All the Buzz About P2P Lending

As anyone who has read Rich Dad, Poor Dad can tell you, the rich spend their discretionary income to buy assets and the poor use theirs to buy liabilities. It's important to remember the simple definition: An asset puts money in your pocket each month, and a liability takes it away. While those concepts are relatively easy to understand, the trouble for many people is finding assets to buy. Few want the headaches of owning rental property, the volatility of the stock market, or the low rates of bonds or savings accounts. What we are all looking for is better than average returns with less than average risk. A new investment tool, called peer to peer (P2P) lending, has recently started gaining popularity. In the classic risk vs. reward battle, this one fares very well.

Imagine that a friend of yours was considering a bank loan for an upcoming purchase. If you had some extra money lying around, then you might be able to help your friend out in a way that actually helped you both. By splitting the difference in interest rates between what your friend can get from the bank and what you can get in a savings account, it becomes a win-win situation. For example, let's assume you have an HSBC Direct banking account which is currently offering 5.05% APY. If the best rate your friend can qualify for at the bank is 15%, then you might compromise on a rate of 10%. You would be getting a much better return than if you had put your money in the bank, and your friend would be paying much less in interest than if they had borrowed from the bank.

While we may all have friends who need money, they won't necessarily need it at the same time, or in the same amounts, that we have it available. If you had thousands, or millions of people looking for money, then it would be easier to find someone to loan to when, and at what terms, you were looking for. To satisfy this need, many P2P lending websites have come about in the last few years. They offer a place to match borrowers and lenders, as well as handle the legal details of the loans, taxes, etc.

Since you most likely won't know the people you are lending to using a P2P lending site, different methods of establishing trust are used. Trust is important, because while you do get a better rate of return in the example above, you also take on more risk, since the return payments are not guaranteed. In the example above, you were willing to take on that extra risk because of the trust that you have with your friend. If you didn't know the person you were lending to, you'd like some extra assurances that they were likely to pay you back. When banks make a loan, they'll largely base your interest rate on your FICO score. This is a single number that basically represents your credit-worthiness, i.e. your likelihood to repay.

The P2P lending sites tend to use this number as a starting point for your interest rate as well. Some sites assign you a credit rating based on your score. Then users will bid on an interest rate for your loan, taking your credit rating into consideration. Other sites pre-qualify you at a certain interest rate based on your credit-worthiness. Users would then be matched with loans that meet their desired criteria: interest rate, cause, or specific loan. You can even loan to specific groups of people, such as Alumni from your University or Retired Teachers, etc.

Regardless of which P2P site you decide to use, its always a good idea to diversity your loan portfolio. Think about how much your risk would be reduced if you loaned $25 to 40 people instead of $1000 to one person. In the first case, if one or two people defaulted before they had completely repaid the loan, you would still make a profit. Obviously, in the second case, you might lose a lot more if the one person you lent to didn't fully repay. As with any investment, I recommend that you start small, see how it works for you, and then expand on that method as its success becomes more apparent.

Here are a few P2P lending sites to take a look at:
Prosper
Lending Club
Zopa

My Required Reading List

One of the most important things I learned from the book "Rich Dad, Poor Dad", is that our traditional education system is severely lacking in the area of financial education. As a result, even people highly educated in the traditional sense often lack basic financial literacy. That thought has caused me to start a reading rampage on the topic of money, wealth, and of course investing and the stock market. Included below are the three best books that I have read on the subject.

Rich Dad, Poor Dad
Robert Kiyosaki and Sharon L. Lechter, ISBN: 0316857750

Jim Cramer's Real Money: Sane Investing in an Insane World
James J. Cramer, ISBN: 0743224892

The Millionaire Next Door : The Surprising Secrets of America's Wealthy
Thomas J. Stanley and William D. Danko, ISBN: 1563523302

I would consider these the foundation of my financial education and mindset. In addition, I highly recommend other books in the Rich Dad series. While I've only read "Retire Young, Retire Rich" and "Prophecy" so far, the manner in which they are written is consistent with the philosophy of the original, and I expect the other books in the series to be as well.

Some other interesting books that I've read on the subject of money and investing are "The Little Book that Beats the Market", "Stock Market Miracles", and William O'Neil's classic "How to Make Money in Stocks." I also read Jim Cramer's autobiography, "Confessions of a Street Addict" just because I find him interesting. The point is, the more that I read, the more that I learn. Take "Stock Market Miracles", for instance. It reads like it was written by an illiterate moron. But if you can get past the poor English and awful grammar, there are actually some good ideas in there. It just goes to show you that having good investment ideas does not mean that you are able to write well about them. So at times even poorly written books are still good books, if they generate ideas that can make you money.

I recently relocated and cannot stress enough the value of a good library. If you don't live near a quality library, it's worth the drive to one. My old local library has a handful of books on the subjects of investment and wealth, and most had copyrights from the Sixties. My new library has thousand of books on the subjects, and seems to get more every time I go. I've been reading twice as many books as I used to since I'm no longer shelling out twenty bucks every time a new one comes along.

