You see, there are no upgrades or downgrades for covered calls, LEAPs, or puts.

It’s because most mutual fun managers can’t see beyond what they have been taught, which has predominantly been to “buy stocks.”

Sure, they’ve heard of options and even know how they work, but they are scared of showing options on their portfolios because the “Average Joe” that invests in mutual funds still looks at options with tremendous skepticism.

They’re dead wrong.

The options market was created for professionals and institutional money managers, who don’t report to the general public, but to their wealthy or sophisticated constituents.

When George Soros took down the Bank of England to the tune of billions of pounds, he did so by using the leverage that options provided him. He saw a trend and figured out how to best capitalize on it with risking less money . If it went against him, he would have lost big, but not nearly as big as someone who was risking it all.

The key to trading options is knowing how to use them to maximize the efficiency of your money. The first – and easiest – strategy for using options is the covered call trade. Here’s how you can use it to separate yourself from the average investor.

Why a Covered Call is “Covered”

In order to execute a covered call trade you need to use both a stock and an option.

The reason it’s called “covered” is because it means that your trade using the option is covered by the underlying shares that you own.

There is no risk to the broker when you execute this trade because if it goes against you, there is protection of equity by the shares you already own. That is why this type of trade can be done by anyone in any type of account, including your retirement account.

When you enter into a conventional covered call trade you are pledging to sell your shares at a certain price (strike price) on a certain date (expiration). For pledging your shares, you will be paid money (premium).

Consider yourself a stock landlord. You are renting your property for any given time, and expect to be paid for it. The money or rent that you receive is yours to keep, spend or reinvest.

In other words, you will have reduced the basis of your stock by receiving money back for the “rental.” Remember that anytime you reduce your cost basis, you have also reduced your risk.

How to Place a Covered Call Trade

An example of a conventional covered call trade would be something like this:

• You buy 1,000 shares of Yamana Gold (NYSE: AUY) for $8.50 per share. You think that Yamana can go to $10 by year’s end. You look at the options chain (a listing of the options available) and find out what the market is buying and selling Yamana’s $10 options for.
• Just like stocks, you buy at the offer/ask and sell at the bid. In this case, you see that the option is trading for $0.90 on the bid and $0.95 on the offer.
• Options are priced in increments of $0.01, $0.05 and $0.10 depending on volume traded, and selling price. In the case of Yamana, this set of options is priced in $0.05 increments.
• Options trade as contracts and each is equivalent to 100 shares of stock. The price is listed in per share amounts but is for 100 shares. So, while the Yamana options are priced at $0.90 by $0.95, the minimum dollar amount that you need to be aware of is for one contract or $90 by $95.

It also means, for the purposes of covered call investing, that you need to own at least 100 shares of Yamana to execute the trade.

• The strike price of $10 means that the buyer or seller of the option is has the right to either buy or sell Yamana at $10 depending on the strategy used and if the contract is bought or sold.
• If the option is sold, as in the case of a covered call trade, the seller of the option is obligated to deliver shares of Yamana to the buyer if the shares close at $10 or higher.

The buyer of the option has the option of taking delivery of the shares or selling the option back into the market.

Getting back to our covered call example, let’s get some other details:

You bought 1,000 shares of Yamana at $8.40, so you paid $8,400. You then sold 10 contracts of the Yamana January $10 call option. (Remember each contract equals 100 shares so for 1,000 shares you must sell 10 contracts.) You sell the options at the bid price of $0.90 receiving proceeds of $900. The $900 comes from 10 contracts, or 1,000 shares, times $0.90 per share.

Your cost in Yamana has now been reduced by 90 cents per share, so it is now $7.50 (8.40 minus $0.90) and the money you received, 90 cents per share is yours to do with what you will.

So how does it all end?

There are three possible scenarios in the works now.

