Avoiding Expensive Mistakes Made By Rookie IRA Investors - How To Open A Long Position Cheaply

Apr.18.12 | About: BP p.l.c. (BP)

100 Mistakes Rookie IRA investors Make -- #1 Buying large blocks of stock (Part Two)

In Part One of this article I discussed how simply buying a full position in a stock at market price was potentially hazardous to your retirement and could lead to a position pushing supermarket carts under a hot sun.

Let's say we have researched BP p.l.c.(BP) and decided that this is a company we want to earn for the long term so that we can collect dividends and hopefully some capital appreciation.

We have noted that BP p.l.c. provides fuel for transportation, energy for heat and light, lubricants to engines, and petrochemicals products. Its Exploration and Production segment engages in the oil and natural gas exploration, field development, and production; midstream transportation, and storage and processing; and marketing and trading of natural gas, including liquefied natural gas, and power and natural gas liquids. [Source: Yahoo.co.uk]

It seems to us that fuel for transportation, heat, and light is the kind of thing that has a future and that we want a piece of the action. With a few hundred thousand dollars in our IRA, we can afford 1000 shares. Do we buy today, or do we wait?

(At this point I am not going to discuss what the maximum amount committed to a single stock ought to be. Frankly I do not know. It is generally accepted that it is not a good idea to put too many eggs in one basket due to the tendency of eggs to break when dropped. Stocks can be like that too.)

It is a little known fact that on any given day there are very few stocks that are at a price that they will never, ever go below again. Stocks go up and down. They tend to go up slowly and come back down rather quickly. As you will recall, Jack and Jill expended a great deal of energy in getting to the top of the hill with an empty pail, but their descent was much quicker and more eventful. Stocks are like that too.

Partly this is due to movements of the overall market in response to the macroeconomic climate and geopolitics in general, and partly this is due to the fact that individual stocks fluctuate a great deal in value according to expectations about quarterly earnings reports, analyst estimates, announcements about earnings reports and whether analyst estimates are exceeded ("crushed" in the jargon of the Street) or failed.

In any case the likelihood that today is positively your final and last chance to buy BP, or any other stock, before the stock takes off for the moon is always very slight, so if you want to take a full position of 1000 shares here are a few suggestions on how to get started.

1) Do what you are itching to do, and buy some stock at the current market price, but no more than 200 shares of the total 1000 you are planning to buy. If the stock immediately moves up in price, at least you will be in positive territory and off to a good start. Even to start a position, in my opinion you might want to wait until the stock is on the second of two successive down days, before pulling the trigger. At the very worst, at least you will be able to buy the stock for less than it cost two days ago, so you will never buy it at an all time high.

2) If the stock now moves down in price, this is good for you, because you can look to buy a bit more stock and lower your average cost basis. If the stock is a dividend payer, this means a higher percentage dividend for your money. You might want to also put in a limit bid somewhere below where you think the stock will ever go. Stocks have a habit of surprising you.

3) Now it gets complicated. At this point you need to stop buying stock and start to learn about using options. More details will follow in subsequent articles in this series, but here is what you need to know for now.

a) A put option gives the buyer the right to sell stock to a purchaser at a given price at a certain date.

b) If you want to buy stock, you can sell puts and receive cash for selling someone the right to sell stock to you. That way EITHER you get the stock put to you at the lower price you want to pay and keep the money you sold the put for, OR you get to keep the money you sold put fork, but you don't get the stock.

This sounds like money for old rope, but there is a catch. When you sell a put in an IRA account, this is called a "cash secured put" and the money you would need to buy the stock if it is put to you is escrowed by your broker until such time as the option expires, or you redeem the option. If instead of going down in price as you hoped, BP actually goes up in price, don't worry, you can buy the put back early for less than you sold it for and still make a profit.

However, here is your real purpose in selling puts. Let us say that you already bought 200 shares of BP for $45 each, and then you bought another 200 shares for $43, so your average price per share is now $44. You want, if possible to buy more stock even cheaper, so you sell a $40 put to see if you can get some more stock for $40 or less. Let us see how this would work in practice.

You already own 400 shares at an average cost of $44, total cost to you was $17,600

You now sell 2 BP July $40 puts for $1.17 per share each, which means that your broker freezes $8,000 ($40 x 100 shares x 2 puts) and you get $234 cash back.

Now, on options expiration day on the third Friday in July if BP is trading over $40, the put options will expire worthless, and you will keep the $234 or 3% return on the $8,000 that was frozen by your broker in only three months. Annualized, this transaction would be worth a 12% return on your money.

The chart below shows the July options table for BP. The bid price for the $40 put is highlighted.

(Click to enlarge)

On the other hand, if BP is trading for less than $40 on expiration day in July, you will have 200 shares put to you at $40 per share, but since you have already received a cash back payment of $1.17 per share, your net cost will be only $38.83 per share (let's ignore the opportunity cost of the $8,000 your broker froze in your account, which will now be released back into available cash in your account).

Add these 200 shares to the 400 shares you already own at an average of $44 per share, and you now have 600 shares at an average price of $42.28. If the stock is now trading below $40 per share, you may now add to your position, and further lower your basis, or sell more puts to further lower your basis.

Whichever way you look at it, you are a lot better of than if you had just bought 1000 shares at $45 each. But you could have done even better, and future Mistakes Rookie IRA Investors Make will address this.

Disclosure: I am long BP.