go hand in hand.


Great, you disagree. How about this, tell me how to calculate the appropriate premium to receive when you sell a put. You obviously know how to do this because you sell some puts, but not others.

Also, tell me this: If you walk into a room where everyone is insuring against a bad event happening, and they're demanding $X for that insurance, why would you sell the insurance for $X when you believe that bad event is more likely to happen than the rest of the room believes?

Or, from this example in your original article:
Here's an example. Yahoo! (Nasdaq: YHOO) is volatile and, until recently, was priced in the teens. Today it's $30. For argument's sake, say you'd be happy to buy shares for the long haul at $25, but don't want to buy at $30 after this quick advance. You're pretty confident it'll see $25 again. Tell me at what premium it makes more sense to wait for the stock to go back to $25 (since you're confident it will) and simply buy it then?

Finally, I would expect that you've had success writing puts in the past. Like insurance, the distribution of payoffs is heavily skewed. You collect a lot of little payoffs, but the negative events are enormous relative to the premiums collected. If you've gotten sufficient premiums, it will balance out. If you don't know how to calculate sufficient premiums, you'll blow up. Either way, I wouldn't base the merits of a strategy with such a skewed distribution of payoffs based on a few experiences.

I thought the days of saying "Price doesn't matter" ended with the Rule Breaker.
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There is a risk that Jeff doesn't mention. The premise of his article is that you would want to buy the stock if its price fell to the strike price of the put option. The premium collected for the put option is merely icing on the cake (or free money if the stock never falls below the strike price).

Now consider the following scenario:

- XYZ stock is at $20
- You sell a put with a strike price of $15
- XYZ stock drops to under $15 for the duration of one week
- During this time the buyer of the put does not exercise the option (perhaps because he thinks the stock will drop even further, or because he is on vacation)
- The next week the stock recovers and rises above $15, never to fall below that value again
- At the expiration date XYZ stock is at $30 and the option is worthless

In this case the seller of the put did not achieve his objective, which was to acquire the stock at $15. Sure, the premium he pocketed might console him a bit, but he also might have missed out on a historic buying opportunity.

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I actually think xFatOtt has a point here. Let's look at this from the point of view of the buyer in your example, who is buying the right to sell Yahoo! shares to you at $25 at any time between now and January 2006. Why would he be interested in this transaction? Well, he obviously wants to protect himself against a possible drop in stock price. He's paying a modest premium for the right to sell a certain number of Yahoo! shares to you at $25, guaranteeing that he will always have that as an exit price - no matter how low the stock goes.

Why do it this way and not just place a limit order to sell at $25? After all, if he exercises the option as soon as the price falls below $25, he's essentially done just that and has paid a lot of additional money for the privilege. How can that be sensible? Well, if he does it this way then he doesn't need to exercise the option right away. After all, he always has the option of selling to you for $25 at this point. He can just hold onto that option for a while and hope that Yahoo! will start to go up again. If it goes back up to $50 by January 2006, then he gets a nice profit out of it and never ends up needing the option at all.

So, under what circumstances would it make sense for him to actually exercise that option before it expires? Obviously, if it's about to expire and the price is lower than $25 then he should exercise it at that point. What about if it still has some time to run? Clearly if the price is above $25 he will never exercise it under any circumstances. If the price is below $25, then he can hold onto the option a bit longer and all he loses is the opportunity cost associated with not being able to invest that money somewhere else. He's not likely to actually exercise the option unless he really thinks there is very little chance that Yahoo! will go back over $25 before the option expires in January 2006.

Going back to what that means from your point of view, there are a few scenarios:
1) If, at any time between now and January 2006, Yahoo! is below $25 and the option holder thinks that there is almost no chance of it returning to $25 before January 2006, then he will exercise the option and you will end up owning the stock at $25.
2) If case #1 never occurs, and Yahoo! is above $25 on January 2006, then the option will be allowed to expire worthless, and you will not get any Yahoo! stock out of the deal.
3) If case #1 never occurs, and Yahoo! is below $25 on January 2006, the option holder will exercise the option and you will own Yahoo! at a price of $25.

So basically you will end up owning Yahoo! stock at $25 if (a) the price is below $25 in January 2006 or (b) the price is below $25 sometime before that and the chance of it ever going over $25 before January 2006 looks remote. Either way, the only way you are likely to end up owning Yahoo! stock and showing a profit on it before January 2006 is if the option holder decides on course of action #1 above and is completely wrong about the prospects of the stock. If there's any significant appreciation between now and 2006, odds are the option will never be exercised and you won't get to participate.

Now, how would this strategy stack up against a decision to simply buy Yahoo! in 2006 if the price was lower than $25, which costs you nothing?

- If case #1 occurs, then you come out ahead if Yahoo! is over $25 in January 2006 (remember, the option holder thought this was very unlikely or he wouldn't have exercised the option). Otherwise, you come out worse.
- If case #2 occurs then you don't end up owning the stock either way, so it's a push.
- If case #3 occurs, then you come out worse.

Of course, this doesn't count the premium you received for the option. In effect, you are being paid to assume a portion of the downside risk for the option holder until 2006. You may end up owning the stock before 2006 (case 1) but that's only likely to happen in pretty bad circumstances (Yahoo! going the way of Enron, for example).

Looking at it this way, it seems less like an entry strategy for Yahoo! stock and more like writing an insurance policy (as xFatOtt mentioned). The real question is, how do you know whether you are being compensated appropriately for the risk? I think xFatOtt's point was that you didn't really address this question in your article. Yes, you will probably end up making money more often than not, but your potential loss in case #1 or #3 could also be much greater than your gain due to the premium. Without a way of figuring out what level of premium is appropriate, you have no idea what your expected payoff will be.

Your ability to make money this way will depend largely on your ability to figure out the chances of each of the various outcomes above and determine whether you are getting a good deal or a bad one based on the given premium. Personally I would have very little confidence in my ability to figure out the odds of a stock declining significantly over a 3-year period - so I don't think this strategy would ever be for me. This is particularly true since I have friends in the industry who do nothing but make risk calculations of this type and come up with option trading strategies. If I'm going to jump into the ring with those guys, I'd better know what I'm doing - and I'm pretty sure that I don't.
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There is a flaw in writing puts as well that the article didn't cover.

Briefly it goes like this, the greatest stks often neve come down to valuations, cheap enough taht wewould buy. Or they may do it very rarely.

So write puts on 10 stocks you like, but deem to expansive to buy ,

3 will crash and you will own them, 1 or 2 will recover, the other 1 and maybe2 won't, many " great" stocks, don't recover. The story turns out to be different..

ie Enron was not so long ago thought to be a great long term holding! many RMs or RBs as well.

Ok the other 7 stocks? you collect a premium but don't onw the stock as it goes higher and higher.

If I wrote a put on HSY in 1983, instead of owning it, big whop, i have 200$, the owner of the stock is up 17 fold.

There are no special tricks, no cheap and easy way out.

Writing puts has some merit.

But through time, real capitalists lay down money and bear risk in owning good stocks at good prices and collectively , get paid for that.

5 yrs ago the FOOL didn't recommend option trading, idea- find good principles and stick to them.

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"5 yrs ago the FOOL didn't recommend option trading, idea- find good principles and stick to them." Susan

This exposes TMF's Achilles’ Heel. The long term buy and hold strategy espoused by TMF only works from the years 1988 to 2001. If you question this investment “mantra,” then in the past you’d have the immediate response, like a quote from the communist Red-Book, “over the long term there is no better return on you investment than stocks.”

This brings up a good Keynesian quote: “Now 'in the long run' this way of summarizing the quantity theory of money is probably true.... But this **long run** is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."


Although Keynes was replying to the liquidationist theory of economic cycles popular in his day, the quote applies well to all “long term” theorists. Yes, the stock market will come back, but you might be dead by the time it does.

AB



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Hi XFatOx,

The bolded part from the above quote is really the crux of the matter: You posit a situation where the stock price is "too steep" and suggest that you might sell puts, given an appropriate premium. That can't happen! The fact that you consider the stock price to be too steep virtually guarantees that you will receive insufficient premium, regardless of the strike price you choose to sell.

Sure it can!

The premium has nothing to do with perceived value of the company. Volatility, closeness to the strike price, time premium based on time left to expiration are what the premium is based on. In fact, I would go so far to say that premiums increase as companies reach outlandish value. This is probably due to increased volatility and the range in which a stock trades as it moves up irrationally.

Bull markets produce the best premiums and the highest valuations.

I read each word in TMFjeff article and I thought he made his points well. I see nothing in error in his entire post. And it was filled with warnings to investors that it is not a strategy for all. But the way he describes his strategy it is as safe a strategy as you can employ using options. I do not believe it to be irresponsible.

Maybe I am missing something in your post or explanation.

tom
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Hi XfatOx,

Also, tell me this: If you walk into a room where everyone is insuring against a bad event happening, and they're demanding $X for that insurance, why would you sell the insurance for $X when you believe that bad event is more likely to happen than the rest of the room believes?

When you sell a put you are giving the buyer of the put the right to sell his shares at a set price or strike price - Shares the buyer of the put owns. The insurance policy is for the buyer not the seller.

The premium is not set by the buyer or the seller so the analogy you are using is flawed. The premium is based on implied volatility or what the option market expects in terms of a stock's future volatility not valuation. It is computed using an option-pricing model such as the Black-Scholes option-pricing model.

I hope this helps explain it a bit.

tom
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1000,
I'm going to reply to both of your posts in one message, so this might get a little mixed up. Before you read this, though, I'd highly recommend reading this thread, which goes over the exact same topic: http://boards.fool.com/Message.asp?mid=16856287&sort=whole#16868639


First, let's start with the basics.

The problem is that selling puts is pretty similar in payoff to going long (buying the underlying stock). More specifically, when you sell a put, you don't have the same payoff as when you buy the stock, but you hope the stock moves in the same direction as if you bought it. You can think of selling a put of strike price K as simultaneously:
1) Buying the underlying stock
2) Borrowing the present value of $K
3) Selling a call at strike price K
or selling a "synthetic put", called so because it has the same payoff as selling a put, no matter what the stock price does.

Whether you sell the put or simultaneously do #1-#3, you'll get the same payoff = min(0, S-K), where K is the strike price of the put and S is the stock price at expiration. (That's payoff excluding the initial premium.) So, increased stock prices at expiration date increase your payoff. In that way, you're going long on the stock.

Bull markets produce the best premiums and the highest valuations.

Well, bull markets produce high valuations, that's true. But how do you know they produce the best premiums? What is "best"? For every transaction, there is a buyer and seller. At a "fair" price, both parties are happy. But when you have a situation where the price isn't fair, one person will be making out better than the other. For example, if you could show that a stock is overpriced, the buyer of that stock at that price is getting a worse deal than the seller. In fact, you could say that the buyer of the stock is getting a bad deal, while the seller of the stock is getting a good deal. Think Cisco in March 2000.

Now we have a derivative instrument that is tied to the value of that security. At some "fair" price, you would be indifferent between buying and selling that security (the put option). But if the price isn't fair, you'd much rather be on one side than the other. Which one? Well, based on the payoff structure of a put, you'd want to be buying puts when stocks are overvalued, the same way you'd like to be selling stocks when they are overvalued. That is, in a transaction involving a put option on an overvalued stock, the buyer of that put option is getting the better deal than the seller of the option. This is exactly the point I was trying to raise in my original post. If you believe a stock is currently overvalued, you by virtue of the put's payoff structure and the link between the stock price and the put price will be selling it at a rate that is too low to compensate you for the risk that you're insuring.