• First, if Yamana closes at $10 or higher at the expiration date in January, your shares will be automatically sold to the buyer of the option at $10 per share, regardless of what price Yamana is trading for, as long as it is $10 or higher.That buyer who you sold the option to was betting that Yamana would close at $10.90 or higher in order for him to make money. Anything less and he loses. The $10.90 comes from the $10 strike plus his cost of $0.90 for the option. If it closes at $10 or higher you will make 33% on your money ($10 strike minus $7.50 cost = $2.50 profit. $2.50 profit divided by $7.50 cost equals 33%).
• If Yamana goes nowhere at stays at $8.40 at expiration you will still make money because you took in 90 cents when you sold the option. Therefore, your return on the trade would be 12% ($8.40 minus $0.90 = $7.50. $0.90 divided by $7.50 = 12%). Since the shares weren’t higher than $10 at expiration, the contract wasn’t executed and it would expire worthless. But you still retain ownership of the shares, free to sell another covered call.
• Finally, if Yamana closes below $8.40, you will still make money since your cost was $7.50. You can only lose money if Yamana closes below $7.50, your adjusted cost and your breakeven point.

Profiting From Covered Calls

As long as Yamana closes below $10, you will retain ownership of the shares and face two options. The first would be to sell your stock and the second would be to sell even more CALL options against your position further reducing your cost. As the owner of the shares you are entitled to any dividends that are paid to shareholders during your period of ownership.

To summarize:

• A covered call trade requires you to own the shares that you then sell options against.

• The money received from selling the options is yours to keep immediately.

• If the shares close above your strike price, they will be taken away (called away) from your account automatically and the money will be deposited in your account.

• Covered calls can be done in any type of account, including retirement accounts.

• Covered call trading can generate additional income while reducing your risk.

Stay tuned over the next few weeks as we break these profitable option trades down even further and we will explore a variation on covered call trading that can reduce your risk substantially while still providing double-digit returns.

Source: Covered Calls: Five Steps to Make Profitable Option Trades

This from a recent interview with Steve Forbes, which you can watch in full on Forbes.com

But then even buying Treasuries, you have the risk of under-performing inflation at today’s rate that you’re getting on Treasuries, right? Certainly with today’s yield, relative to the stock market, I would think Treasuries would be a terrible investment. In fact, we’re short an ETF that owns 20-year Treasuries because we think rates are going up. My point, though, is you can do one of two things.

Generally speaking, to the extent that you can, you can own bonds and stocks, and then within stocks you can pick stocks on your own or you can own a mutual fund or an index fund. I think that picking stocks and doing better than the market over time is very, very, very difficult. Most professionals can’t do it and most individual investors can’t do it. Human beings are hardwired to do precisely the wrong thing, which is buy things when they’re high and popular, and sell them when they’re low and unpopular. And of course to be a successful investor you have to do the complete opposite. I think most average people, who don’t have the time and the training to pick stocks, would be better off in mutual funds or index funds.

Tilson is right that we are “hardwired” to buy high and sell low. That’s why here at Notes we follow only contrarian investors – those that take advantage of the crowd’s uncanny ability to do the wrong thing when it comes to their money. As our commodities investing guru Rick Rule puts it, “You’re either a contrarian or a victim.” Amen to that…

As currencies expert Alex Merk of Merk Mutual Funds wrote recently, “Russian President Medvedev suggests the dollar is on its way out; Russian Finance minister Kudrin says there is no substitute for the dollar. The Chinese see a need to diversify out of the dollar; the Japanese say their trust in the dollar is unshakable.” What’s a poor investor to think?

Merk says Russia’s and China’s – along with fellow BRIC nations India and Brazil – concern over the stability of the dollar and their need to diversify out of dollar-denominated assets is a strategic perspective. As he rightly points out, “There is simply no substitute for the U.S. dollar today; no other market is as deep and liquid, or able to absorb the cash that needs to be deployed by central banks around the world.”

Does this mean the dollar is safe and sound? Not by a long shot. This, again, from Merk:

[We] believe countries around the world are racing to put the “tools” in place to be less dependent on the US dollar. In Asia, for example, after the 1997/1998 financial crisis, Asian countries realized they needed to bolster their countries’ reserves. In the latest crisis, they realized that holding almost exclusively U.S. dollar reserves was a risky strategy. The solution is all too obvious, namely to develop domestic markets. This isn’t just about developing domestic consumption to create a more “balanced” world economy, this is about creating domestic infrastructures, fixed income markets in particular. Currently, many global investors invest in Asian markets by buying US dollar denominated securities plus derivatives. This makes Asian issuers – governments, supranational and corporate issuers alike highly dependent on the US dollar. This will only change if global investors have confidence in the stability and maturity of the local markets. The message to “CEOs” of countries around the world is to show that they are open and ready for business. Such trust is not earned overnight. In Asia, Singapore is a leader; not surprisingly, Singapore has a healthy domestic fixed income market. China is on its way, but needs to do more to provide access to its domestic markets.

