Open enrollment - how to best allocate my 401(k)?

During October and November we have to make open enrollment decisions. One of them is how to allocate our 401k (403, TSP, or another employer retirement plan) investments. Generally we have 3 to 100 choices of underlying funds, and the more choices there are the harder it is to make a decision.

In 2015 the IRS raised the limits to $18,000 on most employer sponsored retirement plans, including 401(k), 403(b), TSP, and most 457 plans. (http://www.irs.gov/uac/Newsroom/IRS-Announces-2015-Pension-Plan-Limitations;-Taxpayers-May-Contribute-up-to-$18,000-to-their-401(k)-plans-in-2015)


I have some suggestions for those who want to make a decision on their own:
Step 1: Determine your risk appetite and your retirement horizon and objectives.

To figure out your risk appetite and retirement horizon you may need to work with an advisor or use automated questionnaires provided by your investment bank/platform. Here are three suggestions:
1) a questionnaire by Morningstar: https://mimadvisor.morningstar.com/public/ingrtqpage

It incorporates time horizon questions giving some perspective on risk appetite and retirement horizon.
2) a similar questionnaire provided by Vanguard https://retirementplans.vanguard.com/VGApp/pe/PubQuizActivity

3) I tried to use and thought it was reasonably accurate the following quiz developed by two university personal finance professors, Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at the University of Georgia. http://njaes.rutgers.edu:8080/money/riskquiz/ 

Step 2: based on the above steps determine what types of investments are suitable for you and select funds based on their composition, historic performance, and expectations for the market.  Here is a calculator recommended by the SEC: http://www.ipers.org/calcs/AssetAllocator.html

SEC’s beginner’s guide to asset allocation (http://www.sec.gov/investor/pubs/assetallocation.htm) notes that there is no single asset allocation model that is right for every financial goal. You'll need to use the one that is right for you. Some financial experts believe that determining your asset allocation is the most important decision that you'll make with respect to your investments - that it's even more important than the individual investments you buy. FINRA’s smart investing in 401k (http://www.finra.org/Investors/SmartInvesting/Retirement/Smart401kInvesting/Introduction/) provides excellent suggestions as well.

This brings us to Step 3: Once you figured out your ideal allocation chose funds in those profiles with the lowest total investment management expenses. This information is required and will be provided in summary section for each fund under performance data. This information is often presented as a percentage or as a dollar amount per $1000. And while $8 to $20 per $1000 may not appear as much it is! You will usually have choices that are identical in composition but some will have lower fees. Why would you pay $180 to $360 annually if you can pay as little as $50 for getting the same level of management and diversification. And while many of us may believe you get what you paid for, you’ll see that historic performance numbers of those funds show otherwise.

As an example, two funds Scout Mid Cap Fund (SMCF) and Vanguard Extended Market Index Investor Fund (VEMIF) with the same bench mark Russel Midcap Index. SMCF has an expense fee of 1.07% or $10.70 per $1000 and 3 year return of 18.67%. Compared to VEMIF with expense fee of 0.24% or $2.40 per $1000 and a 3 year return of 23.28%. Fund with a much lower expense ration outperformed the more expensive fund.

See Warren Buffet's famous perspective on fund management fees http://pension360.org/buffet-is-winning-his-six-year-old-bet-against-hedge-funds/

Financial Discipline

Discipline is defined as control that is gained by requiring that rules or orders be obeyed and punishing bad behavior…

Financial discipline is a discipline concerned with determining value and making decisions. The finance function allocates resources, including the acquiring, investing, and managing of resources.

Here are some suggested steps that can help you figure out your goal(s) and tactical steps to stay on target , or in other words practice Financial Discipline.

Step one:  What are your financial goals? 

Immediate – bills/expenses that must be paid within 12 months or less. 

Short term – goals for the next 5 years.

Long term – goals beyond 5 years, including retirement.

Step two:  Once the goals are defined a plan needs to be outlined.  It could be as simple as a quick budget consisting of your income and expenses.  This should help you identify any flexible items (perhaps additional income sources or expenses you can do without), which can be adjusted to help you reach the immediate, short, or long term goals.

Step three:  Practice ongoing financial discipline by following these tactical steps to keep you on track heading towards your goals.  While these steps are suggested in a certain format you can be flexible in allocating them on your calendar and choosing only those that apply.