When you sell a put you are giving the buyer of the put the right to sell his shares at a set price or strike price - Shares the buyer of the put owns. The insurance policy is for the buyer not the seller.

When you sell a put, you are providing insurance for the buyer of the put. The insurance policy is for the buyer, yes, but it is from the seller. TMF Jeff obviously believes in this analogy because he wrote this in his May 15, 2003 article on stock options: In this case, you can buy a long-term put, which is basically like buying insurance for your shares.

Just picture an insurance market where you can observe the prices of the transactions for different policies (the options market). Now, assume that you believe the insurance market is systematically mis-valuing the policies. Whether you buy or sell a policy (whether you want to be the insured or the insurer) will depend critically on which way the mispricing goes. I assure you, when a stock is overpriced, you should be much more eager to buy the insurance/put option than sell it.

The premium is not set by the buyer or the seller so the analogy you are using is flawed. The premium is based on implied volatility or what the option market expects in terms of a stock's future volatility not valuation. It is computed using an option-pricing model such as the Black-Scholes option-pricing model.

I don't understand what you're saying here. Like any stock, the price of the option (the premium) is set by the actions of the buyers and sellers in aggregate. They may use Black-Scholes or a binomial tree method, but you can't escape the fact that the price of the option will be very much related to the price of the stock.

It's pretty intuitive, actually. TMF Jeff has now written two columns about options that talk about puts. In one, he says that buying puts can be useful (for insuring a highly-priced stock), while in other instances he says selling puts can be useful (getting paid while you wait). He then makes the mistake of saying that selling puts can be good when you think the stock is overvalued. But, wait! Aren't you also more happy to buy puts when the stock is overvalued, because you want to insure against it going down? You can't have it both ways - you've got to realize that the price of the option (the option premium) will determine whether it's better to buy or sell that option. Because of the option payoff (think of the synthetic put), you will be better off buying puts on overvalued stocks and selling puts on undervalued stocks, the same way you'd be better off buying undervalued stocks and selling overvalued stocks.

Finally, here are some snippets from the thread I referenced in my original post:

howardroark: The problem with this logic is that it is making the mistaken assumption that a firm's desire to repurchase shares in the future at intrinsic value ($17.50) is inflexible. When the stock is at $30, the firm has at best a strong belief that IV is at $17.50, and would it fall that moment to $17.50, is would purchase shares...Unless! Unless the reason it fell to $17.50 was because its primary customer went bankrupt or a war started or its executive team were killed in plane crash or something else less dramatic happened to change its estimate of its intrinsic value. Then its IV estimate drops markedly on a moment's notice (this is no hypothetical!) and the firm would normally retain the flexibility to decide not to exploit a price of $17.50 or $15.00 or $13.50 when it believes its IV has dropped to, say, $11. Unfortunately, selling a put option comes at a real cost, and that cost can be seen as the elmination of the flexibility. In other words, the very risk selling the put option entails - the risk of the unknown future - is still being borne.

Ignoring a raw hedge situation, it only makes sense to sell put options if you believe your shares are currently fairly valued or undervalued, meaning if you would buy shares at current prices. If you believe shares are overvalued, you are merely giving up flexibility in exchange for cash, and not enough cash considering your opinion of fair value. In short, it never makes sense to take a long position in your own stock when you believe it is being incorrectly overvalued by financial markets, unless you have arbitrage or hedging purposes in mind.


...

Writing puts can't have an attractive risk/reward ratio unless the underlying stock price is literally at or below your target price. In other words, if a firm does not believe its own stock is the best use of its capital at the current stock price (and yes, that includes whatever margin of safety or discount rate it uses for all of its potential capital investments), it also should not sell puts, regardless whether the strike price is below, at or above instrinsic value. Otherwise you are receiving an insufficent premium for the inflexibility you are taking on.

...

So when you are selling an out-of-the-money put, you are in fact buying the stock and selling in-the-money-calls financing the difference with borrowed money, based on the current price of the underlying stock and not the strike price. That's because the premium you're getting for capping your upside (selling calls) is based on the current stock price and no expectation of a lower "target price." If you don't find the current price to be a buy, there is no reason to buy it with a different risk profile (capped upside) on margin, which is what a sold put does.


...

I assume you agree that some price would be insufficient. For example, if a stock was trading at $100 that you liked at $95, you would not for free grant me the unilateral right to put it to you at $95 anytime in the next six weeks. Why take the risk that something very bad happens in the next six weeks, like an accounting scandal, or a natural disaster, or a bankrupt customer? Taking the liberty to assume that you agree, how then do you determine what to charge for giving me this right?

If you say that $1.50 is acceptable, what is your basis for asserting $1.50? Why not $0.50 or $1.00 or $2.00? Let's take ROIC out of the picture by assuming that you can invest any collateral and earn the risk-free rate. What is an acceptable payment for assuming the risk of short term negative events? The option market prices that risk based in part on an assumed random, lognormal distribution of returns derived from a current stock price that is if anything upwardly biased in your private view and incorporating some measure of expected price volatility.

---------------------------------

In short, by failing to discuss the appropriateness of the premium received, TMF Jeff concluded that it's fine to sell puts on overvalued stocks, when it clearly is a losing move.
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Hi Xfatox,

I read the thread. And made up examples generally are different from what you will find in a real money transaction.

I thought maybe we could go through an example using Netflix.

I will try to set up an example in my next post, but I won't be online till later tonight.

In the meantime, I did want to comment on a few of the paragraphs you mentioned.

When you sell a put, you are providing insurance for the buyer of the put. The insurance policy is for the buyer, yes, but it is from the seller. TMF Jeff obviously believes in this analogy because he wrote this in his May 15, 2003 article on stock options: In this case, you can buy a long-term put, which is basically like buying insurance for your shares.

I agree with that the insurance is for the buyer but is provided by the seller.


I don't understand what you're saying here. Like any stock, the price of the option (the premium) is set by the actions of the buyers and sellers in aggregate


No, this is not correct. The value of the option is set based on volatility of the underlying security. The only factor that changes with the demand is the spread between the bid and ask prices unlike stocks. The spread on options is very high compared to stocks.

For instance, if a stock remains 27 dollars throughout the day. And millions of people for whatever reasons started to trade the options on that stock. The option price would not change; the premium would not change except by the margin of the spread between the bid and ask price which would be narrow due to increased demand. And the more narrow the spread the better price option buyers and seller can get, but that is the only change in price that demand will create in an option price.

If the option price changed with demand, then in theory a strike price of 25 an option might sell for 15 dollars due to demand. If billions of people decided to buy that option; obviosly that cannot happen. The option price does not change because of increased demand for those options other than the spread between the bid and ask price.

I understand what you are saying about overvalution. But this is relative to the seller of the put. The company may be valued fairly and an investor still would like an extra margin of safety the sold puts would give him.

I am going to think as TMFJeff is probably thinking in that this is the way I think about it. He can later correct me if I read something into his thoughts that he was not meaning.


Since TMFJeff makes it clear he is interested in buying the stock at the lower stock price but does not want to pay more, he is by his actions saying that the stock he is interested in is near fair value according to his methods of valuing the stock. He may even be thinking it is undervalued but he requires a margin of safety the premiums on the puts would give. If it fails to go down, he gets the premium which will lower his future cost basis if he ever gets the chance to buy the stock. If next month the stock provides a similar opportunity he can repeat the process. Many stocks trade in a very large range throughout the year. Cheesecake Factory is one that has traded in a broad range allowing for options to be priced higher than normal due to increased volatility. And allow investors to sell puts over and over at the same strike prices.

I did not read anywhere where he indicated the stock was overvalued. You may have mentioned this, but I will have to check your other posts. I do not think Jeff was recommending doing this with wildly overpriced stocks.

I did this using wildly overpriced stocks in the bubble era and did quite well. A single JDSU put was bringing in over 800 a month. JDSU in hindsight was extremely overvalued. But next month it was even more overvalued.

Now is there an advantage using the sythetic puts. If one was using over 2 or three puts then there is a slight advantage and in theory it should begin leaning toward the synthetic put the more calls you sell.

On the other hand, I always use limit orders to reduce the spread. Most the time I can shave a dime off the price of the puts. I am certain I could do the same with the calls. However, interestingly enough, some brokers will not allow you to trade in nickel amounts. So though I could probably get the puts a dime higher to 1.30. I would not even be able to try 1.35 for the calls. I would have to settle for 1.30 or 1.40.

I would be unlikely to be able to get 1.40 and I would not be allowed to enter the 1.35. So the advantage is gone. So, I guess it is best to just sell the puts. But that is just my opinion.

Another problem is trying to use limit orders to sell calls while simultaneously buying the underlying security. You have to wait for one to execute before buying the stock. Or worse if you buy the stock you can fail to get the option above what you could have gotten if you just sold the put. In real life transactions it is not as easy to do synthetic puts and get the small advantage they might provide.

I am doing this in my head, since I have never worked with synthetic puts. So there may be a hidden advantage, but if so I cannot find it. Would you like to give an example using Netflix or I can do so tonight?



tom


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I will counter with my view, the bear market only reinforces the true theme which is own stocks with edge bought at reasonable prices and never sell.

Take my ideas or leave them, but over my 25 yrs of watching many people execute their investment desires,

its how we think and see.

The owner of HSY from 1975 could have sold at up 300% wayBACK ,, so what ? Good Long term investors win because they own many things that are worth 5 10 20 and 30 fold the original cost.
And many things that go no where or down.

The US economy was 600billion in 1960 today it is 10,500 billions.
Corporations participating advance.

Buying GE @ a PE of 40 when it is wasting hard cold cash buying itslef,
isn't a quality buy nor a good price.

This PUT story brings the subject to the forefront.

Yes PUt selling has some merit but note, over time the stks you like that really go up, you won't participate in, and the ones you like that go down, you WILL own. yes in some cases, you will end up buying stks cheaper and they will go up.

Options offer no magic or special tricks. That is investing basics 002.
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No. of Recommendations: 5
xFatOtt,

I'm not sure why you're approaching this with such heat or even hostility (although I may be reading your posts wrongly, of course). But I do appreciate your concern on the issue, and share your desire to keep investors from ever getting hurt.

For what it's worth, I'll repeat again: I never said or even hinted in the options article that price doesn't matter. I've never said that about investing in my whole life (either did Rule Breaker, which I co-managed, for the record -- it was Rule Maker that said price is less important than business quality, but even they didn't say that it didn't matter at all).

Anyway, the article was all about valuation -- with selling puts as a way to buy stocks at valuations that are attractive to you.

So, please, can you tell us how you calculate what is an appropriate premium for selling a put? I know that'll be difficult, as it's at least somewhat different for each equity you'd write puts on.

I'm happy to continue the discussion when I hear from you. I've written several puts for quite a while now and continue to do well with them. I focus on companies I know very well, I would like to own anyway, and at valuations I consider reasonable based on potential future free cash flow (for the most part). Then strike price and time are of course the key factors in relation to the premium size received. But I'll suggest there is no one equation that fits all.

Best,
Jeff
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No. of Recommendations: 2
FogChicken,

Good post -- thank you! I agree, we didn't address how one might calculate an appropriate premium for a put option. That is a big question (much like asking "what's the absolute fair price for a stock?") We should approach it -- in the meantime, anyone interested should visit the CBOE and request a free guide to options.