It other words, global diversification away from the dollar may not happen today or tomorrow. But the risk to the dollar – and to long-term US economic growth – is real.

Notes readers may want to do something about diversifying their portfolio allocation to hedge against this outcome. As usual we recommend considering beefing up the hard assets side of your portfolio and adding TIPS into the mix, too.

If you’re serious about investing in hard assets, we highly recommend you read this special investor report from Crisis Trader editor Christian DeHaemer on what he calls the “Great Red Oil War.”

Of course, you could also choose to trade currencies directly. For information on how to follow master forex trader Bill Jenkins to currency trading profits, click here.

In fact, on Saturday April 4, I spoke at a conference in Orlando and the crux of my presentation was why buy and hold isn’t the way to go anymore.

After my presentation, one of the attendees asked me why I felt buy and hold was dead.  What has happened in the market that caused the long-held belief that buying and holding a stock or the market forever is not the way to invest?

Where do I start?

With the help of my colleague Christian Hill, we went back to 1950 and looked at the S&P 500 over the last six decades.  Here are the returns per decade.

As I looked at these results, I started thinking about how different the market is now compared to the 1950s.  How many people do you think were actively investing in the market in the ‘50s and ‘60s?  Not too many I would guess.  Maybe four or five million at best.  People may have had money in pension plans and the like, but the funds were being managed by a professional investment manager.

In the ‘70s and ‘80s we saw tremendous growth in Individual Retirement Accounts and mutual funds.  This made it easier for the average Joe to get involved in the market.  In the ‘90s, we saw two things greatly impact investment growth- 401(k)s and the internet.

Look at how the ‘90s were the biggest growth decade for the S&P 500.  Do you think that is a coincidence?

By 2005, there were 436,207 plans, 44.4 million participants and $2.4 trillion in assets in 401k plans.  Do you think the growth in participants and growth in assets had anything to do with the tremendous growth in the market during the ‘90s?  You bet it did.

Take a look at the 20-year periods.

Look at the tremendous growth in the last 20-year periods.  I also decided to break it down into two periods, the first 30 years without 401(k) plans and the 20 years since 401(k) plans were introduced.  From 1955-1985, the S&P went up 350%.  This is an impressive number, but from 1985-2005, the S&P jumped 632%.

The second thing that happened in the ‘90s was the onslaught of the internet and internet brokerage firms.  Instead of having to have an account with Merrill Lynch, Shearson or Paine Webber, individual investors could open an account with any number of online brokerages and pay one-tenth the commissions charged by the mainstream brokers.

I am not saying whether I think 401(k)s and online brokerage firms have been good for the overall market.  But what I do know is that these two creations have had a profound impact on how you have to view the market.

They have created easier access to the market and created more involvement from more people.  Unfortunately, they did not come with more education about the markets.  This is why I think traditional views on investing have been changed forever.

God help us if the plan to allow self-directed Social Security ever comes to fruition.

Source:  How Has The Market Changed Over The Last 60 Years?

We see this played out everyday as more brokerage firms struggle to survive and unfortunately, we see folks like Madoff facing serious charges.

Here’s how you can take control of your investments:

1.    Understand what the market is doing.

That’s first and foremost. You can invest in a good stock that’s breaking out of a set-up, but if the market direction isn’t behind you, it’s like riding a bike into a fierce wind. You must understand where the market is and where it’s likely to go in the short-term. Then, invest in the best set-ups that will be helped by the market direction. It’s much easier to ride a bike with the wind at your back.

2.    Trade only the best set-ups.

Let’s take a look at NVEC, which triggered a long-side trade last week…

When a stock is moving higher, it doesn’t go straight up. Instead it rises, then has mini-downtrends where it consolidates its gains before moving higher. These mini-downtrends are where it pulls back off of its highs in an orderly manner — often to an area of key support such as its upward trend line and/or 50-day moving average.