January - Resolve to make yourself financially fit!

1. Manage your debt. Start by paying off all of your high-cost, non-deductible credit cards, and other high cost debt.
2. Establish an emergency fund equal to 3-6 months of expenses.
3. Create (or update) your cash flow statement (income minus expenses) and statement of personal net worth.
4. Give your portfolio a checkup-review the performance as you rebalance back to your target asset allocation mix.
5. Double-check your employer retirement plan contribution percentage. At the very least, try to contribute up to the point where you take advantage of any available employer match.
6. See the IRS Tax Calendar for federal tax items due throughout the year http://www.tax.gov/calendar/

February - Insurance and Tax Information.

1. Check your insurance policies (property and casualty, liability, health, disability, life) to be sure you're not paying too much for the wrong kind of coverage.
2. Annual tax forms 1099, 1098 and W-2 should be mailed to you by your various providers no later than January 31.  Get a head start on preparing your income tax forms.

March

1. Free Annual Report, get a free annual copy of your credit report from Experian: https://www.annualcreditreport.com/cra/index.jsp 

April - File your Tax Return, contribute to IRA...

1. File your income tax return by April 15. Even if you're requesting an automatic six-month extension, you still need to pay any taxes due by April 15.
2. April 15 is also the last day to make a contribution to your IRA or Coverdell Education Savings Account for the prior year.

May - Inventory of your personal assets and Financial Disaster Plan.

1. Create (or update) an inventory of your home and personal property. Use a video camera to make a record of your valuable possessions for insurance (and/or estate) purposes, and then store the video in a secure, remote location (like a bank safe deposit box).
2. Create (or review) your financial disaster plan.

June - Mid-year financial check up…

1. Perform a mid-year review of your finances to be sure you're on track.
2. Planning a June wedding? Don't forget to update your financial plan accordingly.

July

1. Free Credit Report; get a free annual copy of your credit report from Equifax: https://www.annualcreditreport.com/cra/index.jsp
2. Keep learning-add at least one good book on personal finance or investing and a publication such as Forbes, Wall Street Journal, or Financial Times to your summer reading list. 

August - Review your vacation and holiday budget and plan for tax-deductible educational savings.

1. Compare what you actually spent on vacation to the amount you projected in your annual cash flow plan. Start thinking about your holiday budget.
2. As the kids or grand kids get ready for school, think about establishing or contributing to a Coverdell Education Savings Account and/or 529 College Savings Plan on their behalf. 

September - Estate Plan and Small Business IRA.

1. Review your estate plan.
2. If you want to establish a SIMPLE IRA this year for your small business, the account must be opened by October 1 (this date may change visit IRS.gov or our website for updates).

October - Tax projections, open enrollment season, and more

1. File your income tax return by October 15 if you requested a six-month extension back in April.
2. Run a projection of your current-year income tax liability to get a head start on your year-end tax planning.
3. As open enrollment season rolls around at work, take the time to review your health insurance coverage and other employer benefits.

November - Free credit report, holidays, and charitable giving…

1. Get a free annual copy of your credit report from TransUnion: https://www.annualcreditreport.com/cra/index.jsp
2. Don't charge more for holiday gifts than you can comfortably pay for in full when the January credit card statements come around.
3. Take time to give thanks for another year of financial success. Review your charitable giving plans and consider making tax-deductible gifts to charity or to a donor advised fund account before the end of the year.

December - Portfolio review for tax-deductible losses…

1. Check your portfolio again for loss-harvesting candidates, as you rebalance back to your strategic, long-term asset allocation.
2. If you want to establish an Individual 401(k) or other QRP (qualified retirement plan) this year for your small business, the account must be opened by December 31.
3. If applicable, don't forget to take the annual required minimum distribution from your IRA by December 31.
4. Request your annual Social Security benefit statement from ssa.gov. Compare your earnings record against your old tax return info for accuracy.

Getting ready for 2015 tax season…

Fully and correctly completed tax organizers are the key to a smooth and successful tax filing season. And while you are focused on your tax situations and getting your documentation together, it is also a good time to sit down and do some year-end tax planning that could save you money this year and going forward. 

The basics of year-end tax planning are: To minimize this year’s taxes, you will generally want to postpone income and accelerate deductions. The details of how to do this and how does that apply to your situation can be hard to understand. Additionally due to changes in your income, minimizing taxes this year may not be the best strategy. 

