November 2010

Stansberrys

Investment Advisory
The Stock Quitters Secret

The Stock Quitters Secret

By Porter Stansberry

Think back to October 2008... Stocks had just suffered a historic fall. On October 10, the Dow Jones Industrial Average closed one of its worst weekly losses of all time 15.1%. Panic tore through investors... The Chicago Board Options Exchange Volatility Index a measure of fear in the market reached unprecedented highs. Of course, wise investors... those who understand how to value securities... knew theyd simply never see a better time to bloat their portfolios with cheap stocks. Investors ready with cash could load up on the safe, industrial stalwarts that comprise the Dow... GE, Johnson & Johnson, DuPont, IBM, American Express... And the market rewarded their fearlessness with negative balances. In the nearly six months following the panicked fall of 2008, the Dow headed straight down, bottoming in mid-March (at around 6,440) before ebbing upward. Stock investments made during that stretch might one day pan out for investors with the patience to wait for the market to recognize their wisdom. But its impossible to know when that will happen. And few investors have the bull-headed certainty in their decisions to hold out forever. Most will lose faith and cash out at a loss. Meanwhile, one group of investors actually saw its capital grow during this period when all others were losing theirs... During the same six months when the market fell 16.5%, investors following this strategy folks Im calling stock quitters watched their positions grow an average 44% every 90 days an annualized rate of more than 178%. These investors werent lucky gamblers, the kind who kick over that one-in-a-million penny stock just before its shares explode. These stock quitters were following a sound strategy that used rampant fear in the marketplace to generate cash upfront for their investments. Ive written this report to show you exactly how these investors generated such remarkable profits during a historic market slump... More important, when the looming currency crisis reaches full bloom, fear will rip through the stock market once again. You can use this strategy to make safe double- and triple-digit gains without owning stocks. Let me show you how its done...

The Safest Income Youll Ever Make

The stock quitters strategy is more commonly called selling short-term put options or naked put selling...

Many people think of naked put selling as wildly risky... almost disreputable. Nothing could be farther from the truth. The fact is most people misunderstand and misuse the strategy. Done right, its the safest, most profitable income-generating strategy around. You can easily return more than 50% in a year, while putting little capital at risk and never owning shares of stock. Selling puts is a strategy in which you basically get paid for agreeing to buy a stock at a specified price at some point in the future. Its like youre insuring shares held by someone else... A panicky investor wants to know he can sell his shares at a set price no matter how low they fall on the stock market. Youre selling him that insurance... Its a lot like buying and selling homeowners insurance... When you buy homeowners insurance, you essentially buy the right to sell your house back to the insurance company for an agreed on value under specific conditions (e.g. after catastrophic damage) for a limited period of time. By accepting your money, the insurance company has taken on an obligation to buy your house back under the same terms. The longer your policy has to run, the more the insurance company will charge you. A six-month policy costs less than a 12month policy. It works exactly the same way with put options. The longer its good for, the more it costs. When you sell puts, youre acting like the insurance company... If the stock declines (the house burns down), youll buy it at the bargain-basement price. If the stock doesnt decline to the agreed-upon price, then you keep the option premium as a profit (unlike the company that insures your home, well get all of our premium upfront).

A Brief Options Glossary

Underlying Instrument: The stock, stock index, or any other financial instrument that you have the right to buy and sell. Premium: The price of the option. Expiration Date: Options expire on the third Friday of the month. Exercise: When a put buyer exercises his option, he engages his right to sell the underlying instrument at the strike price. Strike Price: The price at which you can exercise your option. This price is based on the underlying instrument. When you sell a put option, you are required to buy shares at the strike price, if the buyer exercises his option. In the Money: Puts are in the money if the price of the underlying instrument is LOWER than the strike price. (A put with a $20 strike price is in the money with the stock at $19.) Out of the Money: Puts are out of the money if the price of the underlying instrument is HIGHER than the strike price. (A put with a strike price of $20 is out of the money if the stock is at $25.)

The key to selling puts safely and profitably is knowing exactly the real risks in owning a companys shares. Just like the insurance company needs to know the details of your home (square footage, upgrades or renovations, what you paid for it, any valuables you keep there, etc.), we need to assure ourselves the companies we sell puts on are fundamentally sound.

We wont insure just any stock. Were going to identify stocks we like and would want to own. Then, well insure them at a price they are unlikely to fall below. No matter what happens, we win. If the stock falls, we buy a stock we wanted to own at a great price. If the stock doesnt fall into our laps, we keep the insurance premium free and clear.