Best,

Jeff
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No. of Recommendations: 2
xFat wrote:

TMF Jeff has now written two columns about options that talk about puts. In one, he says that buying puts can be useful (for insuring a highly-priced stock), while in other instances he says selling puts can be useful (getting paid while you wait). He then makes the mistake of saying that selling puts can be good when you think the stock is overvalued. But, wait! Aren't you also more happy to buy puts when the stock is overvalued, because you want to insure against it going down? You can't have it both ways


I'm writing about selling puts when you don't already own the stock. If you own the stock and want to protect it, you might consider buying puts. If you already own a stock, there's no point in selling puts (unless you think the stock is going to keep rising and you want to make some extra income -- but you're then taking a risk twice on the same equity). So, you can have it both ways. Especially when it comes to the stock market. :)
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No. of Recommendations: 4
Jeff,
I apologize for any hostility that may be coming across. It's due to frustration on this subject, not personal animosity.

With regard to your post, did you really mean this?
For what it's worth, I'll repeat again: I never said or even hinted in the options article that price doesn't matter. I've never said that about investing in my whole life (either did Rule Breaker, which I co-managed, for the record -- it was Rule Maker that said price is less important than business quality, but even they didn't say that it didn't matter at all).

Looking here, http://www.fool.com/portfolios/RuleBreaker/rulebreaker3.htm, I see this:

To us, valuation is, at best, a secondary or tertiary concern. To many long-term investors in growth stocks, traditional methods of valuation should not be any concern at all. It's important to note, though, that downgrading the importance of valuation applies to Rule Breaker stocks -- not all stocks in general. Not Rule Makers. Not Drip Port stocks or our Foolish 8 small caps, etc.

I can understand saying TMF has changed its views on valuation over time, but I think your claim that the Rule Breaker never downplayed the importance of valuation is almost unambiguously wrong.
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No. of Recommendations: 3
Jeff,
With regard to this column, maybe I'll just go back to the basics to see which premise or assumption you disagree with:

1. The investor has calculated an Intrinsic Value or Fair Value or Acceptable Purchase Price for a given stock, call it IV. This is the price at which the investor would be willing to buy the stock.

2. The stock is currently trading at higher than IV, so the investor does not purchase the stock. In other words, the investor considers that stock to be overvalued.

3. Instead of waiting for the stock to fall to IV (at which point, assuming the estimated value of the stock is roughly unchanged, the investor would buy the stock), the investor could benefit by selling a put on that stock and "get paid while he waits".

Given this setup, which is what I interpreted your original column to describe, I disagree that selling puts is a useful strategy. This is because any over/undervaluation of the derivative on the security will mirror the over/undervaluation on the underlying stock. I'm repeating my earlier posts, but if the underlying stock is undervalued, a put will be overvalued and a call will be undervalued, with the reverse being true for overvalued stocks. Jeff, you posit a situation with an overvalued stock and suggest that investors sell puts on that stock, even though those puts will be undervalued - by your assumption of an overvalued stock, the investor will receive insufficient premium to insure against the fall of the stock.

When I said that you gave no mention of calculated fair value of the stock, I should have been more careful. It seemed that you advocated calculating the fair value of the stock using that estimate solely to determine what strike price to sell. What I really meant was that, when considering the sale of puts (or actually the transacting of any security or derivative thereof), the primary calculation is fair value vs. market price.

If the estimated fair value, or IV, of the stock is less than the stock price - game over! Selling puts, no matter what the strike price, is a bad idea. The reason is that the market has estimated the likelihood of exercise and the weighted probabilities of the expected loss at exercise and has accorded that option a price based on those expectations. You, because it's an overvalued stock, believe that the likelihood of exercise and expected loss will be greater than the market does, which means that you should be demanding more of a premium than the market is offering.

This all comes down to the fact that, when selling puts, you prefer the stock price goes up, rather than down. When you are in a "I'd prefer the stock go up" position, you're in a long position. You don't want to be buying long positions in overvalued securities.

Jeff, if you continue to disagree with this, I really wish you'd lay out exactly what assumptions you disagree with.

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No. of Recommendations: 6
TMFJeff said, "So, please, can you tell us how you calculate what is an appropriate premium for selling a put? I know that'll be difficult, as it's at least somewhat different for each equity you'd write puts on."

Here goes:
Here's an example of how you might attempt to value a put (or call) option. I'm going to stretch this across more than one message because it's going to be really long. Hopefully, by doing this I'll be able to demonstrate why selling puts when the underlying stock is overvalued is a losing proposition.

The method used is going to be the binomial tree model, which John Hull's Options, Futures, & Other Derivatives, 4th Edition describes as follows:


This is a diagram representing different possible paths that might be followed by the stock price over the life of the option.


Basically, this is a very simplified world where a stock is trading at S right now, and the investor believes that the price of the stock one period from now can only take two values: an up or a down value. An up period will occur with probability p, while a down period will occur with probability (1-p). The return for an up period will be x%, while the return for a down period will be y%, where y is usually going to be a negative number. At the end of the period, the stock will be worth either S(1+x%) or S(1+y%). Because you know the probabilities of the up period or down period occurring, you can value the stock as S(p(1+x%) + (1-p)(1+y%)).

As an example, suppose you hold a stock that sells for $30 and you believe that an “up” period is equally likely as a “down” period, so p=0.5. You also believe that if an up period occurs, the return will be 6%, while if a down period occurs, the return will be -4%. The only two possibilities for the price of the stock at the end of the period are therefore:
$30*(1+6%) = $31.80, after an up period, or
$30*(1+(-4%)) = $28.80, after a down period.

Because these two outcomes are equally likely (because p=.50), the expected value of the stock in period 0 (before the outcome is known) is .5*31.80+.5*28.80=$30.30.

(This ignores any discounting effect – it really represents the expected value of the stock at period 1, with expectations as of period 0.)

Up to this point, I've only been talking about the value of the stock. Suppose you have an option to sell the stock at $30 at the end of the period (that is, a put option with a $30 strike price). The buyer of this put option will exercise the put option when the stock price is lower than $30 at the end of the period, and it will expire worthless if the stock price is $30 or higher. In order to figure out how much he should be willing to pay for this option, he should just look at the two possibilities that exist: how much is the put option worth after an up period, and how much is the put option worth after a down period?

Well, after an up period, the stock will be selling at $31.80, and the put will expire worthless. After a down period, the stock will be selling at $28.80, and the owner of the put will be able to sell that stock for $30, even though it is trading at $28.80, which results in a $1.20 gain. Because these two events are equally likely, the expected outcome of the put option is a gain of $0.60 (the average of the worthless expiration and the $1.20 profit).

So what does this $0.60 represent? In this simplified world, it represents the expected benefit from the ability to force someone to buy stock from you at a price higher than you could normally sell it for. Conversely, if you were selling this put, it represents the expected cost to you of promising someone that you'll buy that stock at a set price, even when you could otherwise buy it for cheaper.

If you were thinking about selling a put option, you should be comparing the strategy of selling the put option (strike price=$30 in this case) with the strategy of “Wait”, or buying the stock at market at the end of the period, but only if it's less than $30. In the case of selling the put for the $0.60, half the time (up periods), you'll have $0.60, while the other half of the time, you'll have a share of stock for which you paid $30, as well as the $0.60 premium. In the case of “Waiting”, you'll buy the stock half of the time for $28.80 and do nothing the other 50% of the time. In both cases, you'll own the stock half the time, and not own the stock half the time. In both cases, you'll have an expected cash flow of -$14.40.

A binomial tree model extends this simplified world one period at a time, which makes it more realistic. To finish off this post, I'll just extend it to 2 periods. Again, starting with a stock trading at $30, the probability of an up period is equal to the probability of a down period, and up periods return 6% while down periods return -4%. At the end of period 2, there are 3 outcomes that the stock price could have followed: 2 up periods, 2 down periods, or 1 of each. There are 4 (2periods^2outcomes) paths the stock price could have followed: Up-Up, Down-Down, Up-Down, Down-Up, so the stock price resulting from 1 up period and 1 down period occurs with 50% probability, while the 2 up periods and 2 down periods each occur with 25% probability.
Period 1  Period 2  Total Return      Stock Price         Option Value
Up Up 12.4% $ 33.71 $ -
Up Down 1.8% $ 30.53 $ -
Down Up 1.8% $ 30.53 $ -
Down Down -7.8% $ 27.65 $ 2.35
Average $ 30.60 $ 0.59

What this means is that the expected value of the stock 2 periods from now is $30.60. The put option only has value in the case where 2 down periods occur. In that case, the stock will be worth $27.65, giving the owner of the put a $2.35 profit. Because this outcome only occurs 1 out of 4 times, the expected profit for the put is $2.35/4 = $0.59. So in this simple example, a fair (risk-neutral, non-discounted) price/premium for the put option might be $0.59.

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No. of Recommendations: 6
This is a continuation from: http://fireboards.fool.com/Message.asp?mid=19130054

From the first post, I gave an example of a 2-period situation with one stock:
Period 1  Period 2  Total Return      Stock Price         Option Value
Up Up 12.4% $ 33.71 $ -
Up Down 1.8% $ 30.53 $ -
Down Up 1.8% $ 30.53 $ -
Down Down -7.8% $ 27.65 $ 2.35
Average $ 30.60 $ 0.59

Keeping this example, now let's consider one of TMFJeff's claims: Selling puts on stocks with high volatilities is better than low volatilities.

In the above table, the return in good periods was 6%, while the return for bad periods was 4%. Now, let's see what happens when we increase volatility. Consider a 2-period case where good periods return 12%, while bad periods return -10%.
Period 1  Period 2  Total Return      Stock Price         Option Value
Up Up 25.4% $ 37.63 $ -
Up Down 0.8% $ 30.24 $ -
Down Up 0.8% $ 30.24 $ -
Down Down -19.0% $ 24.30 $ 5.70
Average $ 30.60 $ 1.43

In this case, you can see the volatility increases, because the extreme (high and low) possible outcomes are much more extreme than in the first case. That being said, the overall expected value of the stock price is still the same $30.60. This shouldn't be surprising – the increase in the good outcomes balances with the decrease in the bad outcome.

But look what happens to the value of the option! The value of the put option increases from $0.59 to $1.43, strictly because of the increased volatility. The reason for this increase should be intuitive – I made the potential upside for the stock much better (25.4% return vs. 12.4% return), while I made the potential downside for the stock much worse (-19% vs. -7.8%). But the put option doesn't participate in the upside, only the downside! So by increasing the volatility, you can keep the expected value of the stock constant, but increase the expected value of the option greatly.

So, the first part of TMFJeff's claim is correct – the premiums you will get by selling a put will be higher when the stock's volatility is higher. But the real question is: Does that mean selling a put option on volatile stocks is smarter? NO! Why not? Because of the increased risk you take on when you sell such a put.

[Remember, you're comparing a strategy of selling a put (strike price of $X) with a strategy of waiting until the expiration date and buying the stock at market price, but only if that stock is trading at $X or lower.]

In the first scenario, you (the seller of the put) are insuring against a significant decline in the stock price. In the worst-case outcome (2 down periods), you'll be forced to buy a $28.80 stock for $30. For this risk (which occurs 25% of the time) you'll be compensated $0.59. In the second case, you're insuring against a significant decline in the stock price as well. But now, the worst-case outcome (2 down periods, but with a more volatile stock) results in you buying a $24.30 stock for $30.00. For this, you'll be compensated $1.43.