If you would like to postpone income, accelerate deductions, and otherwise reduce taxes for 2014 you can consider the following strategies: 

Increase withholding. 

Clients with substantial nonwage income in addition to their salary should adjust their withholding for the rest of the year to ensure that it covers their required estimated tax payments to avoid the penalty for failure to make estimated tax payments. 

More ...


Marital status.

If you are marrying or divorcing, evaluate how the year-end marital status will affect the tax return. Getting married or divorced during the year? You are treated as having had your Dec. 31 marital status all year. Now is the time to discuss how that will affect your taxes. 

 More ...

Minimize tax on Social Security benefits. 

When a Social Security recipient’s MAGI plus 50% of his or her Social Security benefits exceeds certain base amounts, the benefits can be taxable. The MAGI thresholds are $25,000 for single individuals, $32,000 for married taxpayers filing a joint return, and zero for married individuals filing separately. If your income is close to these thresholds you should consider deferring income to avoid the tax on the Social Security benefits. 

More ...

Miscellaneous itemized deductions.

Group miscellaneous itemized deductions in one year. Miscellaneous itemized deductions are deductible only to the extent they exceed 2% of your adjusted gross income. You should try to group such expenses in one year to meet the threshold. For example: 

· Pay professional dues and job-related tuition in December instead of January to bring them into 2014. 
· Prepay certain expenses using a credit card. Contributions to charity and deductible medical expenses are deductible when charged to the client’s credit card, rather than when the client pays the credit card bill (Rev. Rul. 78-38; Rev. Rul. 78-39). Such expenses charged in December will be deductible in 2014, even though the credit card bill is not paid until 2015.  More ...

Dispose of passive activities to take advantage of suspended passive losses.

Losses from a passive activity that can’t be realized in a particular tax year because of the passive loss limitations are suspended and carried forward until they can be used. If you are carrying suspended passive losses you might want to dispose of the passive activity before the end of the year to take advantage of those suspended losses. When the passive activity is disposed of, the losses from the year of disposition, including carried- over losses that exceed passive income for the year, are no longer treated as passive losses. More ...

Realize stock losses to offset gains. 

You may be holding appreciated investments, but also lost money on some stock investments in 2014. You may want to consider selling the appreciated investments and offset them with the losses. You need to be aware that long-term capital losses first offset long-term capital gains and that short-term capital losses first offset short-term capital gains.  More ...

Convert ordinary income to qualified dividend income. 

You may want to consider shifting investments from ones where the income is taxed at ordinary rates, such as bonds, to stocks that pay dividends. If the dividend income is qualifying (received from a domestic corporation or qualified foreign corporation and the taxpayer held the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date), the income will be taxed at capital gains rates. More ....

Make Sec. 179 expenditures. 

You can elect to deduct currently rather than depreciate the costs of new or used tangible property used in your business over a period of years. Unfortunately, the increased levels that were in effect for Sec. 179 for the past several years have expired. For 2014, the maximum amount that can be expensed is $25,000, and the deduction is phased out when qualifying property placed in service during the year exceeds $200,000.  More ...

For complete listing of downloadable forms visit our webpage http://www.neizvestfrm.com/index/services/tax-planning/tax-return-preparation 

How (and why) should you review your investments for Tax Deductions?!

Today my monthly reminder popped up to: Review my portfolio for tax deductible losses, IRA, SSA benefits, and more".  And I was just thinking how many people would know exactly what to look for.  My guess is: many.  But not all would be 100% certain they are looking at the right thing.  So to accomplish # 1 on the list of things to do in December I would:

Check my investment portfolio for loss-harvesting candidates:

Which means look for positions that have an "unrealized" loss.  You can deduct as much $$$ in capital losses as you have in capital gains and an additional $3,000 can be tax deductible.  So if you had a lot of positions that you sold at a gain you can and should look through your portfolio to sell off some less desirable stocks with an unrealized loss to realize the loss.  This loss will allow you to offset your capital gains and will save you the capital gains tax on your winners. 

As you "rebalance back" to your strategic, long-term asset allocation - means if you traded out of positions your portfolio may no longer reflect the asset mix of 20% in equities, 20% in bonds, and 60% in futures (just kidding) but you understand that after trading out of certain positions you may have a different investment mix than prior to your trades.   This provides an opportunity to sell out of loser positions and use the extra cash to fill in the gaps in the securities that align to your planned portfolio mix.