Heres how it works...

Two Key Points About Puts

Before you start selling puts, you need to understand two critical points about how they are traded: First, one option contract is good for 100 shares. Lets say you sell a put for $2 that has a strike price of $15. Youll get $200 upfront ($2 x 100 shares). Youll also be obligated to buy $1,500 worth of stock if the option is exercised. Two contracts would generate $400 and obligate you to buy $3,000 worth of stock. This is important to remember. Dont sell puts on more shares than youre willing to buy. If youre comfortable owning 100 shares, sell one contract. If youre comfortable owning 500 shares, sell five contracts. Second, your broker will want to make sure youre good for the stock purchase in case the shares are put to you. So hes going to require you keep a percentage of the potential obligation in an account with him. That percentage is called a margin requirement, and it usually equals about 20% (though it can vary among brokerages). If youre going to sell one put with a $15 strike price ($15 x 100 shares = $1,500 obligation), your broker will ask you put up about $300 ($3 per put) in margin. Of course, if the puts expire worthless, youll keep your margin... and the premium. That margin represents your capital at risk, and its how we calculate gains. So if you received $2 in premium upfront and put down $3 in margin, youll record a 67% gain if the options expire worthless.

An Outrageous Deal 72% in 12 Weeks

During October 2008, some Stansberry & Associates subscribers did very well selling puts on the worlds leading ratings agency, Moodys (NYSE: MCO)... At the time, all the major ratings agencies were under intense scrutiny for their role in the mortgage/credit collapse that devastated the economy... You see, during the mortgage bubble, firms like Moodys and Standard & Poors had rated mortgage securities as triple A which should never default even though they contained subprime mortgages. In retrospect, this was irresponsible, even stupid. But at the time, using the best computer models available, Moodys and other ratings agencies believed the default rates in these securities would be below the amount of capital set aside to protect the triple-A portions of these bundled securities. All the attention and criticism including predictable demagoguery from Congress was crushing Moodys stock price. The shares, which had traded for more than $73 in early 2007, were by October 2008 floundering around $20 a 72% drubbing. While the criticism of Moodys may have been warranted, the draconian selloff was not. Moodys is a 107-year-old company that provides ratings on fixed-income securities, debt instruments, and corporations. It covers 12,000 corporate issuers of debt and about 96,000 structured financial obligations, including things like mortgage-backed securities. It has offices in 22 countries and employs more than 3,000 people worldwide. There are two keys to understanding this business. First, its essentially impossible to issue debt without a rating from Moodys, and the issuer must pay for the rating. As a result, Moodys makes money both by selling information to subscribers and by selling ratings to debt issuers. Second, Moodys has a wide economic moat because of its sterling reputation and because the government regulates these firms. To issue a debt security, you

have to receive at least one rating (and typically two) from one of the nationally recognized ratings firms. Moodys and Standard & Poors are widely considered the two leading firms. We knew at the time Octobers storm would pass without hurting Moodys or the long-term quality of its brand. Businesses and governments would continue selling bonds, no matter how bad the economy got. And theyd need Moodys to rate those bonds. Moodys would not be replaced by some new government agency. So we could be confident Moodys was in no danger of going out of business. (Notably, rating a bond implies no guarantees or fiduciary obligations. People who lost money on mortgage bonds cannot sue Moodys.) And we knew this... In the preceding quarter during the worst underwriting period in memory Moodys still made more than $60 million in cash. It remained an incredibly profitable business (profit margins above 20%) that required almost no capital investment to grow. And Warren Buffett owned nearly 20% of the stock. Frankly, regardless of the credit mess, we knew Moodys remained one of the top 20 businesses in the world the kind of stock you hold forever. If youd bought MCO shares on the day I wrote about it (October 22, 2008), you would have made about 7% over the next 12 weeks as the shares traded essentially sideways (assuming you didnt get scared out of the position when it cratered around $15.56 in late November). That performance isnt terrible, given everything else that was going on in the market. But subscribers who followed my recommendation earned nearly 72% on their capital at risk over the same period... You see, in addition to beating down the share price of Moodys, the negative publicity drove up the premium investors could receive by selling the companys puts. Specifically, in mid-October, the Moodys January 2009 puts with a strike price of $15 traded for about $2.15. Selling that put would have given you $2.15 per option and obligated you to purchase MCO shares for $15 each if the stock traded that low by January 16, 2009 (the day the options expired). On October 22, I advised readers to take that deal. Specifically, I told them to: Sell the MCO January 2009 $15 put (MCOMC.X) for no less than $2. (In fact, most readers received closer to $2.15 per option).

