Saturday, February 28, 2009

Tough Question on Retirement Accounts

Let's look at a tough practice question early on a Saturday morning:

Which of the following are examples of tax-free withdrawals from a Traditional Individual Retirement Arrangement for an individual 52 years of age?
I. first-time purchase of a primary residence
II. certain medical expenses
III. certain educational expenses
IV. series of substantally equal periodic payments under IRS Rule 72t

D. none of the choices listed

Did you choose Answer C? No? Answer A? Maybe you saw the trap and chose the correct answer, which is Answer . . . D. None of the choices listed. See, the four Roman numerals given are examples of penalty-free withdrawals from an IRA, but, the more important concept is that withdrawals from your Traditional IRA are taxable. If they come out prior to age 59 1/2 they are also penalized, unless there is a provision allowing the individual to take out some money without paying that penalty. If you want to take up to $10,000 out of your IRA to buy your first residence, you will not be penalized; however, you will add the $10,000 to your taxable income for the year and pay your marginal tax rate on it. Same for the other three choices.
Not all questions are trick questions, but you need to look them over to make sure there is not a trick before proceeding.
If you would like more information on IRA's use the link below. If it doesn't work, click on the title of this post and then type in "publication 590" at the IRS website. I think the following link will take you right to the publication, though:

Thursday, February 26, 2009

Sales Charges and Operating Expenses

Sales charges and operating expenses are two different things . Sales charges are an extra fee added to the price of mutual fund shares when the investor purchases them. They go to the underwriter and the broker-dealers and agents in the distribution network. Sales charges cover the costs of printing the prospectus and other sales literature, sending it out in the mail, paying agents and broker-dealers to sell the shares, and doing all the advertising that we see in magazines and hear on the radio these days.
Do all funds have sales charges? No. The ones that do not impose sales charges are called "no load" funds. But, whether there is a "load" or not is one issue. The other issue is this: all mutual funds have operating expenses. Management fees cover the investment adviser who trades the portfolio. Accounting, legal, consulting, board of director and other expenses are usually lumped under "other expenses" in the prospectus. And, even though the fund calls itself "no load" it can still tack on another operating expense called a "12b-1 fee" that covers the costs of distributing/marketing the fund shares. The 12b-1 fee can not exceed .25% of the average net assets, but as long as it doesn't, the fund can call itself "no load."
So, not all funds have sales charges, but all funds impose operating expenses. Many people think they don't pay ongoing fees to hold their fund shares, but that' s because they don't get a bill. The fund just reaches into the big cash register and pulls out enough cash to cover the operating expenses mentioned above. Again, sales charges are not operating expenses. They are tacked onto the price of an A-share when the investor purchases or subtracted from the proceeds of a B-share when the investor sells. Either way, the fund takes out operating expenses along the way, including the management fee, the 12b-1 fee, and all "other expenses."

Tuesday, February 24, 2009

What is an investment account?

I was checking the balance on my little SIMPLE IRA this morning, and I noticed something that may help people studying for the Series 7. For some reason, the concept of "cash" in an investment account can be a little confusing, so let's end that confusion right now. Below, you can see the actual balances in my SIMPLE IRA account. What makes it a "SIMPLE IRA"? I simply follow the IRS rules for maximum annual contributions, I don't touch the money until I'm 59 1/2, and in exchange for that, I get to lower my tax burden now and let the money grow tax deferred until I finally take it out and pay my ordinary income rate on the withdrawals. That's between me and the IRS. Between me and TD Ameritrade, there is this investment account coded as a SIMPLE IRA, in which I deposit cash and then, at my leisure, buy securities. I make a monthly contribution of $875 into the SIMPLE IRA, which is why we see the first item "cash balance-$875." That check was just recently deposited, so it's sitting as "cash". It will soon be "swept" into the next item, "money market," where it will at least earn some interest while I wait to get up enough courage to buy more stock. The stock I've already purchased over the past few years is worth about $16,000 right now, bringing the total account value to about $28,000. Why am I so imprecise with the stock value and, therefore, the total account value? Because in the time it takes to type each sentence, the value of the stocks and, therefore, the total account changes. This is not a bank account, people.