Are you getting a better deal when you sell a put on the more volatile stock? No! You're simply being compensated for the greater risk you're taking.
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No. of Recommendations: 5
This is a continuation of:
http://fireboards.fool.com/Message.asp?mid=19130054, and
http://fireboards.fool.com/Message.asp?mid=19130626

In this post, I want to point out why anecdotal evidence with regard to selling put options isn't worth very much. It's a case that howardroark describes as Argentine roulette: a thousand-chamber gun with one bullet. The likelihood of a bad outcome is very low, but the magnitude of the bad outcome is many times greater than the magnitude of a good outcome.

Continuing with this binomial tree, when you expand this to a multi-period situation, you begin to move from a discrete (naïve) world where you believe that a stock will have one of only two values at some future date, to a world where a future stock price is uncertain, but is likely to fall in a distribution that looks kind of normal (in the mathematical, bell-curve sense).

Here's a 6-period case. I assume a $30 stock (today) and that 10% up periods are as likely as -8% down periods. You can see that the potential outcomes range from a stock price of $53.15 (after 6 consecutive good periods) to a stock price of $18.19 (after 6 consecutive down periods). However, 50 of the possible 64 (2outcomes^6periods), or 78% of the time, the stock price will be between $26.01 and $37.18.
                           Period                         Final Price                                                         
Price 1 2 3 4 5 6 Paths Prob Weighted Option Weighted
$ 53.15 1 1.56% $ 0.83 $ - $ -
48.32
43.92 $ 44.45 6 9.38% $ 4.17 $ - $ -
39.93 40.41
36.30 36.74 $ 37.18 15 23.44% $ 8.71 $ - $ -
33.00 33.40 33.80
$ 30.00 30.36 30.72 $ 31.09 20 31.25% $ 9.72 $ - $ -
27.60 27.93 28.27
25.39 25.70 $ 26.01 15 23.44% $ 6.09 $ 3.99 $ 0.94
23.36 23.64
21.49 $ 21.75 6 9.38% $ 2.04 $ 8.25 $ 0.77
19.77
$ 18.19 1 1.56% $ 0.28 $ 11.81 $ 0.18
---------- ----------
64

Expected Value $ 31.85 $ 1.89

As in the prior posts, we can look at the weighted-average future stock prices to get an expected value for the final-period stock price. In this case, that's $31.85. Also consistent with the previous posts, we can see the values for a $30 put. In 65.63% of the possible outcomes (those outcomes with final stock price >$30, the put will expire worthless. However, in the remaining cases, the put will be exercised and the seller of the put will incur some loss. In the most extreme case (after 6 consecutive bad periods), the seller of the put will be forced to pay $30 for a stock worth only $18.19, a loss of $11.81. Of course, this extreme loss should only happen 1.56% of the time.

For the risk of having to pay too much for the stock at the end of the 6th period, the seller of the put will demand a premium of $1.89.

In this example, it's pretty easy to look at the potential price paths and figure out what's going to happen over a repeated sample.
- Out of 100 6-period samples, you'd expect that the put will expire worthless about 66 times, and you just pocket the money. Hey, that's free money! I'm getting paid while I wait!
- About 33 times, you'd expect the put to be exercised and you pay more than the market price, losing either $3.99 or $8.25
- 1-2 times, you'll lose $11.81

The problem with anecdotes in a case like this, with a limited sample size, is that the market is paying a premium to the seller of a put to bear a certain risk, including the 1-2% chance of a significant loss. The anecdote-teller likely has not experienced that significant, low-probability loss, although he has been compensated for bearing it. The anecdote teller will likely believe that he is earning money for doing nothing. This is the same line of thought used by an insurer of rare events. Hey, free money – until they blow up.
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No. of Recommendations: 7
This is a continuation of:
http://fireboards.fool.com/Message.asp?mid=19130054
http://fireboards.fool.com/Message.asp?mid=19130626
http://fireboards.fool.com/Message.asp?mid=19130850

and, after all that introduction, I'll try to illustrate why selling puts on overvalued stocks is doing exactly the wrong thing.

The first 3 posts I made provided a methodology that the market might use to price an option, given the underlying stock price and some assumptions about volatility, although it made some assumptions like no dividends and a 0% interest rate. Don't worry, these don't affect any conclusions.

Now, let's move onto a case that started this whole thing – a stock in a good company is currently trading for more than you're willing to pay. Remember, throughout this whole process, the two competing strategies are:

- Selling a put (expiration date of Z) with the strike price set at a price you'd be willing to buy at.
- Waiting until Z (the competing expiration date) and buy the stock at the then-market price, but only if it's less than the strike price.

Assumptions:
The stock in question is trading at $60. The market is valuing it as if (over a 6-period, or 6-node, sequence) there is an equal probability, at each node, that the return will be either +17% or -15%. Doing the same thing as I did in earlier posts, I calculate an expected value at the end of period 6 of $63.69, so the market is expecting about a 6% return over those 6 periods. You (the potential investor) look at that stock and say, “I'd love to own that company, but I'd only be willing to pay $35. In other words, I think the stock is significantly overvalued.

Here's what the 6-period model looks like:
                           Period                          Final Price                                                         
Price 1 2 3 4 5 6 Paths Prob Weighted Option Weighted
$ 153.91 1 1.56% $ 2.40 $ - $ -
131.55
112.43 $ 111.81 6 9.38% $ 10.48 $ - $ -
96.10 95.57
82.13 81.68 $ 81.23 15 23.44% $ 19.04 $ - $ -
70.20 69.81 69.43
$ 60.00 59.67 59.34 $ 59.02 20 31.25% $ 18.44 $ - $ -
51.00 50.72 50.44
43.35 43.11 $ 42.87 15 23.44% $ 10.05 $ - $ -
36.85 36.64
31.32 $ 31.15 6 9.38% $ 2.92 $ 3.85 $ 0.36
26.62
$ 22.63 1 1.56% $ 0.35 $ 12.37 $ 0.19
---------- ----------
64

Expected Value $ 63.69 $ 0.55

Again, the expected value of the stock at period 6 is $63.69. Looking at the put option, the market believes it will expire worthless 89% of the time (those outcomes where the final stock price is >$35). Even if the option is exercised, the market believes it is 6 times more likely that the seller of the put will lose $3.85 compared to losing $12.87. For this risk, the market will offer a premium of $0.55.

But wait! You don't agree with the market's expected value! You scoff at the market! Silly market – you expect a value of $63.69, when a more intelligent investor estimates the worth to be $35!

There are a few ways the intelligent investor can adjust the model to come up with an expected value of $35 (instead of $63.69), by changing any combination of return in up periods, return in down periods, or probability of an up period. I'll just adjust the returns, although it really doesn't change the conclusions.

This is what an intelligent investor, who believes the fair value of the stock is $35, might envision:
                           Period                         Final Price                                                         
Price 1 2 3 4 5 6 Paths Prob Weighted Option Weighted
$ 106.29 1 1.56% $ 1.66 $ - $ -
96.63
87.85 $ 72.47 6 9.38% $ 6.79 $ - $ -
79.86 65.88
72.60 59.90 $ 49.41 15 23.44% $ 11.58 $ - $ -
66.00 54.45 44.92
$ 60.00 49.50 40.84 $ 33.69 20 31.25% $ 10.53 $ 1.31 $ 0.41
45.00 37.13 30.63
33.75 27.84 $ 22.97 15 23.44% $ 5.38 $ 12.03 $ 2.82
25.31 20.88
18.98 $ 15.66 6 9.38% $ 1.47 $ 19.34 $ 1.81
14.24
$ 10.68 1 1.56% $ 0.17 $ 24.32 $ 0.38
---------- ----------
64

Expected Value $ 37.58 $ 5.42

This model assumes an equal likelihood at each node of a +10% return and a -25% return. Just to reiterate, this is the return process that the intelligent investor expects. The intelligent investor believes the current stock is significantly overvalued. In this case, selling a put even with a strike price that the intelligent investor would be willing to buy at, imposes an enormous amount of risk relative to the compensation.

To summarize this example, the market is trading a stock at an “overvalued” price of $60. Selling a put with a strike price (equal to the true “fair value” of $35) would earn a premium of $0.55. Why so small? Because the market believes the likelihood of such a dramatic price decline is very small.

Is this premium acceptable? Absolutely not! The investor believes the stock is much more likely to fall (is more overvalued) than the market believes. As a result, that investor believes that selling a put with a strike price of $35 imposes an expected financial risk of $5.42. SELLING THAT PUT (OR ANY OTHER PUT) ON THE OVERVALUED STOCK PRICE IS VIRTUALLY GUARANTEED TO IMPOSE A SIGNIFICANT RISK THAT WILL NOT BE FULLY COMPENSATED BY THE MARKET.

In this situation (and in any overvaluation situation), the intelligent investor should be buying puts, not selling them.


I hope this series of posts has provided sufficient detail about why I felt (and still feel) that TMFJeff's original article was flawed. Although the binomial tree method I used is fairly crude, simply extending the number of nodes gets the binomial method to converge to the more famous Black-Scholes pricing.
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Jeff, you said: I never said or even hinted in the options article that price doesn't matter. I've never said that about investing in my whole life (either did Rule Breaker, which I co-managed, for the record . . .

I'm sorry, but talk about revisionist history -- that is an amazing contention given this article by your co-manager: http://www.fool.com/portfolios/rulebreaker/2000/rulebreaker000919.htm

which includes this statement:

And price as a valuation consideration is also overrated and doesn't matter so much to me as an investor. That's because I believe our incredibly liquid, increasingly democratized markets today reflect rational prices.

That was your co-manager saying price doesn't matter. There is no ambiguity there.

David goes on:

If prices were truly irrational they would quickly be "corrected" by a flood of buyers or sellers who would suddenly come in, take advantage of that arbitrage by buying or selling in massive amounts, and we would have rationality again.

He wrote that on April 17, 2000. Funnily enough, for about a month before that and over the next couple of years a flood of sellers suddenly came in and sold in massive amounts. Does that mean prices were, in fact, truly irrational at precisely the time he said they were not? Uh-huh.

It seems unwise to make statements now about what was said then that are demonstrably false.

UsuallyReasonable
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No. of Recommendations: 3
xFatOtt -

You've done an excellent job of highlighting the problems of using complex strategies without completely understanding the ramifications of doing so.

I have a point to add from a fundamental investing standpoint. The premise of the article seems to be that stock prices wander around for no particular reason at all, and that it is possible to say something like "if this stock falls 20% in the future, regardless of the reason, I will definitely want to buy."

In reality, stocks often fall for a good reason. If you merely do nothing and wait for the stock to fall to your target price, you get a second chance to evaluate it at that point. If something in the company's fundamentals has changed and that's the cause of the fall in price, then you get a second chance to decide whether you really want to invest in that company. If you write the put, you're stuck, even if you'd really rather not invest given the new situation the company is in.

As you point out, if the stock price is high, you may not get enough option premium to justify the risk that the fall in the company's stock price is due to something that would make you not want to own it.

dan
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No. of Recommendations: 5
If the estimated fair value, or IV, of the stock is less than the stock price - game over! Selling puts, no matter what the strike price, is a bad idea. The reason is that the market has estimated the likelihood of exercise and the weighted probabilities of the expected loss at exercise and has accorded that option a price based on those expectations. You, because it's an overvalued stock, believe that the likelihood of exercise and expected loss will be greater than the market does, which means that you should be demanding more of a premium than the market is offering.