Three Major Factors that Determine the Price of Options

1. Distance of the Strike Price from the Market Price: For out-ofthe-money options, the closer the market is to the options strike price (the closer the option is to being in the money), the more expensive the option will be. 2. Time Until Expiration: The longer an option has to work, the more expensive it will be. Extra time simply gives the stock more time to make the move. An option is known as a wasting asset. It loses value with the passage of time. 3. Volatility: The more volatile the stock, the more expensive the option will be. Because volatile stocks have greater potential for large price moves, theres a higher probability that an outof-the-money option will at some point be in the money.

At that point, the trade could have worked out in one of three ways: If MCO traded for more than $15 on January 16, 2009, the options would expire worthless. We would keep the $2.15 premium and have no more obligation to the stock a total win on our investment, without ever owning the stock. If the stock traded between $13.01 and $15, wed have to buy the stock at $15 a share. But since we would still keep the $2.15, we would be up on the position and holding a Tiffany stock at Zales prices. If the stock traded for $13 or less, wed have to buy the shares at $15, and wed be down on the position. This seemed highly unlikely since $13 represented a 36% discount from the stocks already oversold price... And even if the trade broke that way, wed be holding a world-class stock for 74% less than my estimate of the companys intrinsic value (which I calculate based on 20 times my estimate of the companys annual free cash flow). This was an outrageous deal for us. And it turned out as well as we could have hoped... On January 16, 2009, Moodys closed at $21.30 well above our strike price. We kept the $2.15 premium we received 12 weeks earlier, booking a 71.7% return on our $3 margin.

Almost No Way to Lose Money

The Moodys example also underscores the real beauty of selling puts... We dont have to be exactly right about how or when a stock will rebound... Many factors work in our favor, so even if the shares stagnate, well still profit. We dont have to be right about the stock price rising weve sold out-of-the-money options, so were safe as long as the stock doesnt completely tank. And we dont have to be right forever just for two or three months (our obligation to buy expires with the option). Selling puts gives us huge odds in our favor. Its, of course, possible to lose money on the deal. Every investment carries risk, and no one can predict the future. But selling puts generates income and, at the same time, hedges our investments by getting us much lower entry prices on any stocks we end up buying.

Call Your Broker

If youve never bought or sold puts before, ask your broker for help setting up any trades we make. And before trying to put on any trades, youll need to authorize your brokerage account for trading options. This is an easy process. Your broker can provide you a standardized options agreement. Simply sign the form, and your account should be approved immediately.

Selling insurance and collecting premiums is a much safer and higher-percentage speculation than simply buying stocks outright. In fact, if I do my job perfectly as an analyst, we shouldnt actually buy any stocks well simply collect premiums and earn about 50% on the capital were holding. All we have to do is be prepared

to buy if the time comes... And if we do end up converting one or two stocks, thats fine, too. Our entry prices will be so low we wont have much risk at all.

Published by Stansberry & Associates Investment Research. Stansberry & Associates welcomes comments or suggestions at feedback@stansberryresearch.com. This address is for feedback only. For questions about your account or to speak with customer service, call 888-261-2693 (U.S.) or 410-895-7964 (international) Monday-Friday, 9 a.m.-5 p.m. Eastern time. Or e-mail info@stansberrycustomerservice.com. Please note: The law prohibits us from giving personalized investment advice. 2010 Stansberry & Associates Investment Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Stansberry & Associates, 1217 Saint Paul Street, Baltimore, MD 21202 or www.stansberryresearch.com. Any brokers mentioned constitute a partial list of available brokers and is for your information only. Stansberry & Associates does not recommend or endorse any brokers, dealers, or investment advisors. Stansberry & Associates forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees of Stansberry & Associates (and affiliated companies) must wait 24 hours after an investment recommendation is published online or 72 hours after a direct mail publication is sent before acting on that recommendation. This work is based on SEC filings, current events, interviews, corporate press releases, and what weve learned as financial journalists. It may contain errors, and you shouldnt make any investment decision based solely on what you read here. Its your money and your responsibility.

Stansberrys Investment Advisory 1217 St. Paul Street Baltimore, MD 21202 1-888-261-2693