Cash balance

Money market ¹

Long stock value

Account value

If I follow the footnotes, I see an excellent explanation by TD Ameritrade of what this "cash" and "money market" stuff is all about. Here is how they put it when explaining "money market":
This is the interest- or dividend-earning cash you hold in a sweep vehicle; this money can be withdrawn or used to buy securities. Your money market balance also includes accrued interest that will be paid at month-end.

SIPC covers a certain amount of "cash" in an investment account. Once the cash is "swept" into a money market reserve account, it's a security, and it earns a little bit of interest while the investor decides which stocks, bonds, or mutual funds to buy with it. I've certainly never sat around with such a huge cash percentage, but with home values still falling, and huge banks still teetering on bankruptcy, I'm just not willing to commit to any stocks or bonds just now. But, I can't sit on "cash" or "money market" securities forever--if I do that, I'll never build up a retirement nest egg. Through monthly deposits and--we hope--some capital appreciation, I hope to bring this account value up by a factor of 10. That might happen through some good bond investments, but I'm still betting on the need to buy stocks for the long haul. Luckily, while I wait for the economy to cooperate with my investment goals, I'm sitting on "cash" and "money market" balances that TD Ameritrade is responsible for.

As with most things related to the Series 7--this is not rocket science. It just takes some time to understand what's going on. Only at that point can you really do well on an exam question about SIPC or "cash" balances.

Margin Accounts

Anyone who bought a house back before the bubble burst has a pretty good model for how margin accounts work. Let's say there was this house going for $300,000 that you simply had to buy. Of course, like most home buyers, you had very little actual money to use toward the purchase, so you found a financial firm interested in spotting you, say, 90% of the property's value. You filled out some credit information to get the loan, and pretty soon you were putting down $30,000, with the lender cutting a check to the seller for the other $270,000.
Believe it or not, you were using what the exam calls "leverage." Leverage involves borrowing money in order to increase your potential returns. So, at the outset, your property was worth $300,000 and you owed $270,000. The difference between what you own and owe is your equity, which at the beginning was $30,000.
$300,000 market value
$270,000 balance owed
$ 30,000 equity

At the beginning, your equity is just the cash you put down to buy the property. Let's say that one year later, you get an appraisal stating that the home is now worth $350,000. You've paid down some of the principal balance by overpaying the monthly mortgage payment, so the balance owed is now just $250,000. If we run the numbers again, we see some good news:
$350,000 market value
$250,000 balance owed
$100,000 equity

On paper, you're up $70,000. Talk about leverage, huh? You risked only $30,000 and, at least on paper, you're sitting on a capital gain of over 200%! You could either try to sell the house for a fast capital gain, or you could borrow against this $100,000 of "equity" in order to re-do the kitchen and bathroom. What happens if you borrow $70,000 of your equity, and then home values start to fall in your area? You're in trouble, as we see from the numbers:
$300,000 market value
$320,000 balance owed
$ -20,000 equity

Talk about being "underwater," huh? So, using leverage to speculate on house prices was a lot of fun while it lasted. As soon as the market turns against you, though, the pain sets in.

