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Are You A "Millionaire" or "The Weakest Link\?"

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Are You A "Millionaire" or "The Weakest Link?"
by Mike Parnos, Investing With Attitude

During the bull market investors were playing "Who Wants To Be A Millionaire?" and were winning on a regular basis. It was a no-brainer. There was no need to phone a friend or even ask the audience.

When the market turned and it was time to actually use brains, the name of the game changed to "The Weakest Link" -- and we found out who the weakest links were.

Early in life, in kindergarten, children learn the art of finger painting. A piece of paper, a tube of blue, a tube of red, a smudge here, a smudge there and, before you know it, there's a masterpiece attached to a refrigerator door.

As children become "adults," they learn the time-honored tradition of not taking responsibility for much of anything. Instead of finger painting, the great American pastime has become finger "pointing."

Today, in our litigious society, people seek to fund their retirement with compensation from large corporations or insurance companies whenever anything goes wrong in their life. They don't search for remedies - they search for excuses.

A few years back a woman sued McDonalds when she spilled some coffee on her lap. She claimed the coffee was too hot. McDonalds caved in and gave her a nice chunk of money to go away as part of a nuisance settlement. She was a klutz with a coffee stain. Now she's a klutz with money.

For decades the tobacco industry has been deluged with lawsuits by those who foolishly ignored the Surgeon General's warning. This brought finger-pointing to a new level. It has become an art form as smokers try to place the blame on anyone handy - especially if the pockets are deep and the nuisance value is high enough. How does this pattern apply to recent stock market developments?

In the past few years, individual investors have lost trillions of dollars as the stock market declined. Those are a lot of zeroes and commas -- and a bitter pill to swallow. Nest eggs and retirement accounts evaporated a lot faster than they had been accumulated. Inexperienced investors had trusted their money to "financial professionals" to invest or tried on their own to jump on the money train before it derailed.

Individuals had to just suck it up and take responsibility for their own poor judgment of investments and/or advisors. Their fingers were poised to point, but had no specific direction.

But now, it appears the game may have changed. There are some deep pockets to go after. Let the games begin.

Not long ago, brokerage firm Merrill Lynch & Co. was sued by a former client who claimed he was misled by a bullish stock recommendation. Merrill Lynch agreed to pay Debases Kanjilal, a 46-year old pediatrician, $400,000 to settle a case filed with the New York Stock Exchange.

Kanjilal suffered a loss of $500,000 after having invested in Infonet, an Internet stock, based upon the buy recommendation of prominent technology analyst Henry Blodget.

Merrill Lynch's caving in may have opened Pandora's box. It's just what losing investors were looking for - someone else to blame. They now have a direction to point their finger. They may have found a way to be absolved of their own ignorance.

These same brokers and analysts were heroes when the market was skyrocketing and the profits piling up. In the midst of the euphoria, as a money manager, it was tough to be wrong.

Now it's the brokers, financial planners, analysts, accountants, and anyone who has ever voiced an opinion or generated a quarterly report are in the sights of securities attorneys - and no silencers are being used.

Ambulance chasers could become portfolio chasers. In the "slip and fall, give me a call" tradition, a former broker, Robert Magnan, has taken the torch and is championing the cause of losing investors everywhere. He portends to want to help recover losses.

However, Magnan has a cloudy past of his own. In 1997, as a broker, he pleaded guilty to five counts of securities fraud. He now maintains his current mission is to "make amends for my 10 years in the brokerage business."

He had a "backlog" of over 300 clients with a total of about $40 million in losses. Magnan, whose form employed 15 telemarketers, anticipates 6,085 new cases from his referral network of 13 lawyers. A case can probably be made against your neighborhood full service investment professionals. They sat idly by - not advising or explaining to clients, who didn't know any better, to either sell or how to insure their portfolios.

Maybe I've watched too many courtroom dramas, but the concept of "depraved indifference" -- usually applied to murder cases -- could logically be applied to the investment world.

To parallel the legal definition of "depraved indifference" - "Circumstances would indicate a depraved indifference to a portfolio of investments exists when one engages in conduct (a stock recommendation or an overlooked business expense) that creates a grave risk of loss to another person's portfolio and thereby causes substantial losses." Let the legal community chew on that for a while.