This all comes down to the fact that, when selling puts, you prefer the stock price goes up, rather than down. When you are in a "I'd prefer the stock go up" position, you're in a long position. You don't want to be buying long positions in overvalued securities.


xfatott,

I couldn't agree more. I was going to respond to Jeff's original post, but figured someone could put it better than I - and you have.

The only reason - the ONLY reason - you would sell puts is if you think the realized volatility will be lower than the implied vol offered by the market.

You wish to sell dear and buy cheap. That's the only reason.

In addition, the bid-offer spread in these markets is normally not very liquid and the market-makers are not your friends. I come at this from a different perspective than most retail investors, however.

You will not be compensated for the risk you are taking in the 'strategy' Jeff has offered. In addition, I firmly believe 95%+ of the readers here do not properly understand all the risks of the strategy.

If you make these trades for reasons other than selling expensive vol - you're in the wrong market. There simply is no free lunch. This strategy is no different than that of the Wise, who think that writing calls on their stocks is somehow a 'yield enhancement' strategy - getting it completely backwards.

Again, to paraphrase xfatott - If you think the stock is going down $5-15, shouldn't you be buying the puts?

sincerely,

Naj,

professional options trader.
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No. of Recommendations: 0
Hi Dan,

As you point out, if the stock price is high, you may not get enough option premium to justify the risk that the fall in the company's stock price is due to something that would make you not want to own it.

This is what I think Jeff was talking about. He wanted to own the stock so it is my opinion he was not saying he thought the stock was vastly overvalued. Perhaps even undervalued somewhat, but he preferred a greater margin of safety than the present stock price gave him.

tom
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Hi Naj,

Again, to paraphrase xfatott - If you think the stock is going down $5-15, shouldn't you be buying the puts?

I just don't agree with that. It is a matter of risk. I do not sell puts because I believe the stock is going down, I do it because I believe the stock is close to fair value and the put sold gives me an extra margin of safety.

I sell them because, I believe my research tells me even if I am wrong about the intrinsic value of the company and the stock drops and I have to buy it, I am buying it at a price point that will allow me to see good future appreciation.

As for value, if I can recieve a 10% premium for a month that annualized out to 120% a year. Or even 5% which annualizes out at 60% then surely this is a market in which it is worth participating.

Personally, I see no downside to using this as part of one's investment strategy. Sure, one should understand all the risks involved and should have done his homework on the underlying security. But I still don't see an argument posted yet that convinces me that this is a risky strategy or one that is not worth the effort to use.

Of course, this is just my opinion

tom

tom
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I do it because I believe the stock is close to fair value and the put sold gives me an extra margin of safety.


So you think there is a free lunch? That the options seller is just giving away that 'extra margin of safety?'

As for value, if I can recieve a 10% premium for a month that annualized out to 120% a year. Or even 5% which annualizes out at 60% then surely this is a market in which it is worth participating.

That's actually 213% and 79.5%, but who's counting? If you like those returns, you should participate in the fx markets and make 10 times that in 1-3 months, shouldn't you?

Personally, I see no downside to using this as part of one's investment strategy.

And this is EXACTLY what I was afraid you were going to say.

Sigh.

Naj

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No. of Recommendations: 6
I just don't agree with that. It is a matter of risk. I do not sell puts because I believe the stock is going down, I do it because I believe the stock is close to fair value and the put sold gives me an extra margin of safety.

I sell them because, I believe my research tells me even if I am wrong about the intrinsic value of the company and the stock drops and I have to buy it, I am buying it at a price point that will allow me to see good future appreciation.

As for value, if I can recieve a 10% premium for a month that annualized out to 120% a year. Or even 5% which annualizes out at 60% then surely this is a market in which it is worth participating.

Personally, I see no downside to using this as part of one's investment strategy. Sure, one should understand all the risks involved and should have done his homework on the underlying security. But I still don't see an argument posted yet that convinces me that this is a risky strategy or one that is not worth the effort to use.


1000,
The downside is simple: the possibility of being forced to pay more for the stock than it is worth. Maybe a really, really simple example will be able to express this.

Suppose you want to buy shares of American Express. The current market price is around $42. You don't want to buy at this price, you'd like to buy at around $35. So, going by this notion of "getting paid while you wait", you sell a put with a $35 strike price, expiring in October 2003, or about 5 months from now. Yahoo lists this option as one with a good amount of open interest and a price of about $0.95.

So what's the risk? The risk is that, on the date the option expires, shares of American Express are trading significantly lower than your strike price! Assuming you can receive $0.95 by selling the put (so no transactions costs or bid-ask spread), conditional on the stock being lower than $35, you'll pay a net $34.05 per share.

Your risk, then, is the risk that AXP is trading for lower than 34.05 at that point. What kind of 5-month return would lead to the stock price being lower than $34.05 5-months from now? 34.05/42 - 1 = -18.9%.

Between 1973 and 2002, there have been 356 (overlapping) 5-month returns on the monthly CRSP files. Of these, 49 were lower than -18.9%. So, on these 49 times, you would have realized a loss on the exercise of the put, relative to simply waiting until the expiration date. One of those times, in late 1974, the 5-month loss was -50.5%!

If that extreme result were to occur today, you would be paying a net $34.05 for a stock trading at $20.80 per share, or an immediate loss of $13.25 per share! To top it all off, if this extreme event were to happen, it would probably come at exactly the wrong time because either:
1) AXP experienced a permanent loss of value, and you no longer find the stock attractive at $35, or
2) The overall market has declined significantly, making the $3500 forced purchase price more expensive than it seemed when you wrote the put, on a relative valuation basis.

So that's what you're insuring against: extreme outcomes. This is not a risk-free transaction.




[Note: Discounting factors and AXP's significant dividend yield make this a more complicated valuation exercise than my earlier examples.]
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Hi Naj,


That's actually 213% and 79.5%, but who's counting? If you like those returns, you should participate in the fx markets and make 10 times that in 1-3 months, shouldn't you?


Actually, I was not compounding but adding it as if I could have done it each month with the same amount. I don't believe you can compound this type of return. It is difficult to find situations each month and to do this with an increasing amount of money would make it that much tougher. But I did say annualized, so point taken.

And this is EXACTLY what I was afraid you were going to say.

You obviously think there is a downside. What do you see the downside to be to using this strategy?

My thoughts are the following;

I see a company I consider fair value. Normally that would mean buy it up. But let's say I am fully invested and need to bring in extra cash to expand my investment portfolio. I have enough to buy 100 shares of a company that I consider fair value, but it is a new position and I feel it would be to my advantage to lower my cost basis instead of buying outright? I choose to chance losing the investment as it rises and collect the premium which expands my cash account. Or I risk buying it but lower than it was presently. What is the downside?

tom
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see a company I consider fair value. Normally that would mean buy it up. But let's say I am fully invested and need to bring in extra cash to expand my investment portfolio. I have enough to buy 100 shares of a company that I consider fair value, but it is a new position and I feel it would be to my advantage to lower my cost basis instead of buying outright? I choose to chance losing the investment as it rises and collect the premium which expands my cash account. Or I risk buying it but lower than it was presently. What is the downside?

tom


Hi Tom,

You haven't said one word about the vega, delta, or gamma of the option, much less the fair value of the implied vol relative to realized or expected future vol.

What are the market makers doing? What's the vol skew? Do these options contain an overly high degree of kurtosis?

How can one possibly assess this transaction with any semblance of rationality without analyzing those factors? I'm mystified.

bowing out,

Naj



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Hi XfatOx,

The downside is simple: the possibility of being forced to pay more for the stock than it is worth. Maybe a really, really simple example will be able to express this.

But this is the same risk you take when you buy the stock outright.

This returns annualizes out to 6.6%. This is definitely not worth taking the risk. Naj can check my math. Compounding the returns is the only way to make sense of the example.

So, I think I see what you are saying. The return from the option must be worth as much or more than your expected return on the underlying security. I agree with this.

It is my opinion, Jeff also agrees with this and considered it a given. However, I now see your point that this would have been an added issue to discuss.

Am I following your logic now?

tom
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Hi Naj,

How can one possibly assess this transaction with any semblance of rationality without analyzing those factors? I'm mystified.

bowing out,


Fair enough.

I think I understand now what XfatOx was trying to point out. The return from the option must bring back gains equal to or greater than the expected returns on the underlying security.

As for valuing specific examples, I was not interested in that as much as trying to understand the value of the strategy. I have used it successfully in the past and the strategy has produced good results for me.

tom
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No. of Recommendations: 2
The downside is simple: the possibility of being forced to pay more for the stock than it is worth. Maybe a really, really simple example will be able to express this.

But this is the same risk you take when you buy the stock outright.


No, it's not the same risk. Here are the two alternatives:

1. Sell a put at a certain strike price ($X), expiring at some point in time (D).

-or-

2. Decide that you will, at that same expiration point from above - D, buy the stock at the market price, but only if it's $X or lower.


In #1, on expiration date, if the put is exercised, you will experience an immediate loss of some amount. I don't know how much that amount is, but you'll definitely have a loss - otherwise, the owner of the put wouldn't exercise the option. So your loss on expiration date (the risk you are taking on by selling the put) can be measured as the difference between the market price (that you could buy at) and the strike price, at which you are forced to buy.

If you simply wait, in scenario #2, you buy the stock at the market price and there is no immediate loss. Plus, you have the flexibility/option to say, "Hey, I changed my mind".

By selling the put, you're taking a premium now for the promise to take a loss (equal to strike price - market price at expiration) in the future. It's the same as insurance.
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Hi XFatOx,

If you simply wait, in scenario #2, you buy the stock at the market price and there is no immediate loss. Plus, you have the flexibility/option to say, "Hey, I changed my mind".

But you an always buy back the contract. You can change your mind by just buying back the sold put to close the contract.

tom
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Hi XfatOx,

Another thought too.

You can also sell the put, take the premium, and if the stock goes up rebuy the put for a portion of the premium given. And if the stock goes down again you can then resell the same put over again increasing the money you collect on it that month. I usually stick with one-two months options because the percentage annualized return is greater.

This is just another thought. The put contract can be traded the same as the underlying security.

tom
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But you an always buy back the contract. You can change your mind by just buying back the sold put to close the contract.

I really don't understand the point of this - if you change your mind after you've written a put, you have to buy back the contract at some unknown price. Buying and selling the same contract brings on transactions costs and uncertainty - how on earth is that the same as the flexibility you have when you don't sell the put?

By the way, it is x-F-a-t-O-t-t
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1000,
You can also sell the put, take the premium, and if the stock goes up rebuy the put for a portion of the premium given. And if the stock goes down again you can then resell the same put over again increasing the money you collect on it that month.

I seriously don't understand the logic here. What you're saying applies to any asset: If the price movement is favorable you can take profit off the table. If the price movement is unfavorable, you can double down.

Is this some bizarro world "heads I win, tails you lose" deal?
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Hi XFatOtt,

I am sorry

By the way, it is x-F-a-t-O-t-t


I did not have my reading glasses on. I felt I could see well enought without them, but evidently I am was wrong. I am sorry I really thought it was the other.

I really don't understand the point of this - if you change your mind after you've written a put, you have to buy back the contract at some unknown price. Buying and selling the same contract brings on transactions costs and uncertainty - how on earth is that the same as the flexibility you have when you don't sell the put?


If you change your mind on buying a stock after you bought it you have to sell it also at an unknown cost and you will also have a transaction price. Option commissions are a bit higher than stock commissions.


tom

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Hi XFatott,

Is this some bizarro world "heads I win, tails you lose" deal?