In a margin account, customers buy stocks and bonds with borrowed money, as well. With the Federal Reserve Board's Reg T requirement at 50%, customers put down 1/2 the current value, with the broker-dealer financing the other half. The broker-dealer will earn interest on the margin loan, and--just like a mortgage lender--they will foreclose, so to speak, on your property if its value begins to plummet. Let's say you wanted to buy 10,000 shares of LMNO, a company developing a new glow-in-the-dark alphabet soup for kids. The stock trades for $30 a share, so you put down $150,000, and the broker-dealer spots you the other $150,000. You start out like this:
$300,000 market value
$150,000 balance owed
$150,000 equity

As with the house, the equity at the beginning is just the cash you put down. Luckily, LMNO gets mentioned by a raving, spitting, lunatic stock jockey on CNBC the next day, sending it up to $47 a share. Check out your increased equity suddenly:
$470,000 market value
$150,000 balance owed
$320,000 equity

Imagine making $170,000 that fast on $150,000! Leverage is awesome, as long as the lever swings in your favor. You could sell and walk away with a fast profit, or you could do what you did when the house value rose--you could borrow against your equity. On a $470,000 stock position, Reg T is $235,000. Any equity above that can be played with. So, you have $320,000 in equity, which is "excess equity" of $85,000. Believe it or not, you could tell the broker-dealer to cut you a check for $85,000 right now, and they will simply tack it onto the debit balance that you owe them. Or--and I swear this is true--you could buy $170,000 worth of stock. Remember that "SMA" is the $85,000 you can borrow cash-money; your buying power is exactly twice that amount, or $170,000. Let's say you use your buying power just like a homeowner putting a big, unnecessary addition onto a 4,000 square-foot home. You buy the $170,000 of stock and your account looks like this now:
$640,000 market value
$320,000 debit balance owed
$320,000 equity

As you can see, clearly you are now rich. You should probably start looking at properties in Florida, Texas, Arizona, or whichever sunny paradise you will be retiring to in just a few short months. You might even want to start drafting the snarky letter of resignation in which you call your supervisor an inferior, bald-headed, suck-up. But then--no, this can't be right--suddenly LMNO is in the news because of a product re-call. Apparently, the factory in Georgia that supplied the glow-in-the-dark coloring agent was infested with rats and roaches, forcing over 300 kids to become violently ill all across the country. Will the company be able to avoid bankruptcy? Maybe. But the stock is now trading for $11. But, but, you owe a lot more than what the stock is worth! Yes, you do. And that means you can either send in a bunch of cash to pay down the debit balance, or the broker-dealer can sell the stock (just like a foreclosure) and use the proceeds to pay some of what you owe.
So, margin accounts are not so different from mortgages. You put down a percentage of the property's value and pay interest on the loan that finances the rest of the purchase. As long as the property's value is rising, your equity is increasing, and you can borrow against that equity. But, if you max out all your borrowing power, and then the property starts dropping in value, well, that's when the creditor starts leaning on you for cash. Pay up now, or we'll have to sell the property.

Sunday, February 22, 2009

Buy Stops, Buy Limits

So, I guess I have to follow that last post with a discussion of buy-stop and buy-limit orders. Let's say you've been watching Starbucks lately. It last traded at $9.58 on Friday, so for whatever reason this price intrigues you. But, just like the older folks who attended my garage sale last autumn, you can't just buy something on the cheap. You insist on buying it even cheaper. No matter what price tag somebody sticks on a stock or a used waffle iron, frugal folks like you still insist on buying the thing a little cheaper. Fine. If you insist on buying Starbucks (SBUX) for $8 or lower, place a buy-limit order @8. Once you do that, you'll be in a position to buy SBUX as soon as the ask price drops to $8 or lower. What if the price drops to $8 or lower, filling your order, but then keeps dropping to, like $3, or, like, $1?
At that point you would be crying and wishing you had placed a buy-stop order instead. Why?
With SBUX trading at $9.58 a share, let's say you were intrigued but still nervous about the company's near-term prospects. There's a recession on, and it's not that hard for most people to cut back on their unnecessary spending. So, you're not ready to dive in, especially when you could see that stock dropping down to the low single digits. Then again, it's a great company, and as soon as the employment rate picks up again and wages start rising, people will probably go back to their old coffee and latte habits. So, you decide to play it both ways. You refuse to buy the stock if it's dropping from here. But, if it rises to a certain target point, you buy it automatically. The stock has to show you it has legs first, in other words, and only then will you buy it. Won't you end up paying more that way? Yes. If you enter a buy-stop @12 on SBUX, you will end up paying $12 if the stock rises to that point. On the other hand, if the stock drops quickly to $2 or $3 from here, you won't touch it.
This example isn't just academic for me. I help a good friend manage his IRA. He's normally very sensible, but when he saw SBUX trading in the high teens a few months ago he was convinced he needed to buy it. I was convinced that Starbucks was entering a period of scary pain that would last at least 3 - 5 years, possibly ending in bankruptcy. With the stock at $17, I didn't recommend buying it at all, but I could only get him to compromise on placing a buy-stop @20. If the stock had risen from there, he would have bought it. Of course, we just saw that the stock has dropped to the $9 range and may well drop further. The buy-stop @20 never executed and then dropped off after 6 months. Thank God for buy-stop orders. They put the investor in a position to buy stocks that are rising in value, avoiding stocks that are dropping in value. If, on the other hand, you place a buy-limit order, you will buy the stock only if and only as it is dropping. Kind of a dangerous game if you think about it, like trying to catch a falling knife.