Always remember not to buy into the same positions within 30 day of the sale because that will render the trade useless for tax purposes.

This Forbes article How to Pay Taxes Like Mitt Romney is a good reference: http://www.forbes.com/sites/financialfinesse/2012/01/25/how-to-pay-taxes-like-mitt-romney/

Here is the remainder of the December to do items on my Financial Calendar:

2) If you want to establish an Individual 401(k) or other QRP (qualified retirement plan) this year for your small business, the account must be opened by December 31.

3) If applicable, don't forget to take the annual required minimum distribution from your IRA by December 31.  - If you are 70 and 1/2.

4) Request your annual Social Security benefit statement from ssa.gov. Compare your earnings record against your old tax return info for accuracy.  - Yep, Social Security Administration may make mistakes.  It also will help to have this document for your updated plan for next year.

Whole life insurance versus Term. You could be mising out on thousands in savings!

Let’s review the following situation.  Mike, a young man in his 20s bough a whole life insurance policy for $1,600/year.  Fast forward ten years, the policy’s current value is $1,300 and policy coverage is $95,000 in the event of death.  This policy was sold as a supplement to disability insurance, i.e. the value of the policy could be used as a savings bond/savings account in the event of the insured’s disability.

Let’s revaluate an alternative scenario.  What if Mike bought term life insurance at $250/year and allocated the remaining $1,350 to a savings account that earned 2.5%.  He would still have his insurance coverage of $95,000 but his savings value would be at $15,503.

Whole Life v Term Life Insurance

Comparative table

	Whole Life	Term Life Insurance
Annual Premium	$             1,600	$                 250
Death Benefit	$           95,000	$           95,000
10 Year Cash Value of Insurance	$             1,300	$                    -
10 Year Savings	$                    -	$           15,503

In this example, over a ten year period Mike could have saved $12,200 more if he opted to buy Term Life insurance.  If your whole life insurance coverage is more than $95,000 and your annual premium is higher you could be saving more!!!  There is a limited number of circumstances in which whole life policy is a better solution than a simple term life policy.  You should discuss the advantages of whole life insurance with a financial professional that is not commissioned for selling insurance products.

Five Factors that affect Your Credit Score

Recently I reviewed a book by Joe Lance Letizia "The complete Guide to a Higher Credit Score" and was surprised by this interesting statistic: "studies indicate that individuals with 6 or more (recent) inquiries on their credit reports are 8 times more likely to declare bankruptcy than those with no inquiries on their report".  Here is a brief Summary from the Chapter on Credit scores and the Five Factors that affect them:

Component	%	Details
Payment History	35%	Payment information on all types of accounts: credit cards (visa, AmEx, Home Depot), installment loans (mortgages, auto, student).  Public Records and Collection items: bankruptcies, foreclosures, lawsuits, etc.  Details of delinquencies: late or missed payments, etc.  The number of accounts with no late payments: timely payment history will increase your credit score.
Length of Credit History	15%	The length of time your credit accounts existed.  And history of use on certain types of accounts.
Credit Mix	10%	The types and Quantities of credit accounts.
Amounts Owed	30%	Amount you owed on all your credit accounts.  Overall amount you owe on credit cards and other accounts.  The types of loan balances.  The number of accounts with a balance.  The amount of credit line used on credit cards and other revolving accounts.  The amounts still owed on installment accounts.
New Debt/New Credit	10%	The number of New accounts you have.  How recently they were opened (a lot of new cr5edit accounts indicates higher risk).  How many recent credit requests you've made.  Certain studies indicate that individuals with 6 or more inquiries on their credit reports are 8 times more likely to declare bankruptcy than those with no inquiries on their report.

What's at risk when you only invest in very safe Bonds?

Most consumers have heard the story about buying bonds to be more secure, to avoid market fluctuation, and a whole slew of benefits.  But are they getting only part of the information?  Possibly.

Here is how bonds respond to upward shifts in interest rates:

This chart illustrates what has happened to bonds as interest rates slowly climb up and there is an expectation of more aggressive rate increases. (You can run this chart on yahoo Finance).