No, I was just saying like when you buy a stock you can always change your mind. I am not suggesting trading the put contract only that it can be done just like trading a stock.

If the stock is very volatile the premium on the option will be great enough that trading it is not only possible but profitable. When the tech companies were high, I was able to trade the same put option repeatedly in the same month allowing me to do better than if I had only sold it once.

tom
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No. of Recommendations: 4
I have used it successfully in the past and the strategy has produced good results for me.

Be careful with this line of reasoning. One of xFatOtt's earlier points was that in situations like this where you have a high probability of a modest positive gain and a low probability of a large loss, the fact that it's worked well for you in the past may not mean that it will work out for you in the long term.

To give another example, suppose you know somebody who owns a house and needs to insure it against fire. You could sell him a series of 1-month insurance policies, for half the price of the best commercially available insurance policy. You would do very nicely on this and get a nice stream of profits - at least until there was a fire. And that might not happen for five years, or ten. If you'd been selling him these policies every month for five years and getting income from it, you might well have started thinking of it as a sure thing. But that doesn't change the fact that if there actually was a fire and you had to pay for the house, or if you did it on a large enough scale for the law of averages to come into play, it might end up being a losing strategy for you in the long run.
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Hi FogChicken,

Be careful with this line of reasoning. One of xFatOtt's earlier points was that in situations like this where you have a high probability of a modest positive gain and a low probability of a large loss, the fact that it's worked well for you in the past may not mean that it will work out for you in the long term.

That is a good point. I do make sure I like the stock I am using this strategy with and value the company to the best of my abilities. The company must be at what I consider fair value or slightly below, so if I can get it I can expect it to be a good investment. I only do this if the premium is equal or greater than 5% that month. Anything less than that is not worth it to me.

tom
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I'll admit I'm new to the options arena, and would like to ask you experts a question or two.

1) I was looking at options for Martha Stewart Living and noticed that Sep 03 puts were $0.50 (Bid). Just for grins, I clicked on this contract which took me to the trading screen. The message I saw was "MY BROKER'S NAME does not allow selling puts as an opening transactions."

Does that simply mean I can't enter an order outside of normal trading hours?

2) TMFJeff stated in his first articl that options aren't for everyone. He went on to say that you should have "professional" help with your taxes. Why is this the case? Isn't an option treated the same way as a short-term gain or loss with a normal stock transaction (assuming the contact expires within one year)?

Kevian
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Hi Kevian,

The message I saw was "MY BROKER'S NAME does not allow selling puts as an opening transactions."

I have never seen this type of message, but it could simply mean you have not opened an option account or a margain account. You will need both to buy or sell options.

) TMFJeff stated in his first articl that options aren't for everyone. He went on to say that you should have "professional" help with your taxes. Why is this the case? Isn't an option treated the same way as a short-term gain or loss with a normal stock transaction (assuming the contact expires within one year)?

I am afraid I am one of those that has a tax guy doing my taxes. There are some differences though. When you sell a call on a stock, you need not report that. Instead I believe you use it to lower the cost basis of the stock you sold the call on, if it is a covered call. But like I said I have a guy that does my taxes.

Hopefully someone else can give you better information.

tom
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Thanks for your reply Tom:
You're probably right regarding my account; I haven't submitted any documentation to start trading options. As far as taxes are concerned, I use TurboTax. Does anyone know if TurboTax is equipped to handle options trading?

Kevian
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No. of Recommendations: 4
UR, speaking of revisionist history, I noticed that one of David Gardner's comments in the article from 2000 that you linked directly contradicts an assertion of his in a recent article.

http://www.fool.com/portfolios/rulebreaker/2000/rulebreaker000919.htm

<Price per share really doesn't matter, and many investors are badly misled by their belief that low-priced stocks are good, and high-priced are not.>

http://www.fool.com/news/commentary/2003/commentary030506dg.htm?source=mptoppromo

<Readers of our Motley Fool Investment Guide know that one investment strategy we have championed for 10 years now is to look for promising and mainstream small-cap stocks that trade in the single digits per share, because they are simply off Wall Street's radar. Wall Street defaults to stocks trading in excess of $10 per share.>

I guess he thinks you can fool some people all of the time.

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I guess he thinks you can fool some people all of the time.

Uh, Don, I think in the first article DG was trying more to teach the lesson that people immediately dismiss a stock because it's highly priced and immediately embrace a stock because it's trading for $0.37 and you can buy a LOT of it.

In the second, he's pointing to a very real phenomenon in that many money managers on the street don't or can't buy stocks below $10. The Foolish 8 typically looks at stocks (IIRC) above $5 and below $10.

Two different lessons, not related to one another. You agree they are different, yes?

Bogey
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<You agree they are different, yes?>

Uh, no. I believe the 2 quotes are exactly the opposite of each other, and are an illustration of (a) historical revisionism (in the Marvel piece) and (b) talking out of both sides of his mouth.

<Uh, Don, I think in the first article DG was trying more to teach the lesson that people immediately dismiss a stock because it's highly priced and immediately embrace a stock because it's trading for $0.37 and you can buy a LOT of it.>

Maybe it takes a TMF Zenmaster to somehow pull this intended "lesson" out of either of those articles, because I read them (and posted the links to them) and didn't come away with the same interpretation.
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Uh, no. I believe the 2 quotes are exactly the opposite of each other, and are an illustration of (a) historical revisionism (in the Marvel piece) and (b) talking out of both sides of his mouth.

Don,

I can't tell if you're just trying to be antagonistic and poke jabs anywhere you think you can find a hole, or if you're really not capable of seeing the difference in the two different statements. Can you not hold two seemingly opposite thoughts in your mind at the same time?

In the first, David was saying that people shouldn't disregard highly priced stocks, from a nominal standpoint, just because they are highly priced. After all, that would shut many people out of a stock like Berkshire, right? So, teaching people not to blow off highly-priced stocks just because they are highly-priced, and not fall in love with low-priced stocks just because they are low is a good lesson, right? You DO see this, yes?

In the second piece, he's talking about the very real phenomenon of Wall St. money managers who aren't allowed to go after stocks under $10 and how that might present an ineffiency in the market place. In other words, there may be some overlooked stocks between $5 and $10 because a certain segment of the market is ignoring them. That also makes sense, doesnt' it?

If you're trying to be difficult and try and "catch" David Gardner whenever the chance prevents itself, then fine. I'd love for you to explain from a qualitative standpoint how both statements can't be valid at the same time.

If you aren't trying to be difficult, well...

Best,

Bogey

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<I can't tell if you're just trying to be antagonistic and poke jabs anywhere you think you can find a hole, or if you're really not capable of seeing the difference in the two different statements.>

In other words, you can't decide whether I'm nasty or stupid. That's along the lines of asking "when did you stop beating your wife?"

<In the first, David was saying that people shouldn't disregard highly priced stocks, from a nominal standpoint, just because they are highly priced.>

That's not what he wrote, it's your attempt to spin what he wrote. He said "price per share really doesn't matter." That's pretty plain English, isn't it? It doesn't say it doesn't matter at some prices and at other prices it could matter. If you want to make an argument that he misspoke or wasn't precise in his language, fine, but to simply alter the meaning of words and then insult anybody that doesn't buy your spin is sort of pathetic.

<So, teaching people not to blow off highly-priced stocks just because they are highly-priced, and not fall in love with low-priced stocks just because they are low is a good lesson, right?>

I guess if your target audience is financially illiterate.

<In the second piece, he's talking about the very real phenomenon of Wall St. money managers who aren't allowed to go after stocks under $10 and how that might present an ineffiency in the market place. In other words, there may be some overlooked stocks between $5 and $10 because a certain segment of the market is ignoring them. That also makes sense, doesnt' it?>

No, I think it makes about as much sense as the Rule Maker and Rule Breaker criteria and whatever else TMF pulls out of thin air. Technology fund managers don't look at energy stocks, maybe that also creates an inefficiency in the marketplace.
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I guess if your target audience is financially illiterate.

Don,

Many people who come to the Fool are total beginners, yes. We've gotten lots of feedback from beginners over the years who have an unnatural fear of higher priced stocks, which I'm sure is why David wrote what he wrote.

No, I think it makes about as much sense as the Rule Maker and Rule Breaker whatever else TMF pulls out of thin air.

It's way too easy to make throwaway statements like these and then walk. If you want to go point by point through the Rule Breaker and/or Rule Maker philosophies with me and tell me what you agree and don't agree with, then that's fine. At least then we have a conversation and I'll probably agree with you on certain things.

But, dropping these little critical bombs with nothing to back them up isn't terribly productive. I somehow get the sense that you're not all that concerned with being terribly productive though. All I can say is that at least the Brothers are willing to share their thinking and learn together with everyone in the community. Where's your real-money portfolio? Where's your philosophy?

Bogey

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I can not always agree with the stated criteria. Some opportunities do crop up which pay substantially more while you wait: I am long on KMP and it payed between 8 and 9 % when I bought it and it has appreciated substantially in the past 6 months. With the business plan of this partnership and the quality management they will continue to acquire and grow I believe.

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Bogey, a while back (on the Improve the Fool board) you invited me (and others) to provide you with an advertising campaign that would sell newsletters while also adherering to higher standards, which I thought was ballsy enough. Now if I'm going to dare question the Gardners I need to provide my investment philosophy and real money portfolio on your copyrighted site?

It's your site. If you don't think I'm adding anything evict me.
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TMFBogey: David was saying that people shouldn't disregard highly priced stocks, from a nominal standpoint

http://www.fool.com/portfolios/rulebreaker/2000/rulebreaker000919.htm

DG does say that. From the linked article:
Price per share really doesn't matter, and many investors are
badly misled by their belief that low-priced stocks are good,
and high-priced are not.

But he also says:
And price as a valuation consideration is also overrated and
doesn't matter so much to me as an investor. That's because I believe
our incredibly liquid, increasingly democratized markets today
reflect rational prices.

Which seems to be making the point that the market is basically efficient.

In the second piece, he's talking about...how [a share price less than $5] might present an ineffiency in the market place

David has often made a kind of "qualified efficiency" argument that, frankly, I find difficult to understand. He seems to argue that while the market is generally efficient, there are types of stocks "rule breakers" or "small caps" that are systematically mis-priced. If certain small-cap stocks were systematically mis-priced, why wouldn't other people go exploit that market inefficiency? It wouldn't matter if some people "ignored" these stocks as long as enough people (and therefore money) paid attention.

No dog in this fightingly yours,

Hubris
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Bogey, a while back (on the Improve the Fool board) you invited me (and others) to provide you with an advertising campaign that would sell newsletters while also adherering to higher standards, which I thought was ballsy enough

Yeah, and I noticed you didn't provide anything there, which kind of proves my point.

Now if I'm going to dare question the Gardners I need to provide my investment philosophy and real money portfolio on your copyrighted site?

Not at all. I asked you to point to specifics in the philosophies so that we can have a conversation. You obviously aren't going to do that either.

As for leaving, that's the last thing I want. I'd rather you stopped taking cheap shots and actually engaged in a reasonable conversation about issues. Is that so hard?