We connect the lines of the mini-downtrend. A break above the pink line triggers a trade on the long side. For that reason, NVEC was an ideal long side set-up last week:

On Tuesday morning, NVEC triggered a trade by breaking above the pink line.

By Tuesday’s close, we were already enjoying a gain of 5%. And Wednesday morning, we locked in gains of 8.9% — a nice gain in today’s market in just over 24 hours.

This leads to step #3.

3.    Take your profits when you have them.

While on the surface, a 9% gain may not seem like much, I have to tell you that if you just did one trade like that a week, you’d significantly outperform most brokers, money managers and mutual funds. After all, most of these money handlers are nothing but “Managing To A Benchmark” cookie-cutter indexers that know how to sell but not how to manage. Have you seen what the indexes and mutual funds are down year to date? If your traditional account mimics the indexes, you know you’re working with one.

Just think about it. Let’s say you have a portfolio of $50,000. And you invest in 200 shares of NVEC at 28.22. After selling it at $30.74, you’ve made a profit of $504. Multiply that by 52 and you have a one-year profit of $26,208 or 52%! And that’s just from doing one trade like NVEC a week.

What would a one-year gain of $26,208 do for you? Well, it would easily put you well ahead of what most brokers could do for you.

Stocks may continue to go in the direction we want after we take profits. But for the time being, you are never going to go wrong ringing the register on short-term gains. For example, what if we didn’t lock in our NVEC gains at $30.74? Our gains would have been gone as the stock went right back to where it was when it originally triggered.

Now don’t get us wrong. We aren’t out to get brokers. We know a lot of them and many are very good. But the point we are trying to make is the days of handing your money over and expecting a traditional Wall Streeter to perform are over. To be successful, you have to be in control of your investments. After all, only you have your best interests at heart. As good as your conventional Wall Streeter may be, he’s not able to watch your investments as good as you can.

Source: Quicker, Safer Trades Every Week

The so-called benefit was to be able to watch people make every conceivable bad money decision. It was almost as if it was a school for how not to do things. They weren’t stupid, far from it. They just had never had any opportunity to learn any other way of doing it.

Whether it was buying a car, a house, investing in the markets or a small business, it was a constant stream of disasters. They seemed to be drawn to the wrong choices.

This describes most small investors. My entire career in the money business has been spent pounding the table about the costly errors the average guy makes with his money. As we plow our way through this most recent economic tumble, the average person is being exposed to new and more expensive ways to throw their money away.

It seems investors can’t do anything right in this market. Treasuries have always been thought of as the ultimate safe haven. The recent huge move up in price, driven by the shift from the crumbling market of ‘08, is about to teach the uninitiated a very costly lesson.

The part that really upsets me is that this is no different from the usual beating the small investor takes.

Institutions such as insurance companies, banks, pension funds and mutual funds, moved into treasuries as a safe haven from last year’s stock debacle well ahead of almost all others. Institutions always move before the small investor.

This gigantic shift of money drove bond prices through the roof. In fact, some treasuries had gone so high the interest rate was ZERO. Most people miss the significance of this, since most people don’t think of treasuries as gaining or dropping in price. The popular concept is that these are just like bank CD’s, no fluctuation, and no risk. Dead wrong.

Unless you are planning to sit on your treasury bonds, notes or bills for the full maturity, you have almost as much risk in these as you do in almost any other investment.

As is always the case, the followers got in after the institutions drove prices out of sight. So, the price the little guys paid a few months ago will drop as the big players continue to sell their positions and move to higher yielding bonds.

When the individual investor sells, he will learn the hard way that treasuries fluctuate in price.  In this case downward from the top of the bubble, and the safe haven has just become another money hole.

Bonds are bonds; the US government guarantee is only good if you hold these to maturity. This may be stating the obvious for many of you, but after almost 20 years of talking to the average investor, believe me, this is big news to them.

The institutions get away with this because they anticipate moves and in most cases create the moves. The average guy follows, as best he can, based on information that is days and weeks old at best. Too little, too late.

Another developing problem with treasuries is that OPEC and China own a huge percentage of our outstanding debt. These same groups are being killed by the worldwide economic slow down and the drop in oil prices. If either of them decides to liquidate their holdings in treasuries, we could see a massive drop in prices beyond that of our own institutional driven drop.