I pulled this chart today as the market expects a new direction for the Fed's monetary policy due to changes in FOMC's leadership with an accelerated shift into higher interest rates. Higher rate expectations devalue lower yielding (particularly longer maturity) bonds.

Based on this chart Vanguard total bond (BND) portfolio's versus Dow (DJI) to date performance, a professionally managed bond portfolio lost about 5% of its value, while a portfolio mirrored after Dow gained 15%. That's a 20% difference in value!              

Your IRA or 401k and how escaping reality is just more fun!!!

 

A few days ago was an anniversary of our marriage.  My husband got me a very beautify ring.  And I got him, what I though was a very thoughtful gift, the game of Shogi (Japanese Chess) and a book with details on the game.  He looked at the game and said he'll think about the value of learning a new set of rules and symbols and suggested to try and play regular chess first.  My reply was "We both played chess before!  What's the challenge?!"

I was disappointed, I wanted us to learn a new hobby that would replace our current pass time of watching TV series and going to the movies.  Fast forward a few days, the box with Shogi is now carefully placed out of sight and we are back to watching True Blood, Dexter, Orange is the New Black, and the Walking Dead.  This might be because the default for de-stressing is to escape reality by watching something entertaining on TV.  Another, component is the routine or inertia of what we have been doing.  Change is usually hard if not impossible for most people.

This leads me to believe that many private investors who set their investment accounts to a specific set of funds never look back because they are in the same state of mind as our state of mind when it comes to spending evenings by watching TV.  While not getting into the game of Shogi will not effect our immediate retirement plans, I think we will miss out on learning something new and complex, which they say is good for brain exercise and overall well being.  What the investors are missing by not revisiting their retirement portfolio, are the changes in the market that directly effect their ability to maximize the return of their invested money. 

Many people I speak with about their IRAs or 401ks note to me that their balances seem to be the same as they were a few years ago.  If I left my IRA balanced the same way that it was balanced a few years ago I would be in a loss. Because a few years ago bonds and CDs were stronger than most stocks while now most bond saturated portfolios are flat or in the negative. 

In order for an investment portfolio to do well it is key to introduce new information in the management and review your investments regularly.  It is also key not to become complacent.  As seen in commercials, where a couple is realizing their 401K has disappeared and they don't know why, it's a valuable skill to break up the routine. 

To maximize your return, instead of setting the portfolio and forgetting it, YOU MUST:

1. review it quarterly or more frequently
2. make sure it is returning as much as the Dow Jones (DIA), NASDAQ(QQQ), S&P 500 (SPY), or another index(es) that you chose for your investment plan
3. make certain you are maximizing your tax savings by allocating the maximum to this tax deferred investment account
4. review your diversification (do not have more then 5 or at most 10) to be certain you allocate the higher percentages to sectors that are positioned to do well in the next quarter
5. trade!  Yes, you can sell positions to reinvest the proceeds in what you perceive will be a stronger sector.  Remember your gains in this account are not taxable* (if you comply with IRS rules)

How often do you check on your money?

They say that quarterly is enough. However, if you don't report an error on your bank/credit card statement within a 60 day window (after getting the statement) you would have missed your boat and will have to "eat" any unauthorized transactions. When it comes to your portfolio (investments under management, 401k, IRA, 403b, TSP, or other) should you give it the same level of attention? After all, you are working very hard to accumulate this money for a comfortable lifestyle at retirement.
 
Don't feel bad if you haven't been looking at your portfolio for over a quarter. Some people just throw the money in and don't review (forget re-balance) their retirement savings for years.  Here are a few reasons for looking at your money more often: 1) markets change, what once was a hot stock or sector no longer is, 2) bonds are not risk free, 3) mutual funds can underperform, 4) there are new investment opportunities each year (for example MLPs).
 
If you have a difficult time reminding yourself to look at your portfolio you can engage an investment advisor to do it with you. Even if you spend several hundred dollars each quarter (for an hourly fee advisor) you will end up gaining thousands over time in healthy investment portfolio returns.  Here is a few hints for your review:
 
1) If you don’t know how your portfolio performed compared to market or a specific benchmark you haven’t looked at the right performance indicators.
2) If your portfolio is simply following the market you are overpaying for management. If you pay a professional manager to diversify your portfolio they should earn their fees.
 3) If your money is in mutual funds, how much do you pay for mutual fund management fees (known as expense ratio, which is money spent on paying the fund's managers and for transactions, if actively trading)? Are the fees higher than 1%? Do you know of less expensive alternatives (ETFs, which usually have lower expense ratios)? If the management fee/expense ratio is 2.5% your money has to make 2.5% to break even forget outperforming the market.