Sell Stop or Sell Limit?

People are often confused by the difference between sell-stop and sell-limit orders. And, for some reason, some candidates actually start to confuse stop and limit orders with options, which would be sort of like confusing an airplane with a cheeseburger. Options are derivative securities. When we discuss "stop" and "limit" orders, we're talking about a method of buying and selling. Stop and limit orders can be used to buy and sell stock or options, but they are not investments, remember. They are types of orders.
The easiest way to place an order to buy or sell stock is a "market order." There is a market price for the security; a market order gets filled at the best price the market will currently bear. So, if the exam question says that the customer primarily wants his order to be filled, choose the market order. It will be filled as fast as possible at the best price currently available.
Stop and limit orders are specialized. The customer names a price at which something needs to happen. If the stock never reaches that price, nothing happens. For example, let's say you bought 1,000 shares of ABC common stock @20 back in 1998. Today the stock trades for $48, and you see from your notes that your target price was $50 for that stock back when you bought it. It's only $2 away from the target you had for selling, so you can enter a sell-limit order @50. You will not accept one penny less than $50 a share, but if somebody is willing to pay $50 or more, you will sell automatically. Notice how the stock price has to rise for the sell-limit order to execute. What if the price does not rise? Nothing happens to your stock. If you had marked the sell-limit order "good for the day," it would go away. If you had marked it "good 'til canceled" or "GTC," the order would remain on the books. What if the stock had dropped? It would have dropped. A sell-limit order is placed above the current market price and, therefore, only goes off if the stock rises. If the stock drops, the investor wishes he would have placed a sell-stop order, instead.
A sell-stop order provides protection. With the stock sitting at $48, you were sitting on a potential capital gain of $28 per share. If you had wanted to protect that paper gain, you could have placed a sell-stop order @45. At that point if ABC had dropped to $45 or lower, your shares would have been sold automatically to protect most of your gain on the stock. If the stock had risen or at least stayed above $45, you would have continued to hold it.
See the big differences between the sell-limit and the sell-stop order? If the investor uses a sell-limit order, she really wants to sell her stock. She just wants a few dollars more. Unfortunately, she gets no protection against a drop in price. On the other hand, if the investor uses a sell-stop order, she does not necessarily want to sell. What she wants is to have her cake and eat it, too. She wants to hold the stock as long as it cooperates, but she wants it sold automatically at the first sign of trouble. Sell-limits are placed above the current market price for the stock. Sell-stops are placed below the current market price for the stock.
What about buy-limits and buy-stops?
Let's save that excitement for another post. It's not even 6 AM on a cold Sunday morning in Chicago. I don't want to overdo it.

Friday, February 20, 2009

Options Strategy

Not all options questions involve T-charts and calculations. Many have to do with strategy/suitability. The old what-should-the-pretend-investor-do-now questions are often the hardest of all, so let's have a little fun with one of these early on a Friday morning.