Bogey


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Hey Bogey, sorry I didn't supply that advertising campaign you were looking for. I suggested that since you guys present yourself as champions of the individual investor that you might consider complying with the advertising requirements the SEC imposes on Registered Investment Advisors. You basically said that selling newsletters was the primary consideration, so unless somebody supplied you with an advertising campaign that met the SEC requirements AND could sell newsletters you'd keep doing what you're doing. So I guess the ball is in my court and unless I supply TMF with ad copy free of charge it's unfair of me to criticize the continued selective disclosure. I find that strange.

With regard to specific issues about Rule Maker, I think the entire concept was nonsense, as I pointed out a while back:

http://boards.fool.com/Message.asp?mid=15963299

<Here's the basic problem.

<Annual sale growth of at least 10%
Gross margins greater than 50%
Net profit margin of at least 10%
Cash King Margin greater than 10%
Cash no less than 1.5 times total debt
Foolish Flow Ratio no greater than 1.25>

and

<At least one sustainable competitive advantage
Great management of unquestionable integrity
Expanding possibilities>

This is nothing more than a stock screen and a few qualitative things that a bunch of guys came up with in some meetings. There's no evidence whatsoever that it makes any sense as an approach to investing.

What if annual sales growth was 15% and gross margins were only 48%? Not a Rule Maker!

What if the company raises long-term debt at 6% (3.5% to 4% after tax), uses its working capital efficiently and holds minimal amounts of cash? Not a Rule Maker! But if they held onto a wad of cash instead of buying back shares with excess cash they could become a Rule Maker!

What if a retailer with a low cost model like Costco generates high turnover per square foot but net margins less than 10%? Their gross margins are barely 10%! Not even close to being a Rule Maker!

Rule Breakers and Rule Makers are cute marketing slogans that helped sell books, but that's about it. The RB and RM portfolio managers implicitly acknowledge this when they buy stocks that they acknowledge don't meet all the criteria.>

After checking off all these criteria, there were absolutely no valuation parameters to determine what to pay for a stock. If a stock meets RM requirements, buy it any price. Because as Tom Gardner said, business quality is fully 100 times more important than valuation.

And then when the portfolio tanks shut it down, start over with a clean slate, and talk about how much Tom's picks are up year to date.

I'm sure if a Wise mutual fund company had done similar things a few years back you guys wouldn't have made a peep.
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No. of Recommendations: 14
Atlanta Don, I understand your skepticism. I'm sure, on some level, you favor an economist like Keynes. You may not have loved all this thinking, but at least this simple quote. When asked after a speech why he had directly contradicted precisely what he had spoken about just a year previous, Keynes replied, "When I realize I'm wrong, I change my mind. What do you do?"

In the case of the Rule Maker portfolio, if you really consider what happened, you'll see that in fact we did select -- almost without exception -- great businesses. The companies have survived, many of them are turning around, some never needed to turnaround. The FLAW however was in underrating valuation. I was wrong. So what did I do? I changed my mind. What would you do?

The net result is Stock Advisor, a newsletter in which I have very clearly a) confessed to my prior mistakes, b) outlined a detailed approach, c) held myself completely accountable, d) beaten the stock market by 19 percentage points per selection based on Graham-Doddsville thinking.

I understood when I got into public money management -- something that many a great money manager thinks is hell on earth -- that I would make mistakes and have to live up to them. I think I have and continue to. But that does not, and should not (I don't think), lock me into never investing again. That mentality would have shut down Benjamin Graham permanently in the early 1930s, when terrible blunders using margin destroyed his finances. Instead of whimpering and hiding, Graham worked through every one of his mistakes, methodically, and went on to teach some of the world's greatest 20th century investors.

I will not be Benjamin Graham. But I can be honest, hard working, self-critical, methodical, and ambitious as well. . and perhaps I'll someday earn the scraps of Graham's table. I think he would want me to try.

Tom Gardner, Fool
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Hello TMFBogey, TMFTomG & AtlantaDon

TMFBogey I hope you do realize that AtlantaDon is one of the most value adding posters of the boards, especially about stocks which is the major purpose of the site anyway. I find your comments about him not wanting to be productive, at least unfair. He is among the posters who give much more than what they receive, unlike the majority of the posters (myself included) who are rather on the opposite side of the spectrum. It is not the first time that I notice (not by you I am talking in general) what I would describe as unnecessary comments about him. In another board he tried (along with a few others) to explain (in great details I might add) some weaknesses of a company's stock and instead of receiving a "thanks" or at least be ignored if people were not valuing his comments, couple of clearly clueless posters not only told him stuff like "go away" etc but also went a step further implying that he had "dirty" motives for his critical remarks (talks the stock down because he is short etc). I realize that such situations are considered "normal" when people talk about money, however I believe it would not hurt the TMF to somehow "protect" posters of Don's quality. I also would expect from all TMF people to be able to understand his quality.

Besides the above I think there is a flaw in the logic "Where's your real-money portfolio? Where's your philosophy?", without even mentioning the copyright issue. Let's say that his philosophy is wrong/silly/stupid/whatever, let's assume he believes in astrology for selecting investements. How this makes his critics on a specific subject -RM RB in this case- wrong or right? He pointed out concrete remarks about what he disliked in those portfolios, this should be enough without the need for him or anyone to explain his own philosophy.
Speaking of productive and constructive criticism, after having followed his posts for over a year, I consider him among those people who clearly explain why they say something.

Now let's come to TMFTomG's post. First of all allow me the cheap shot on my part that the line "I made a mistake, I recognize it, I correct it" is different than the previous posts of TMFBogey. I am well aware that TMF has not a "single voice", TMFers post personal opinions on those boards etc, eventually I approve this policy, on the other hand it should not be surprising when two people from TMF see differently the same issue for AtlantaDon or me or anyone to also have a different point of view. I say this because the first posts by Bogey were giving me the impression that he considered Don's post as coming out from another galaxy.
Second and more important, I appreciate what TMFTomG says about making a mistake. Personally it is first time I see it in such an open way by him. Still though I have some critics. Those are meant in general and I apply them to myself. I see two problems in the situation: Problem one is that saying out loud "I made a mistake" is a necessary but not the only step towards the right direction. It is important to recognize the reasons for the mistake, to find out how can you avoid it in the future. Else the "I made a mistake" motto looks more like an excuse than a confession. Problem two is one of persuasion, namely when a mistake has occurred I will be less confident to follow you in the future; it is your task to persuade me to do so and it is not an easy task. The burden of proof. It is up to you to prove that you are right and not me (or Don or Mickey Mouse) the one who needs to prove that you are wrong.
From the second part of your answer I am not sure you are on the right path but I believe you have the potential to arrive there. I do not see any correlation with Graham to be specific. And I mean the marketing tools not the stock picking methods. Even if it really exists, you should not have mentioned it. I do not expect nor want you to go in a process of "public humiliation for past mistakes", I do not know what to say about better disclosure versus the marketing needs and your legitimate wish for profits through the business, I really wish you can make billions of dollars but I would honestly suggest a little more humbleness (modesty) regarding the promotion texts.

If you had missed it when I had said it, I first read The Motley Fool back around the end of 1995 and I am thankful to both of you (Gardner brothers) for launching this site. I never invested on stocks till the beginning of 2002 and (unfortunately) I had never bothered to read the boards till the end of 2001 (my initial reason to read the boards was to ask a question about discount brokers who accept non resident aliens... stupid enough like I was I had never considered reading internet boards to find information about stocks). You have created a useful site and this is not an easy achievement, however the boards are by far in my opinion your most useful asset and you should go out of your way to retain, honour and protect posters like AtlantaDon. They are real gems and even when they criticize you (unfairly in your opnion) they deserve your total attention.

best regards
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No. of Recommendations: 1
smyr,

Thanks for your note. I rec'd your post because I agree with you that Don is one of the best posters on the site. He's been a great contributor for some time now and I wouldn't want to lose him.

Best,

Bogey
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No. of Recommendations: 7
smyr,

What a wonderful post. Thank you for sharing thoughts which make practical sense. I value your participation here -- and, of course, having read Atlanta Don's posts for years, I certainly value his contributions.

I must start by saying that this is certainly not the first time I've said, wow, I got it 50% wrong with the Rule Maker portfolio. I'm sorry that Atlanta Don sees the criteria as utterly useless. I think that's a dramatic overstatement. But, hey, free market and open community.

What went wrong in the Rule Maker Portfolio is two things. First, it did not include valuation criteria. As Graham made the mistake of using margin to a troubling extreme early in his life, I made the mistake of not valuing the businesses I was considering for investment. Valuation is certainly not a cornerstone of the work of Philip Fisher. And Charlie Munger has said (paraphrase): "If you get the right business, the price should take care of itself." (from Outstanding Investor Digest)

I took comments like that to an extreme, unfortunately. I've certainly not shied away from confessing this.

The second mistake is that I applied all this thinking exclusively to large-capitalization growth companies -- a universe of stocks that over long periods have not done all that well. Mind you, Microsoft and Pfizer aren't about to fall to pieces. However, far more opportunity exists for small investors down among the smaller and less familiar ventures.

I have certainly shared these ideas here, on our radio show, in speeches, and in Motley Fool Stock Advisor. I don't mind saying, "I was missing critical pieces of the investment puzzle." The question then is, can you go back and methodically correct your errors.

Having spent the last two years of my life deep in books, and having reviewed each decision in my equities investment career (good and bad), looking for flaws to my logic, and having added valuation as a primary component, I think I've gone a long way toward correcting my errors.

In the end, we'll just let the market speak. As of today, Stock Advisor is one of the fastest growing stock newsletters in history. Whoop-tee-doo. The real question is, "Are people renewing?" Right now, we are showing some of the highest renewal rates for a first year business in the history of the business. I suspect Hidden Gems -- looking for unknown companies and carefully pricing them -- will grow rapidly and feature high renewals.

Why? Because the product concept is sound and because, as is the case for the first Hidden Gem recommendation, I turned over 200 company-rocks before selecting 1 for recommendation. I am doing the work, believing that, at the very least, 49 out of 50 companies are not worthy.

Of course I will make mistakes from here. And I will be completely transparent about them. Right now, my 15 Stock Advisor selections are up 24.89% versus S&P 500 returns of 5.95%. If I was taking high risk gambles on hype stocks, I'd frankly be a little anxious about those returns. If I wasn't valuing businesses, one by one, I'd be anxious about those returns. But today 12 of my 15 selections are beating the market, and often by a wide margin.

And I think I can explain, in detail, and with sound logic, why I recommended a company like Affiliated Managers Group, which has risen 38.8% since my August recommendation (and I'm not just hand-selecting one winner). This is a fine business that owns Tweedy Browne among other great management firms. And the executives focus on, report, and dole incentives out based upon *cash earnings* (their term for a more sophisticated definition of free cash flow).

If I turn over enough rocks, find companies with superstrong financials (cf, Marty Whitman's "A Balanced Approach"), price them carefully, focus on capital preservation, and give the investments time to perform, I think I'll continue beating the market. If that happens, and if members learn right along with me, I suspect Stock Advisor and Hidden Gems will feature industry-high bases of membership and industry-high renewal rates. It would be great to count you among the members. If not, of course, I wish you the best on your investments.

Foolish regards,

Tom Gardner
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No. of Recommendations: 14
TomG, I'm glad your approach to investing has evolved. I think most all of us evolve our approach as we learn. I'm glad to see you'll no longer be telling beginning investors that valuation basically doesn't matter. There are a number of us on this site that tried to pass on that information a few years ago and were basically mocked by David for it.