Is your money secure at the Bank?

As many risk averse high net worth investors you might've been parking your money in a non-interest bearing deposit account but the unlimited FDIC coverage for those accounts ended on January 1, 2013. 
Now what? You could find out how your bank is doing by reviewing the Uniform Bank Performance Reports (published by the FDIC) or reading an analyst report (but we remember the recent credit crisis and the limited value that should be placed on analyst ratings). Unfortunately banks' regulatory ratings are not public but if the banks are in real trouble you can generally find Formal Agreements, Memos of Understanding and other similar communication published on the regulatory websites (FDIC.gov, OCC.gov, etc).
If you think "better be safe than sorry" and would like an alternative, a safety net can be a CDARS program. This program is offered only by some banks; it allows up to $50,000,000 (fifty million -- but the coverage may be different depending on availability) FDIC insurance coverage through member banks swap of deposit money. The rates on these deposits are generally lower than the general CD rates at the banks because the banks have to pay a spread (a small fee) to the administrator.
You can secure your money in the bank! CDARS can provide significantly more FDIC coverage for your money. To find a bank in your area that participates in this program visit CDARS.

Global portfolios are the only way to go.

Chinese export surge lifts shares, commodities

Full Article: http://reut.rs/ULneGP

World shares, commodities and growth-linked currencies rose on Thursday as stronger-than-expected Chinese exports raised hopes of a more robust recovery in the global economy this year.

Before you move into ROTH IRA

We have a tendency to take shortcuts. It is a psychologically proven design of most humans. But before saying I am converting to ROTH to take advantage of the current low capital gains rate (recommended by your trusted financial adviser) perform a long term analysis.

Tax planning

Should it be focused on highest possible return or optimal performance? The answer is personal preference. Some people only focus on getting the most money back, this is generally not the most effective financial planning or resource management. Others invest time to reach the balance between optimal earnings and taking advantage of all possible deductions. One tax professional reiterated: all good tax decisions are inevitably bad business decisions.

Cultivate your inner milli(onaire)

Is it possible that everyone has the opportunity to cultivate the habits necessary to become wealthy? 

Maybe. 

If you have the desire and the drive (I believe) you can become more financially secure than you may be now.  Here are four simple steps (when I say simple I mean straight forward not that they are easy to implement or introduce):

Start at the beginning:  Where do you want to be financially?  Start with easy goals, such as a savings account for a rainy day (i.e. three to six months of basic expenses saved up for an emergency).  You can also look at your current debts and prioritize the pay off by taking care of the most expensive credit lines (the ones with the highest interest rate), going down the list to the least expensive credit (such as mortgage or student debt, which are in most cases tax favorable).

Next: Review your income (all money you have coming in from work, hobbies, refunds, etc) and your monthly expenses (focus on the necessities and discretionary spending).  Take a look at our sister blog on NeizvestAcademy that pertains to the budget strategies.

Lastly: Use a retirement calculator, usually available online through your bank's website to estimate how much you'll need to save annually to reach your financial goal.

Now for the simple but not necessarily easy part: identify sources of savings or additional income to help yourself reach the financial security goals identified in the first three steps of this process.

ERM – Institutional Investment Trades & Portfolio Management Responsibilities

Boards of directors are charged with overseeing management’s implementation of various internal controls and policies.  But when it comes to large and complex institutions how can the boards be expected to notice all deficiencies? 

A moderate size community bank’s investment portfolio was liquidated to create additional liquidity to support its operating capital needs and to allow it to borrow less.  In this liquidation, the senior management initially just wanted to liquidate the securities at market or what’s worse at market established by just one broker.  In other words, just letting the broker who called to discuss rebalancing the portfolio provide that day’s bids and execute a multi million dollar trade.

You might say: So?!  The management knows what they are doing and the brokers will always give a fair bid!  This may be the correct assessment some times but not always (actually almost never.)