Dante purchased 100 shares of XYZ @44 several weeks ago. Now that XYZ last traded at $45, Dante is concerned that the stock has met resistance, and is, therefore, not likely to rise significantly. Therefore, you would recommend that Dante
A. buy 1 XYZ Oct 45 call
B. buy 1 XYZ Oct 40 put
C. sell 1 XYZ Oct 40 put
D. sell 1 XYZ Oct 50 call

Many students absolutely hate a question like that. Notice how it doesn't fit neatly into some magic options decoder chart, nor does it have anything to do with a memorized formula. You basically just have to think analytically. And, as usual, your job is to find something wrong with each of the recommended strategies so that you can eliminate three of them. We need to take the facts presented in the question and apply them first to "buy 1 XYZ Oct 45 call." Well, if Dante doesn't think the stock will rise, he would not want to buy a call. Call buyers are bullish; they think the stock is going up. Period. A is eliminated, then. What about "buy 1 XYZ Oct 40 put"? Is there anything in the fact pattern that says he expects the stock to plummet? No? So, he would not buy a put--B is eliminated. At this point many students want to choose "sell 1 XYZ Oct 40 put," but I'm not sure they really think through the strategy; instead, I think they just want the question to be over at this point. But, if Dante already owns the stock, he's at risk that it could drop. If he sells a put, he will get hurt twice if the stock drops. In other words, he'll lose money on the stock position, and he'll lose money on the short put for every dollar the stock drops. What about "sell 1 XYZ Oct 50 call"? At least this position is a hedge--a covered call. He's bullish on the stock; writing the call is bearish/neutral. In other words, it's not crystal clear whether he should sell the put or sell the call. But with analytical thinking and good test-taking skills, at this point you eliminate "sell 1 XYZ Oct 40 put" because there is something inherently wrong with a strategy that will double Dante's pain if the stock drops. And you're left with Choice D, the answer that was hardest to eliminate.

If you see a tough options question, post it in a comment.
Let's have some more fun with options, people. Heck, the weekend is nearly upon is.
BTW, today's Friday Free Broadcast is on "Rules and Regulations," which is key to the Series 7 and several other exams. Pull down the schedule at under Get Free Stuff.

Saturday, February 14, 2009

Mutual Fund A, B, C shares

When you recommend mutual funds to investors, part of your suitability obligation is to help determine the proper share class. An investor with, say, $100,000 and a long time horizon should be purchasing A-shares. She will knock down the front-end sales charge with her quantity purchase, and her expenses going forward will be significantly lower than on B- and C-shares. B-shares are suitable for an investor with a long time horizon and a smaller amount to invest. This investor will avoid the front-end sales charge, and as long as she holds the shares 6 or 7 years, the back-end sales charge will go away, and then her shares will convert to A-shares with their lower operating expenses. She will pay higher operating expenses, but due to her small amount of $ to invest, she couldn't reach a breakpoint on A-shares, anyway. This is her best option. C-shares charge high operating expenses, and, unlike B-shares, these things do not convert to A-shares. So, they are generally for investors with a short time horizon. We don't want to keep hitting them with high annual expenses for very long, but if the investor will only hold the shares, say, three years, C-shares are ideal. No need to hit her up with a big front-end sales charge if she's only going to hold the fund a few years. As long as the investment is under, say, $500,000, C-shares will be suitable for a short-term investment. And that implies that a larger investment--even over the short-term--would be more suitable in A-shares, since the front-end load would be knocked down so low and then the investor would also enjoy the low operating expenses going forward. In other words, it's freaking complicated. And that's why many firms end up getting fined millions of dollars and returning millions of dollars to over-charged customers. They don't have adequate training and supervision in place. The rep's don't know enough about the various share classes, or maybe--just maybe--they prefer making the highest compensation possible, regardless of what's best for the customer. When you read the news release at the link below, please know that I am absolutely not bashing Wachovia here--heck, I'm a Wells Fargo shareholder (they own them now), and I also sell a lot of Pass the 7(c) books, DVD's etc. to Wachovia employees all across the country. Every firm out there could provide us with dozens of similar fines and mishaps--the securities industry is complicated. No one can stay on the right side of the regulatory line all the time. I don't see a need to explain the UIT angle, since the FINRA news release does such an excellent job of bringing up the testable points. Check out the news release at :