You can take responsibility for your finances -- or not. You can take responsibility for your life - or not. You can possibly become a millionaire or you can continue to be the weakest link. Remember, it's the weakest link that goes home with nothing.

Finger pointing is the highest form of weakness. When you choose to blame anyone but yourself for your problems, you ARE the weakest link.

Mike Parnos

Strategy Du Jour

It seems a number of readers are interested in pursuing their degree, so here's another strategy -- direct from the Couch Potato Trading Institute.

For those of you who watch cable, you may have seen the new series The Shield. It's the story of a rogue cop who, along with his special task force, operates both inside and outside the law to ultimately resolve situations and end up with something that occasionally approximates justice. The only thing that is predictable is that it is unpredictable. If 10 minutes of an episode go by without anything outrageous happening, you can bet that the next 10 minutes will be wild. Well, I like my stocks the same way - wild and unpredictable. And in the wonderful world of options, I discovered a way to take advantage of these situations with minimal risk. It's a variation of the Straddle.

What's the best part of using a Straddle? You don't have to pick a direction. If you know the direction a particular stock (or index) will move, you've probably been hiding under a desk at the FDA or know the same little voice that whispers in Martha Stewart's ear.

I don't hear voices and it's been awhile since I could fit under a desk, so, like you, I have to do a little homework. In true couch potato tradition, this can be easily done while watching a baseball game - a game in which they spend twice as much time scratching and spitting as playing.

First, we have to look for a stock that's current volatility is lower than its historical volatility. Maybe the stock has been consolidating for a while, has an upcoming earnings announcement or simply has a history of large spikes.

For example, Microsoft (MSFT) has been a bit of a sleeping giant, trading in the $50-$55 range since late April. On Tuesday, MSFT was trading at about $54.50. Looking out about three months, let's buy the October 55 put for $5.00 and the October 55 call for $5.20. We've invested a total of $10.20 in this straddle, but we're not risking $10.20. Why? Because we're going to hold the position for the maximum of a month. If, in four weeks, MSFT hasn't made a substantial move, we will exit the position.

The reason for selecting an option at least three months away is that, during the first month, there will be minimal erosion of premium - usually 15% or less. For this example, we'll use 15%.

Therefore, if we close out the MSFT position in a month, we'll actually be risking only 15% of the $10.20 - about $1.50. That's the worst-case scenario.

I like it when my risk is defined. Like I know that when I eat two Twinkies, the most weight I can gain is the actual weight of the Twinkies. For me, that's an acceptable risk.

The way we profit in our straddle position is that, when a major move occurs, the side of the straddle that is increasing will go up faster than the opposite side will go down.

If MSFT were to announce an earnings warning next week, it's not unrealistic to expect the stock to dip 5-7 points. If MSFT tanked by $5.00, the October 55 call could be worth about $8.10 and the October put could be worth about $3.00. The total is $11.10. Sudden major moves are usually accompanied by an increase in volatility and a subsequent increase in option premiums. So, it's likely that the $8.10 could turn into $8.25 and the $3.00 could be $3.10. Now, as we liquidate the position, we've taken in $11.35.

What did we pay to enter the position? $10.20. We've made the difference between $11.35 and $10.20 -- $1.15.

What did we risk? $1.50. Our return on our risk is 76.7% ($1.10 divided by $1.50).

Straddles are also functional in that they consist of the purchase of options and can be used by option traders who don't yet have trading approval to trade spreads.

This isn't an exact science and the above numbers are projections that are close enough to get the point across -- straddles, if put on selectively and treated with loving discipline, can be a couch potato's dream trade.

Ain't life sweet? What more could you ask for? A gourmet dinner, orchestra seats at the theater, a night of unbridled passion and a profitable trade. You can have it all. But, without the profitable trade, you probably might not be able to afford it. Your evening might consist a Gilligan's Island rerun, a TV dinner, and a response of "You've Got To Be Kidding".

P.S. At Thursday's close, the MSFT spread described above could have been closed for $11.00. MSFT only moved down two points, but the volatility of the entire market spiked - and option premiums went along for the ride. Liquidating at $11.00 would have provided an $.80 profit in three short days with virtually no time erosion exposure. Occasionally the market gives you a gift, but don't hold your breath waiting for the next one!

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