Don’t get caught in this safety trap!

The place to be right now is corporate bonds. The shift from treasuries has just started. This has been prompted by a slight thawing in the fearful response that drove the institutions to treasuries last fall. As this thaw continues, more and more big dollars will leave treasuries and look for higher paying investments that do not carry stock risk.

There was a big jump in corporate bond prices, in some instances 25- 40 percent, in the last few weeks that marked the beginning of the shift to corporates. But this big move has started to correct with the new uncertainty about how the TARP monies will be distributed, the further weakening in the banks and financials, and the concerns about whether or not the banks will be fixed by the government’s efforts.

This temporary drop in prices is one of the best buy signals I have seen since last November. You can pick up investment grade companies at good discounts to PAR and I am seeing yields as high as 7.2% on maturities of six to thirty months.

Here’s an opportunity to get in ahead of the followers. Take a look at the Bond Trader. To date, it has not had a single loss and has taken capital gains in the last few months of 40-90%.

The average total return for the discounted investment grade bonds in the portfolio is between 15% and 33% with maturities under three years and current yields of 7.2%. That’s a lot better than watching your stock portfolio drop every time the wind shifts.

For once, be in front of the followers. Get in on this now. Don’t wait for the TV to tell you its happening. If the TV talking heads are saying it, it already happened.

I’ll be back next week. Keep your powder dry and your eye on the horizon.

Source: The Treasury Bubble

This from Smart Profits Report:

I’ve been spending the past two weeks intently trying to make sense of the dramatic shifts in our financial markets, the U.S. economy, and even our societal mood.

The news is not good.

In fact, a friend of mine who’s an investment banker summed up the current conditions best, using just one word: “Brutal.”

She reports that her business hasn’t just slowed… it’s at a complete standstill. As a result, she and her colleagues won’t receive any bonus this year.

Meanwhile, the mainstream media continue to rant and rave, almost relishing the situation. A popular radio talk show host is predicting financial Armageddon in the United States, terrorist attacks and pretty much every other type of catastrophe. Frankly, I’m surprised a devastating locust attack wasn’t mentioned.

And I bet that if you talk to people you do business with – from your local shop owner, to gym manager, they’ll tell you that business is off considerably.

Before we dig into the other side of this mess, let me just state for the record that this is a scary time – and things will probably get worse before they get better.

But if you’re one of those folks who are having a difficult time picturing the other side of this mess – a brighter side – you need to realize just how extreme market conditions already are. As the saying goes, “This, too, shall pass” – and the market will eventually return to normal.

Here’s a little perspective – and some common sense…

Perspective Amid The Panic

Take a look at the following facts – ammunition that suggests we’re due for a bull market.

Okay, maybe not today… maybe not next month… maybe not even in the first half of next year. But the numbers below should give investors confidence that it will soon be time to back up the truck and load up on stocks.

#1: Excluding the 1929-1932 crash, bear markets recouped their losses in an average of 22 months.

With the exception of 1929, the largest declines were as follows:

– The 1937 Bear Market: A 50% decline, which lasted 13 months and recovered all its losses in 58 months.

– The 1974 Bear Market: A 43% decline, which lasted 21 months and recovered all its losses in 21 months.

– The 2002 Bear Market: A 45% decline, which lasted 25 months and recovered all its losses in 40 months.

The current bear market is down 52% – from peak to trough – and has lasted for 14 months.

#2: According to Wells Capital Management, between 1984 and 1994, the loan delinquency rate was above today’s level.

In fact, current business loan delinquencies are actually near record lows and consumer loan and credit card delinquencies are at the same level as they were three years ago.

And while delinquencies will rise further as the economy regresses, Wells believes this doesn’t support a depressionary debt collapse.

#3: Volatility is at an all-time high.

During 1929, volatility peaked at 68%, according to Barron’s. In 1987, it peaked at 64%.

The Volatility Index (VIX) recently set an all-time closing high of 80.9 on S&P 500 options expiring in 30 days, which indicates an average daily move of 5%.  That’s an unsustainable amount of volatility and the markets will certainly slow down and become less frenetic.

#4: At the recent lows, the S&P’s annualized 10-year real return was a negative 3.8% – an all-time low. At market lows of 1974, the trailing real 10 year annual loss was 2.7%.