Do you think a change in your approach makes it ethical to essentially throw out your past investing track record and continually emphasize only your recent returns? Are your recent returns the result of your changed approach or the return of a speculative market, or perhaps some of both? On a YTD basis, as Fred Hickey of the High-Tech Strategist points out in his most recent newsletter, the more speculative the index the more it is up:

Dow +8%, S&P 500 +12%, Nasdaq composite +22%, Morgan Stanley High Tech Index +31%, the SOXX (semiconductor index) +36%, BTK biotech index +37%, the Street.com Internet index +45%.

Your approach may have changed radically, but the last time I remember you and David boasting about returns was in the last bubble and now that we're in a mini-bubble (in my opinion), here it is again.

I don't come on this site to see what you and David are doing or to go after you. But you can't come on this site without getting hit over the head with what I find to be offensive marketing, and I raised the issue on the Improve the Fool board. You guys have regularly hammered Wall Street, the mutual fund industry, the financial press and money managers and assumed the higher moral ground for yourself. Yet I don't think it's too strong a word to describe your advertising as sleazy. Dave's stocks are up x%, Tom's stocks are up y% in the last year. You selectively discuss your best picks with 20-20 hindsight, which violates the advertising rules in the SEC's 1940 Investment Company Act. And Bogey's response was basically that you don't have to comply with that act from a legal standpoint and selling newsletters takes precedent over higher than necessary standards. Or maybe if I thought your advertising was out of line I could write some to replace it. And the fact that I didn't means I'm not helpful. It's outrageous.

A TMF article yesterday advised against hiring a money manager because most don't beat the market. Tom, my guess is that when your entire track record is put together you haven't beat the market. But those who come onto your site are greeted by a half page banner that says "Tom Gardner is at it again". At what again?

Basically, the message of TMF is "TMF Good, Other Financial Services Bad". The integrity of everybody else is in question, but not TMF's. Anybody that isn't doing it exactly as you're doing it is "Wise", even if what you're doing is constantly changing. I point out two quotes from David Gardner that directly contradict each other and a TMF staffer acts like I can't read.

Please, just get off the soapbox. Given your own practices, you don't have the standing to criticize money managers that don't beat the market, or mutual fund companies that bury bad performance records by merging losing funds into larger ones. You guys are one more financial services company hawking products.

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No. of Recommendations: 2
And Bogey's response was basically that you don't have to comply with that act from a legal standpoint and selling newsletters takes precedent over higher than necessary standards. Or maybe if I thought your advertising was out of line I could write some to replace it. And the fact that I didn't means I'm not helpful. It's outrageous.

Don,

I was trying to share with you an economic reality. It's next to impossible to sell a newsletter without somehow describing the benefits of the product. The primary benefit for purchasers is performance. Why buy a newsletter whose ideas aren't very good?

If we have to decide between going above and beyond the law and selling very few newsletters or abiding by the law and having a robust business, which would you choose?

My comments about coming up with a campaign that abides by the 1940 Act and sells a lot of subscriptions was genuine. If we could do that, we would. I threw it out to the community who was criticising the marketing of the product because obviously we have not been able to come up with it and I simultaneously wanted to give you the opportunity to generate even some small idea and also demonstrate how difficult what you were asking us to do actually is.

Anyway, this thread is going on too long. As I said to the previous poster, I think you're a great contributor, even if I don't always agree with you. Thanks for the thread.

Best,

Bogey
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No. of Recommendations: 8
Don,

Thanks for your thoughts. Couple of replies.

1. If you netted out my lifetime performance as an investor, you would find very substantial market outperformance. Much of this would be courtesy of an investment in America Online back in 1994. But the whole enchilada would be significant outperformance.

2. If you netted out David's investment performance -- short, intermediate, and long term -- you would find massive market outperformance. The Rule Breaker portfolio was a smash success, all told. David's Stock Advisor recommendations are up 49.6% over the past 15 months. I don't suspect his New York Stock Exchange selections -- Marvel, Martha Stewart, Hasbro, Federal Express, Tenet Healthcare, Charles Schwab, and America Online grade out as highly-speculating Nasdaq runners.

3. In my group of businesses, you will not find one high-flying speculative business. That is, unless you consider Moody's, Mid-Atlantic Medical, Borg Warner, Costco, First Health Group, Sanderson Farms, and a recommended sell of Whole Foods at $61.46 as frightfully Nasdaq-like to the extreme. I'll leave that up to you.

4. If you net out just the real-money portfolios online that we ran -- and all of them -- you will find market outperformance. If you net out the two newsletters right now, you will find in excess of 37% returns versus S&P returns of 5.95%.

5. In principle, I do have a problem with management firms that charge 1.5-2.0% to manage money and consistently lose to the market. I don't take moral issue. We live in a free country. If you want to smoke marijuana, sleep til 1pm, and invest in an underperforming mutual funds, I say, "Hey, live it up." However, were I to counsel an individual investor with funds that they'd like to protect and expand. . I would have no problem saying,

"Read Intelligent Investor. Allocate a good portion of capital to Vanguard's Index Fund. Allocate capital to some of the funds in the Affiliated Manger's Group family (Third Avenue, Tweedy Browne). Spend $100 -- an achoo of a fee in financial services -- to subscribe to the Gardners newsletter and learn to evaluate and invest in individual companies."

You may find that to be disgustingly flawed. I think it's a pretty good plan for most investors, primarily those with capital to preserve and grow into and through their retirement. It doesn't come from a soapbox. It doesn't come from a high horse. It's just a plan that I think is better than average.

Foolish best,

Tom Gardner
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No. of Recommendations: 8
<If we have to decide between going above and beyond the law and selling very few newsletters or abiding by the law and having a robust business, which would you choose?>

That's an easy question. If I was trying to build a reputation for high ethical standards and a long-term approach to investing, it would be the former. Why not get rich slowly in a sustainable way instead of trying to do it in a hurry at the risk of your reputation?

Think about the implications of your question in a different situation. Say you're considering investing in a company and internally, the CFO is speaking to the CEO:

"If we adhere to the spirit of the accounting standards, we'll report $.40/share this quarter. But if we apply the accounting standards aggressively, though legally, we could report $.50/share. That would cause a big pop in our stock."

Which do you think they should do? Do you think it will become apparent over time which philosophy they abide by, and does that have an implication about the long-term success of their business? Will it influence employee retention and how people feel about working there?
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No. of Recommendations: 2
But if we apply the accounting standards aggressively, though legally, we could report $.50/share.

Don,

The examples aren't quite the same, are they? In one, you're asking us to do far more than the law requires. In other words, you're suggesting we be ultra-conservative in our marketing approach whereas the CFO is suggesting the company be ultra-aggressive.

When it comes to financial management, I'm a fan of underpromise and overdeliver, so I'd always opt for the company to be normal or conservative in their accounting.

On the newsletter side, I'm tossing it out there to you that if you don't talk about performance in the newsletter industry, you'll have almost no subscriber base at all. That's not building the business slowly, that's not building it at all.

So, if you're going to play in the newsletter sandbox, you need to talk performance. So long as we're talking about total performance in the numbers, I'm okay with talking performance.

Whether or not the Fool should be playing in the newsletter sandbox at all is a different discussion. I think it's fine so long as you're upfront about performance, etc.

None of this is to say that the Fool hasn't screwed up in marketing over the years. We absolutely have. "Crush the Market in 15 Minutes a Year" is the prime example. We'll make mistakes in the future too. All I care about now, and all I've ever cared about, is that we're up front with performance and consumers can make an informed decision about our products. I believe we provide a better service than most out there.

Best,

Bogey


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No. of Recommendations: 0
Kevian,

Others have answered, but I'll add my thoughts to your questions:

1) You do need to apply to make your brokerage account "options qualified," if you're interested in using options. That's almost surely why you were not allowed to make any trade.

This said, I believe you should do much, more more reading on the topic and make "paper" investments long before doing the real deal. (And selling puts on Martha Stewart is an interesting idea -- a low-priced stock offering decent premiums. The risks are obviously high today, though.)

2) Taxes are much different for options than stocks. When you sell (or write) puts, it counts as immediate income, for example. They're complex and you'll need help.

Again, options are not for most, but are a tool I've found to like (only after about 15 years of investing in stocks, I might add).

Fool on,

Jeff
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No. of Recommendations: 7
<2) Taxes are much different for options than stocks. When you sell (or write) puts, it counts as immediate income, for example. They're complex and you'll need help.>

That's incorrect. Just like the proceeds from a short sale of a stock, you're not taxed on the proceeds of the short sale of an option until the short option position is closed out in one of the following ways:

1. You buy the option back to close the short position, and you have a taxable gain or loss in the year of the closing transaction.
2. The option expires worthless, and the premium you received becomes taxable for the year the option expired.
3. You are assigned the shares on the options you've written, in which case your cost basis in the stock is reduced by the premium you received when you wrote the option.
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No. of Recommendations: 8
Sorry, I hadn't noticed this thread had continued.

For what it's worth, Don, I don't agree with your interpretation of David's statements. It seems clear to me that the first quote:

<Price per share really doesn't matter, and many investors are badly misled by their belief that low-priced stocks are good, and high-priced are not.

refers to something so dumb you're probably having trouble conceptualizing it -- the idea that a $1 stock is good because it's so "cheap" (after all, it's only $1), compared to a $25 stock which is "expensive" (25 times as much). I remember when I first read David's "Twinkies" article (from which I quoted), I had a bit of trouble accepting that anyone could really think that way, or that David could feel the need to make this mind-numbingly obvious point. But in a world of people who are relatively financially ignorant, there will be ones who do think a $1 stock is "cheaper" than a $25 one, and I'm sure the Gardners, being out in the public eye, encounter them. I can see why you would have had trouble believing anyone would have such a silly misconception, but there are those who do.

As to the second quote:

Readers of our Motley Fool Investment Guide know that one investment strategy we have championed for 10 years now is to look for promising and mainstream small-cap stocks that trade in the single digits per share, because they are simply off Wall Street's radar. Wall Street defaults to stocks trading in excess of $10 per share.

This means what it says it means, they are looking for small cap stocks off that don't get Wall Street's attention. While I think that it is incorrect to describe it as they have done (you can be small cap and be over $10/share, and there is plenty of trading activity in sub-$10 stocks, even by institutions), I can see that the above quoted statement is not in contradiction to the first one.

I'm willing to take off after the Fool when they're wrong or contradict themselves, but I don't think this is one of those times.

UsuallyReasonable
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refers to something so dumb you're probably having trouble conceptualizing it -- the idea that a $1 stock is good because it's so "cheap" (after all, it's only $1), compared to a $25 stock which is "expensive" (25 times as much)

Hi UR,

Here, here!

I have 2 colleagues at work who have been investing for several years & they often ask me what compaies I'm interested in. The next question invariably is what price are the shares and just as invariably anything with a relatively high share price is met with "that's too expensive for me!"

These 2 have degrees & professional mariner qualifications and do not lack intelligence or math skills. It doesn't matter how many times I explain that one BRK.B at $2400 is the same cost as 100 MSFT at $24 (valuation hasn't come into into the argument), they nod their heads in understanding and still buy stocks that are "cheap" in per share price. In fact to one of them the $24 for MSFT would be "expensive"

I find it hard to believe and these guys aren't even newbies.

Regards
Philip
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No. of Recommendations: 0
...In fact to one of them the $24 for MSFT would be "expensive"


Sad to say, 6-years ago I felt the same way. Many of my co-workers more experienced with stock than I still feel that way.

I guess it's fair to say stock splits to the rescue.

TB
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