While a miniscule example, what’s $10 or $15 million to a multi million dollar institution you would say?  Well, it may mean a lot.  If the bank has not made money for the past 3 to 4 years a difference of $50 to $75 thousand may mean a lot to its bottom line. 

The better approach to such a trade would be:

First management should review the most recent security valuation report from the bank’s bond accounting provider.  This would provide an idea of the most recent market value for the bonds (by the way most banks can only hold bonds in their investment portfolios). 

Next management should assess if the bonds to be traded are used as collateral (some depositors require for their accounts to be secured by bond collateral to some degree) or are part of a repurchase agreement.  If so to find other bonds or find out what is necessary to notify the depositors or repurchase agreement administrators.

The following step, management should to determine the true market value of the bonds by either allowing a broker (or a few approved brokers) to list the bonds on the bond trading board (PIC), which would allow the “market” to bid on them.  In this move management would have to communicate the desired price to the broker so that when the bonds are listed the  open bids are close to target.

Alternatively, management could contact a few brokers and ask them to bid the bonds for their own portfolios.  In other words the bond would not get listed in the market.  Often the brokers will have other institutional clients looking for bonds in a specific market or by a specific issuer and will be able to provide bids that are competitive.

Once management get an idea of the minimum sell price they should create a report of the possible gain/loss for the full trade.  This report should be updated as the bonds sell.

Using this approach for a bond trade management will be organized and accountable for the trade.  Additionally the transaction becomes transparent (if reported correctly) to the board and other users of this information by clear documentation of the fact that management in no way forgone the interest of the bank or its shareholders.

But does this always happen?  What does your bank’s policy or procedures state about how such trades should be handled?

Resources:

OCC’s Bulletin 2002-19 Unsafe and Unsound Investment Portfolio Practices: http://www.occ.gov/news-issuances/bulletins/2002/bulletin-2002-19.html

Options Strategies: ILMN & AMZN

Here are some sample options strategies on two stocks, which show what happens under various types of options scenarios. The two underlying stocks are ILMN and AMZN. For this exercise, I pulled daily options quotes from CBOE.com http://www.cboe.com/DelayedQuote/QuoteTable.aspx

Before you consider playing with options be sure you know when they expire! Here is the 2012 expirations calendar: http://www.cboe.com/AboutCBOE/xcal2012.pdf

Basics: When you trade options contracts the standard contract size is 100 (options- calls or puts)

Strike price is the price on the face of the option.

Uncovered Option - A type of options contract that is not backed by an offsetting position that would help mitigate risk. “Trading naked”, as it is called, poses significant risks. However, an uncovered options contract can be profitable for the writer if the buyer cannot exercise the option because it is out of the money.

To translate this Jargon: uncovered or naked option is when you don’t own the stock or a commodity but you sold a call or a put contract. You can also be uncovered when you buy a put, which will give you the right to sell a stock or a commodity at a strike price, when it’s higher then the current price of the stock. Buying an uncovered put is not risky because you will almost always be able to buy the security at a lower price and will be able to resell it to the put writer at the strike price.

Out of the money options are those that have a strike price that is too high or too low making them worthless before they expire.

Here is an example of writing uncovered calls and puts:

 

Uncovered Calls and Puts
ILMN	Expiration in March		Max Risk Exposure
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Call @ $50	Put @ $50	Call @ $50	Put @ $50
On March 3/10/2012	0.6	0.35
Expired un-exercised Gain/ (Loss)	60	35
If called on the 16th	n/a	7
Gain/(Loss)	60	28	unlimited	4,965
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Call @ $180	Put @ $180	Call @ $180	Put @ $180
On March 3/10/2012	5.35	1.21
Expired un-exercised Gain/ (Loss)	535	121
If called on the 23rd	1,504	n/a
Gain/(Loss)	(969)	0	unlimited	17,879

You can see that because ILMN did not fluctuate before the expiration date the writer of the hypothetical call and the put earned 60 and 28 dollars respectively. Here is how it worked: It would not make sense for the holder of the call to exercise it because the strike price was $50, which is higher then $49.93 (the stock closed before the expiration date). On the other hand, the holder of the put contract could have exercised the put and made the writer buy the stock from them at $50. The assumption is that the writer would turn around and sell it at $49.93, thus losing $7 on 100 shares.