#5: Only 16 stocks in the S&P 500 are positive on the year.

#6: Morningstar tracks over 11,000 equity mutual funds. Every single one is down for the year.

I share these statistics with you, not to show you how dire things are, but to illustrate the excessive fear that investors are experiencing. So what’s the solution?

In Times Of Pain, Go Against The Grain

Market history teaches us that during these kinds of extremes, it’s usually a good time to move in the opposite direction.

I’m not necessarily recommending that you load up on stocks today, because I think we have a little more pain to experience yet.

But with the market so far past its normal limit, I fully expect it to return to a more typical environment. And in order for that to occur, the market must rise significantly.

I believe the next six months will be a once-in-a-generation opportunity to buy assets at irrationally low prices.

Source: The Numbers Don’t Lie… Why A Bull Market Will Arrive Sooner Than You Think

You also have to know that the Social Security System was flushed away by congress a long time ago. The general fund, or the excess contributions made to Social Security for the last 50 years, was squandered along with another nine trillion dollars.

That leaves all of us over 50 with the responsibility of funding most, if not all of our retirement. Unfortunately, the down turn in the stock market, as the result of congress mandating that Fannie Mae (FNM) and Freddie Mac (FRE) guarantee mortgages to people who could never possibly pay for them, has crushed an entire generation’s retirement funding.

The simple fact is, since ‘87, the majority of Americans have poured almost all of their retirement dollars into stock mutual funds in their IRA’s and their 401k’s. Prior to the mid 80’s all of it went into bank investments. Our exposure to the stock market is the largest and most wide spread ever. Losses in investments this time will be much greater than 1987.

Time has almost run out! For the majority of Boomers there is only one more opportunity to secure their retirement. Most of us will live far below what we should have been able to afford no matter what we do. But, if we don’t spend the next ten years doing more than playing the stock market lottery, we are in deep kimshi.

Every person over the age of 50 has no choice but to shift into a reduced risk investment strategy. We no longer have enough time in our working lives to wait out another disaster in the stock market. We also cannot delude ourselves that we will somehow avoid another huge down turn in the market.

The truth of the matter is that the very nature of the stock market is to flush out the weak every few years. No one knows what will cause the next explosion, but it is coming.

There is some good news. Holy cow! Do we need some good news, or what?

Reduced Risk Portfolio.

Most investors avoid this type of strategy because it implies stodgy, turtle like returns. But if you reduce the risk level of your holdings by diversifying into corporate or tax-free bonds, you don’t necessarily reduce your return. In fact, history has taught us you actually increase your overall return because you don’t give back any in a correction, almost zero.

The stability bonds add to your portfolio will actually let you sleep at night. You know going in exactly how much you will make and exactly when it will appear in your account. And with a little effort, you can see the same returns from bonds that the stock market has produced long term.

In the past few corrections you ended up giving back almost as much as you earned during the Bull Run. The really sad part is that most people have to get hit over the head many times to get the message. Most have nothing left by the time they learn the truth about stocks.

The critical point for the boomers reading this is, you don’t have the time anymore to wait out another correction. If we get slammed again, we don’t have the working years left to replenish our accounts. We will be up the proverbial creek. This is your last window of opportunity to secure a retirement.

If there is any good to come of this sell off it may be a final wake up call for us to stop playing Vegas with money we can’t afford to lose. We are not 35 years old anymore with 30 years to get it right. Get it right this time or learn to live below the poverty level.

In my head I am still 25. I am still thin, fast and almost immortal. But my lower back tells me loud and clear I am 55. We all need to feel our age in our wallets, too.

This country is on the verge of a financial tragedy. If the baby boomers don’t wake up and get their money house in order, we could be setting up our children to live at the third world level. The financial burden of keeping us in our old age will make their lives a mere shadow of what we have known.

Our time is not running out, our time is up.

Let the other guy go down with his ship. We live to fight another day.

Source: The Baby Boomers’ Last Window of Opportunity

He says it is essential to guard against today’s downside risks with trailing stops, inverse ETFs, and put options.

And every investor should have a plan to re-engage with the markets when this financial storm passes.