Wednesday, February 11, 2009

Covered Call Maximum Loss

I saw a question somewhere (don't have it with me) where the investor owns 100 shares and has written a call. The maximum loss doesn't make sense to me--help!

Actually, this is a little tricky at first. Most students focus so hard on the call the investor wrote that they forget it's the stock we should be worrying about. Let's say that Laura buys 100 shares of XYZ @75 and writes an XYZ Oct 80 call @2. This is a "covered call" because she has the 100 shares she is obligated to deliver should the stock rise above $80. If you look at that outcome, you notice it represents Laura's maximum gain. She owns the stock and, therefore, wants it to rise. But, if it rises above $80 per share, she has to sell it at $80 a share, period. So, her maximum gain is $500 on the stock plus the $200 premium, or $7 per share.
On the other hand, if the question asks about Laura's maximum loss, you have to turn things around. Remember--she bought 100 shares of XYZ for $75 a share. All she took in was $2 a share for writing the covered call. She would have been at risk to lose $75 a share; now she can lose $73 per share. Not much downside protection, right? That's why the exam may say that a covered call writer "receives partial protection and increases her overall return." That's just a fancy way of saying, "she gets a premium." The premium she receives is her "downside protection," and it is her increased overall return.
So, you have to be analytical--like a chess player--when working a question like this. Ask yourself what happens if the stock rises; what happens if it drops. If it rises, Laura gains $7 a share. If it drops to zero, she could lose $73 a share--that's just the price she paid for the stock minus the premium she collected.

Saturday, February 7, 2009

Market letter rule change

Oh great--another rule change by FINRA. As if test takers didn't already struggle enough with the definitions of sales literature, correspondence, etc., FINRA has just relaxed the rule covering "market letters."

Let's start with the big picture: what is the significance of these definitions of "sales literature," "correspondence," "advertising," etc.? The big picture is that FINRA and the SEC hold firms responsible for all outgoing communications. If the communication is considered "advertising" or "sales literature," a compliance principal has to review and pre-approve the material, also keeping copies for the firm's files. If the communication is considered "correspondence," pre-approval is not required. The firm simply needs an effective monitoring and internal education program in place to make sure registered rep's don't send out emails, faxes, and letters with ridiculous claims like "You, too, can triple your money this quarter without subjecting your investment to loss of principal."

