Option Investor


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Hedge funds seem to get blamed for everything. Their buy programs drive the market up artificially. Their aggressive selling in the last half hour of the day wipe out billions of value of long term investor holdings. Plus, many resent hedge fund managers because they can make outrageous amounts of money.

According to the reports, there may be fewer hedge fund managers (and hedge funds) to resent in the future. Why? Because the hedge funds are closing at an unprecedented rate. They have taken a huge hit in the last few months and their investors have been clamoring for their money.

Typically, hedge funds don’t keep a lot of spare cash lying around. There’s not much there for a rainy day. Their dollars don’t make them money sitting in the bank. Managing can only generate significant profits if they put the money to work. The advantage hedge funds have over mutual funds is that they are allowed to use more aggressive strategies. That’s why, under normal circumstances, they have the potential for higher profits.

Hedge funds are different from other investment vehicles inasmuch as the managers are paid on a percentage of the profits – a substantial percentage. Twenty percent of the profits plus a 2% management fee is typical for the industry.

Well, as we all know, it’s been raining losses. Actually, it’s been pouring. Hedge fund positions (and dollars) have been circling the bowl and disappearing into oblivion. In addition to a large percentage of regular investors bailing out of positions, hedge fund investors have been calling up the managers and demanding their money – or what’s left of it.

The only way hedge funds can satisfy the redemption demands is to sell stocks – even if it’s stock in good companies. They have no choice. They have to generate the cash. This selling just keeps driving the prices down further and further.

Now, to understand why hedge funds are closing, you need to understand their method of profit calculations. They use what is called a “high water mark.” Let’s say you invest $10,000 in a hedge fund. If the hedge fund generates a $2,000 profit, the fund gets 20% of the $2,000 which is $400. The hedge fund has now established a new high water mark of $12,000.

For the fund to make money, it has to generate more profits. It will get paid only on profits over the new high water market of $12,000. Herein lies the current problem. What happens if the hedge fund loses a large portion of its value?

If the fund, for whatever reason, loses one-third of it’s value, it now has a value of only $8,000. The high-water mark is still at $12,000. That means the fund can’t make any money until it makes back the $4,000 to get to the $12,000 high water mark.

Many funds are looking at months, even years, to make it back to the position where they can make money on profits. It’s a lot easier to close the fund and return the remaining money to its investors. Then, the same managers can open up a new hedge fund. The high water mark starts anew with the new fund and the managers are now in a position to make money again on profits they may generate.

Of course, this is all contingent on them being able to find investors with hopes of accelerated profits. But, just as there’s never a shortage of gamblers in Las Vegas, new investors won’t be hard to find. Hedge funds, especially funds with managers having a respectable track record, will find willing participants.

And the cycle begins again.

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CPTI NOVEMBER Position #1 - RUT Bull Put Spread – 537.52
On 10/15, with the RUT at about 436, we sold 20 RUT November 390 puts and bought 20 RUT November 380 puts for a credit of $.80 ($1,600). Maintenance is $20,000.

CPTI NOVEMBER Position #2 - RUT Bull Put Spread – 537.52
On 10/16, with the RUT at about 480, we sold 20 RUT November 360 puts and bought 20 RUT November 350 puts for a credit of $.80 ($1,600). Maintenance is $20,000.

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In the past, I outlined a strategy based on an initial investment of $100,000. At that time, $74,000 was spent on zero coupon bonds maturing in about seven years at a value of $100,000. The principal $100,000 investment is guaranteed. We're trading the remaining $26,000 to generate a "risk free" return on the original investment. We are not compounding our profits by dramatically increasing the number of contracts we trade. With the September profits, our new cash total is $66,440 ($64,220 + $2,100).

ZERO PLUS POSITION – RUT Bull Put Spread – 537.52
On 10/16. we sold 30 of the November 360 bull put spreads and bought 30 of the November RUT 350 spreads for a credit of $.80 ($2,400).

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Couch Potato Trader Disclaimer All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies.

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