This from Money Morning:

As the worst financial crisis in recorded market history rocks Wall Street, millions of investors on Main Street keep asking a single question.

When will this end?

The market volatility is unprecedented: Where professional traders once ranked a day as “wild” if we witnessed a 300-point swing, in recent months we’ve seen 600- and 700-point swings on a regular basis. On Oct. 9, a Thursday, we rode out a record-setting swing of 1,000 points.

That wild backdrop is bad enough. At the same time, however, the major market indices are heading lower – at times with a speed and ferocity never before seen. But the real killer is that there is seemingly nowhere to hide.

This is what Wall Street’s Armani Army doesn’t tell you about traditional diversification: It doesn’t work when everything goes down at once. (The one exception is the specialized inverse investment vehicles that we’ve repeatedly counseled you to employ precisely to prevent this kind of total freefall. Two examples that we’ve mentioned numerous times were the Rydex Inverse S&P 500 Strategy Fund (MUTF:RYURX) and the ultra-aggressive “2X” ProShares UltraShort Financials (AMEX:SKF) exchange-traded funds).

Most noticeably, of course, was last Friday’s trading, which began after an overnight bloodbath in the markets overseas. A notice from the CME Group Inc. (CME) that stock index futures contracts were “limit down” – meaning they’d achieved their maximum allowable downward move for U.S. stocks even started trading for the day – didn’t help much.

While much of this is commonly explained away as a panic reaction to the news, the reality is that it’s primarily a financial panic that’s driving this market action lately. And, just in case you recall my comments a few weeks ago about not having seen the hair on fire selling I thought lay ahead, this is exactly what I was referring to.

This time around, ironically, it’s not panic from normally flighty retail investors that’s causing the markets to go haywire. Instead, it’s the big boys that are apparently panicking.

My experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week when the newspapers finally catch up, but the massive swings we saw in currencies, gold and other commodities are certainly consistent with an unprecedented liquidation – and a forced one at that. Perhaps even more than one.

Long the domain of hedge funds and their uber rich clientele, many hedge funds were over-weighted in these categories in recent months in an attempt to chase performance. Overweighting, in case you’re not familiar with the term, means they’ve made excess investments in those areas. And chasing performance means they’re trying to create higher returns by making disproportionately larger bets than they would otherwise. Part of this could be from simply trying to generate larger performance fees, but it could just as easily be attributed to anxious managers placing ever-larger bets in an attempt to make up losses (most hedge funds are under water this year).

Where this gets fund managers in trouble is when they make these over-weighted bets by using leverage. You’ve probably heard this term a lot lately. In case you don’t understand what it really means, let me digress for a moment to explain it. Leveraging up (or simply “levering” to those in the industry) means using borrowed money to control a huge pile of assets that you wouldn’t otherwise be able to control.

In recent years, for instance, it wasn’t unusual for a hedge fund to lever up 30 to 1, meaning for every $1 dollar they invested they borrowed $29. As a result, a fund with $100 million under management could control $300 million or more of investable assets. I’ve heard of some funds running 50 to 1, while currency traders routinely run 100 to 1.

While using other people’s money dramatically enhances the potential for higher returns, it really enhances the potential for massive losses. Where this gets them into trouble is that a fund running 30 to 1 only has to lose 3% of the $30 worth of equity to get wiped out, as in kaput.

Somewhere along the way, as bad turns to worse and performance deteriorates, a hedge fund’s creditors will place a margin call, meaning they want the hedge fund to pony up more collateral or return the money it was loaned. Or, investors will place redemption requests meaning they want out. Either way, this forces the operator of a hedge fund to raise money any way it can.

If a given hedge fund does not have enough cash to meet the margin calls or redemption requests, they have to raise cash by selling assets. And they typically start with the most liquid stuff like gold, currencies and commodities. At first, the sales progression will be orderly, but as I suspect was the case last Friday (and on many big down days recently where chaos ruled), it will rapidly deteriorate into a fire sale where the hedge funds involved dump everything they can at any price just to get out.

And that’s where their problems affect you and me.

As scores of highly leveraged hedge funds dump billions of dollars worth of holdings at once, they effectively “flood” the markets with whatever the asset is that they are trying to sell. In doing so, they push the values down for the rest of us.