Okay, so "sales literature" requires pre-approval. What is considered to be "sales literature"? As we can see at, sales literature includes "Any written or electronic communication, other than an advertisement, independently prepared reprint, institutional sales material and correspondence, that is generally distributed or made generally available to customers or the public, including circulars, research reports, performance reports or summaries, form letters, telemarketing scripts, seminar texts, reprints (that are not independently prepared reprints) or excerpts of any other advertisement, sales literature or published article, and press releases concerning a member's products or services."
Ouch—FINRA rules are painful this early on a Saturday morning. Notice that the regulators aren't so worried about protecting the institutional investors, which include pension funds, mutual funds and insurance companies--they're big boys and girls, so the firm doesn't have to pre-approve sales literature going only to institutional investors. But, if the sales literature is sent to retail investors, it needs to be pre-approved. A "market letter" is considered sales literature. Basically, it's a marketing piece disguised as some friendly, thoughtful analysis from the firm's president, chief economist, "chief equity strategist," etc. Today, I would picture a market letter coming to me with headlines such as "After the fallout and the bailout--now what?" or "Is the housing market finally finding the bottom?" and then some sage-sounding advice from someone clearly smarter than the average retail investor. Up until now, such market letters had to be pre-approved under NASD rules, and under NYSE rules, to be pre-approved by a supervisory analyst or other “qualified person” at the firm. Not anymore. Sort of. Remember, we're dealing with securities regulators here, and they insist on keeping things as clear as mud. But, we can follow them as long as we remain patient. What the rule change involves is this: a market letter can now be considered correspondence, as long as it does not go to 25 or more existing retail customers in a 30-day period and does not make any financial or investment recommendation "or otherwise promote the firm's product or service."
Well, first I can see a loophole about a mile wide--if I were the market letter guy at the firm, I would just take out anything that looks like a direct promotion of the firm's product or service. But I would make sure you see the name of the firm in the text of each "story" at least every 15 words or so. I mean, that's all these so-called "market letters" were ever for--put the name of the firm in front of the client on a regular basis and give the client a reason to want to call and buy or sell some securities--what is this, rocket science? Anyway, if the market letter inserts a little display ad with "Call today for a free IRA check-up with your financial representative today," and goes to 25 or more existing retail customers in a 30-day period, it will have to be pre-approved.

And this really stinks for test-takers, because when you're defining "correspondence," the number 25 is used in a slightly different way. For market letters, discussed above, the rule uses "25 or more existing retail customers in a 30-day period." But the definition of "correspondence" includes a form letter that is sent to fewer than 25 prospects in a 30-day period." Why? Well, a form letter that introduces you as a go-getting new registered representative working for Broker-Dealer XYZ would be sent to drum up business, and you'd probably like to mail it to thousands of prospects just so maybe 5 of them won't hang up on you when you follow up later. This form letter has to be pre-approved. But if you sent it to 24 prospects, it would be considered "correspondence," and would also probably be useless at drumming up new business. However, if you send faxes/emails/letters to existing clients, the number is no longer relevant. The number "25" is for "prospects," and if the letter goes to 25 "prospects" in a 30-day period, it becomes sales literature subject to pre-approval. Letters/faxes/emails to existing clients are considered correspondence, period. On the other hand, for this new rule that allows firms to call market letters "correspondence," the number "25" is for existing customers . . . if the market letter makes investment recommendations and goes to 25 existing customers it once again becomes "sales literature," subject to pre-approval. But, if it doesn't meet that definition it can be treated as "correspondence," which requires a monitoring and training/education program at the firm, not pre-approval. Why the difference? Basically it’s a simple as this: form letters are used to drum up new business with prospects. Market letters generally go to existing clients.

Why the rule change? According to the regulatory notice "FINRA has been concerned that the pre-use approval requirements in some circumstances may have inhibited the flow of information to traders and other investors who base their investment decisions on timely market analysis." As far as I can tell, there is no apology to Series 7 candidates, who now have to spend another 10 minutes or more studying the mind-boggling differences among sales literature, correspondence, advertising, etc.

Friday, February 6, 2009

Breakeven on a hedged position

I am working a practice question that has confused me.
Question: An investor has purchased West German marks at 65 and has purchased a 65 put for .75. At what point would he have a profit?
65.76. Since the investor buys the marks at 65 and buys protection, a 65 put for .75, the breakeven is 65.75. The investor is losing below 65.75 and gaining above 65.75; therefore the only number greater thank 65.75 is 65.76.

I thought for puts you PUT DOWN for the breakeven, so how is it 65.75?

When an investor buys a put all buy itself, he is speculating. In that case you would, as you say, "put down for the breakeven." If I buy an XYZ Oct 50 put @3, the breakeven is 47. I need the stock to drop below that point to have a profit.
But, when I'm hedging with a put, it's only there for an emergency--I don't want to have to use it any more than I want to use my homeowner's insurance. Still, I pay my premium so that I have protection against disaster. Therefore, I have to add the premium I pay to the price I pay for the stock to find my breakeven. Similarly, a homeowner should add the premiums she paid for the homeowner's insurance to the price she paid for the house when trying to figure her profit upon selling the house.