This table also shows the possible loss in the even the underlying stock went up. When it comes to calls the possible loss is really unlimited. On the other hand the loss on puts is limited to the multiple of the difference between the strike prices on the put and the close price of the stock before expiration.

Now in the example with AMZN you’ll see that the stock jumped from $184 to $195 in 12 days. Also, you’ll notice that due to this change the options did not expire on the “expiration calendar date” but continued to trade through the 23^rd. The writer of the call ended up loosing $969, because they had to sell the stock to the call holder at $180, while it was trading at $195. But because there was a profit from the original sale of call options was $535 the loss was not the full $1,500. Put expired unexercised because the strike price was lower then the close.

An uncovered bull call spread is constructed by buying a call option with a low exercise price, and selling another call option with a higher exercise price. Often the call with the lower exercise price will be at-the-money while the call with the higher exercise price is out-of-the-money. Both calls must have the same underlying security and expiration month.

Uncovered Bull Call Spread
ILMN	Expiration in March
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Buy Call @ $50	Sell Call @ $55
On March 3/10/2012	0.6	0.15
Expired un-exercised Gain/ (Loss)	(60)	15
If called on the 16th	n/a	n/a
Gain/(Loss)	(60)	15
Net Gain/(Loss)	(45)
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Buy Call @ $180	Sell Call @ $185
On March 3/10/2012	5.35	0
Expired un-exercised Gain/ (Loss)	(535)	225
If called on the 23rd	1,504	(1,004)
Gain/(Loss)	969	(779)
Net Gain/(Loss)	190

This is a strategy will work if the stock is expected to go up beyond the shorted (sold call option strike price). You see that because ILMN did not move very much the investor would have lost $45. They let the call contracts bought for $60 expire and the written call contracts sold for $15 expired unexercised.

An uncovered bull put spread is constructed by selling higher striking in-the-money put options and buying the same number of lower striking in-the-money put options on the same underlying security with the same expiration date. The options trader employing this strategy hopes that the price of the underlying security goes up far enough such that the written put options expire worthless.

Uncovered Bull Put Spread
ILMN	Expiration in March
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Sell Put @ $55	Buy Put @ $50
On March 3/10/2012	4.54	0.35
Expired un-exercised Gain/ (Loss)	454	(35)
If called on the 16th	n/a	7
Gain/(Loss)	454	(28)
Net Gain/(Loss)	426
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Sell Put @ $185	Buy Put @ $180
On March 3/10/2012	3.1	1.21
Expired un-exercised Gain/ (Loss)	310	(121)
If called on the 23rd	n/a	n/a
Gain/(Loss)	310	(121)
Net Gain/(Loss)	189

As you can see, this strategy worked well in both scenarios but was particularly successful for AMZN because of the drastic change in price. In other words the naked puts written went on unexercised and puts purchased cost less then the gain.

Uncovered Short Call Butterfly

A short butterfly position will make profit if the future volatility is higher than the implied volatility.

1.      Sell 1 ITM Call

2.      Buy 2 ATM Calls

3.      Sell 1 OTM Call

In The Money (ITM):

1.      For a call option, when the option's strike price is below the market price of the underlying asset.

2.      For a put option, when the strike price is above the market price of the underlying asset.

Uncovered Short Call Butterfly
ILMN	Expiration in April
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Sell Call @ $45	Buy 2 Calls @ $50	Sell Call @ $60
On March 3/10/2012	5.6	2.16	0.26
Expired un-exercised Gain (Loss)	560	(432)	26
If called on the 16th	(493)	14	n/a
Gain/(Loss)	67	(418)	26
Net Gain/(Loss)	(325)
AMZN	Expiration in April
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Sell Call @ $175	Buy 2 Calls @ $185	Sell Call @ $195
On March 3/10/2012	13.44	6.8	2.95
Expired un-exercised Gain (Loss)	1,344	(1,360)	295
If called on the 23rd	(2,004)	n/a	n/a
Gain/(Loss)	(660)	(1,360)	295
Net Gain/(Loss)	(2,020)

In this situation the combination worked against the investor in both scenarios. Max Profit = Net Premium Received - Commissions Paid. Max Profit is Achieved When Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call.

Here are references used for this summary:

http://www.theoptionsguide.com/short-butterfly.aspx

http://en.wikipedia.org/wiki/Butterfly_(options)

http://www.investopedia.com/terms/i/inthemoney.asp