For an example, imagine a house in your neighborhood selling for 50% of its appraised value. Upon completion of the sale, all “comparables” in the area, including your own home, will likely take a hit as a result. So it’s in everybody’s interest to keep prices as high as possible.

But nobody can do that when there are more homes than buyers – even in the best neighborhoods.
So when is it going to stop?

We don’t know. No one does. Hedge funds are notoriously secretive in their reporting, so even though there are estimates as to how much they own and (by implication) how much they owe, it’s hard to gain perspective on how much leverage is actually being used. Nor do we really know who holds what asset – especially as it relates to potential liquidations.

Over the weekend, rumors were flying that U.S. Federal Reserve examiners are hounding Citadel Investment Group LLC regarding “counterparty risk” and its exposure to debt. Citadel, naturally, vehemently denies this, but lately where there’s smoke, there’s certainly been the potential for fire.

[...] The bottom line is this: What should we do for now?

That’s actually the easy part even though it may not feel like it.

1. If you’re retired, take a good hard look at how much money you really need for the next five to 10 years. Talk to your financial advisor and, if needed, take some risk off the table. Move what you need into cash, or such safety-first choices like the American Century Capital Preservation Fund (MUTF:CPFXX). Do not own anything you would not want to have in your portfolio if the stock markets were to be shut down for a short time.

2. If you’re not retired – but are close – and have properly diversified your money to something akin to the 50-40-10 structure we advocate (50% base-builders, 40% global growth and income, 10% speculative), hang in there. And remember, this is exactly why we diversified our holdings in the first place – to get through the rough spots. It’s just that this is perhaps the roughest most of us have ever seen.

3. Stick to your plan. Hopefully that includes the disciplined use of trailing stops to capture gains and minimize losses, as well as specialized inverse holdings that profit with each further decline. And don’t forget options to hedge existing risks.

4. Above all else, make sure you have a plan – as we do – for re-engaging the markets when the coast is all clear. It may be awhile before we reach that point, but it’s important to maintain your upside potential in a down market. When the train leaves the station, the one place you don’t want to be is left behind on the platform. Studies like those from Standard & Poor’s show that investors can typically make up 80% or more of bear market losses within the first year of a recovery, once that recovery actually arrives.

Source: Four Ways to Sidestep the Damage Wall Street’s Big Money Movers are Inflicting on Main Street

More from Penny Sleuth:

Congratulations on making it through yet another week of panic, margin calls, and forced selling! If you’re surviving, and you’re not down too much this year, you’re better off than most money managers.

Out of the thousands of hedge funds in existence, hundreds are closing up shop and liquidating, if the past weeks’ trading action was any indication.

Many of these hedge funds should never have been started to begin with, because their illusory gains during the credit bubble were too often made with leverage, rather than analytical talent.

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Recommend Plays That Go Up Even When the Market Goes Down

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You don’t have to worry about the uncontrollable macro outlook on the markets or the management and earnings of a specific company. Your only concern is simple: Making gains in any type of market.

You have the opportunity to make gains no matter what the market itself decides to do.

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The Good with the Bad and the Ugly

Yet their demise hurts anyone trying to manage an investment portfolio in a prudent manner — similar to how Bear Stearns and Lehman Brothers permanently stained the entire investment banking industry.

It’s a case of a few bad apples spoiling the whole barrel. Unfortunately, it remains to be seen how regulators and politicians will punish every investor, including those who have acted prudently.

For example, I just read a publicly released copy of a letter dated Oct. 2, sent from the U.S. Congress to Harbinger Capital Partners. It asks Phil Falcone of Harbinger Capital to reveal practically everything that’s confidential about his funds and to testify before a committee. Let’s hope U.S. regulators don’t take action to drive even more investment talent overseas, because we need them here to help keep our markets efficient.

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Hidden Government “100-F Documents”… That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

Find out how you can now use these same “secret” documents to post returns as high as 400 — 600% over the weeks ahead by clicking here…

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The Baby’s Bathwater

It amazes me how long this environment of panic has lasted. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion — many of them down 20% in a day and 50% over the past month. These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative Internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years.  There are some screaming bargains out there — unless, of course, half of the world’s population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything’s possible.

Source: Hedge Funds Forced to Cover