When I buy 100 shares of XYZ for $55 and then buy an XYZ Oct 50 put @3 for protection, I'm hoping to never have to use that put. If I have to use it, that means my stock has dropped and I'm selling at a loss of $5 per share, plus the $3 premium. What I'm hoping is that XYZ stock keeps rising, and I just sort of forget about the put, glad I never had to use it. Since I paid $3 for the protection, I won't break even until XYZ rises to $58. And, I won't profit until it rises above $58.

Same thing in the question you cite above. Take the price paid for the currency. Add the price paid for the put. Then, make sure you know whether the question wants the breakeven, or the price at which the investor profits. Remember, those are never the same thing. Breakeven is a "tie." Above or below a breakeven an investor would have a profit.

Fair and reasonable commissions

Many people become frustrated with the Series 7 when it seems that all the information they're being forced to learn has "nothing to do with the real world."

Actually, it does.

For example, say you're struggling to memorize the "factors used to determine fairness" for commissions and markups. You may think you're learning a useless set of bullet points, but just the other day a large broker-dealer was fined $300,000 for charging unreasonable commissions, and one of the registered reps was barred by FINRA (which is bad).
Here is a snippet from the FINRA press release:

As a consequence of the firm's inadequate supervision, during the period from April 2002 to January 2006, representative Hernandez charged approximately 27 customers commissions that were substantially in excess of the firm's calculated rate for appropriate charges. He overcharged one customer approximately $1.2 million. In February 2006, the firm terminated Hernandez's employment. In March 2008, in a separate action by FINRA, Hernandez consented, without admitting or denying the charges, to findings against him and he was barred. Two other registered representatives in different branch offices also overcharged commissions on a repeated basis, but on a smaller scale.

Oh well. Don't think I'm picking on a particular firm. If you study the disciplinary actions by FINRA, you'll soon see that virtually all firms get fined and sanctioned for something or other. I'm just recommending that when it comes to rules and regulations, you can dig in a little deeper and see how the "test world stuff" relates to the so-called "real world."

The link to the full press release is:

Sunday, February 1, 2009

Gift tax rules

QUESTION: Taxation question (loophole or just plain bad news?): If Parents of client want to give money to their child, can they give it by paying off things like the child's house, car, etc? Or will it be subject to taxes?

RESPONSE: One the one hand, parents can give their children as much money as they want--but if they give more than the "annual gift tax exclusion," the excess is subject to gift taxes. For 2008, the maximum was $12,000; for 2009, it's $13,000. So, if the parents give each child $13,000 this year, there is nothing to file, and no gift taxes to pay. If they give them $100,000 each, the excess is subject to gift tax rates. Paying off a car loan would not qualify for an exception to gift tax rules, as far as I know--though I'm not a CPA or tax professional. The exceptions that the test might bring up would include paying someone's tuition or medical expenses--these don't count as gifts as long as the payment is made directly to the education or medical provider. So, to wrap up--if the "kid" owes $13,000 on the car, the parents can either pay the holder of the loan or give the "kid" $13,000. They don't have to worry about gift taxes based on the size of the gift. The purpose of the gift isn't relevant here. If the loan is more than $13,000, though, the excess above the annual gift tax exclusion is subject to gift taxes. Also, if husband and wife file separately on their income taxes, they can each give the kid $13,000. See and search on "gift taxes," for more information on that. Just wondering, have the parents considered letting their kids pay their own damned bills? There are charities that try to cure cancer, help the homeless, feed the hungry, etc. Not really what you're asking, of course, and probably not what your clients would want to hear. It probably does explain why I don't work directly in the financial services industry--not sure that clients would want to hear the unvarnished truth and sarcasm never seems to work successfully as a sales tool.