New Feature Added to Sidebar

Starting today, I'm going to keep a running total of my percentage gain for options on the right hand side of this page, under my profile. I'll only show realized gain, since you shouldn't count your gain before you actually sell to lock it in. I'll also list the number of transactions I've made so that "He got lucky (or unlucky) once" theory will hopefully be dismissed. Gain is shown with commissions considered, but not taxes. I'm not posting it to brag, but rather to give you a reference point about what I have been able to accomplish using options. I'm not recommending that you try it, but do hope the information is useful.

Working When You're Not

I've been out of the world of the stock market for a few days, since I went away for the Fourth of July Holiday. That didn't stop my account from working for me while I was gone. Before I left, I set a few Good till Cancelled limit orders. When I returned I had email alerts telling me that some of my orders were executed and a new chunk of cash was in my account. As a reminder, when you place a limit order, the duration is either for "Today", or "Good till Cancelled". If you set it for today, and it doesn't get executed by the time the market closes, your order will expire and the money you had allocated for the purchase will be returned to your account. Good till Cancelled orders will tie up your allocated cash and be queued for execution until you manually cancel the order. Another option I often choose is "All or None." That means that if I place a limit order for a certain number of shares or contracts, the order won't be filled unless it can get all of them at that price. Without that, you might get fewer than you ordered at that price. The problem there is that if the duration of your order is for the current day, the rest of the order will expire. That's a problem if you were estimating that commissions were only a small part of the purchase price because they may become a large portion as a result. For example, let's say I place a limit order for 10 contracts at $1.00. With Scottrade, that would cost me $7 plus $1.25*10= $19.50 in commissions and $1000 for the options. So the commission is less than two percent of the cost. But, if I haven't selected "All or None" and the order expires before the whole thing gets filled, I'll be paying a higher percentage commission. Let's say only 1 contract gets bought at that price. I'd pay $7 plus $1.25 = $8.25 in commissions and $100 for the options. Now the commission is more than 8%!
So what I do is either select All or None, or make the order Good till Cancelled. The second method works, because if the order is filled at multiple times, you only pay the commission once.

Infinite Returns

There's an easy way to have infinite returns on your investments. Your percentage gain is simply your gain over your cost. Since your gain is limited by how a stock performs, another way to increase your return is to lower your cost. If you could get your cost down to zero, then your return would be infinite, since gain divided by zero is infinity(Don't get me started on calculus). How can you possibly get your cost of a stock to zero? It's really quite simple. Let's say you buy 100 shares of stock and over time it goes up by 5%. You could sell all 100 shares and take a gain of 5%, or you could sell 95 shares and get back all of the money you started with. In that case, your investment cost you nothing, so when you sell those remaining 5 shares in the future, you will have a gain with no cost. In this simple example, I might sell 97 shares so that taxes and commissions are paid for as well. Obviously, as your gains increase, the percentage of shares you have to sell to get your money back goes down as well. Lately I've been buying options that go up so fast that I am able to make about 20% on my initial investment by selling only 2/3 of the calls I bought. So instead of taking the 80% gain on my entire investment, I take a modest gain (20%) and get the rest of my options for free. I've been able to pull this kind of turn around in as little as a week. Just imagine if you could do this repeatedly and get free call options every week.

Earnings, Earnings, Everywhere

Now that we’re swinging back into earnings season, I thought that I’d make a few comments on the subject. Once a quarter, publicly traded companies release a quarterly report. That makes sense, right? The report is usually released first as a hardcopy, with a conference call following, to talk about the results. Both events typically happen after the markets have closed for the day. You can listen to the conference calls and read the report by visiting the company’s investor relations webpage.

When earnings are reported, it’s like a reality check to see if the investors have gotten it right over the last few months. Many analysts try to predict what the EPS, or earning per share, for a particular company will be. By the time earnings are released, the price of the stock tends to be priced at the level that would be appropriate if the average analyst’s estimates were correct. So if the company beat estimates, the stock will tend to go up and if they don’t meet the estimates, it will tend to go down.

All other things being the same, you want a company to have as high an EPS as possible, since that means for each share you own, the company has earned (you) more money. Of course you don’t get the money they earn, but solid earnings will generally make the price of the stock go up, which does mean more money for you.

The company that I’m waiting for earnings from right now is Research in Motion, who reports on Thursday afternoon. I hoping there’s good news to help my September options. Wouldn’t a merger with Palm be nice?

When a Bad Day is a Good Day

The market seemed to have a pretty rough day today. I was smiling all day about that. I hope tomorrow is even worse. Am I short a lot of stocks? Nope. Do I have lots of puts? Nope. Am I a sadist? For the last time, nope.
Here's why a down market gets my spirits up:
A lot of good stocks took a hit along with the bad ones. So when I buy tomorrow, or the next day, or whenever the market is about to start coming back, I'll be buying at a reduced rate. This strategy is particularly profitable with options, because it's likely the good stocks will come back from today's losses pretty quickly.

My Options Strategy

My latest guilty pleasure in the world of the stock market is options. They are generally considered (and often subsequently dismissed) as being too risky for most investors. A better way to describe it is that they have a different risk/reward structure than traditional stocks.

Here’s how the basics work:

A call option gives you the right, but not the obligation, to buy a stock at a certain price within a certain timeframe. A put option gives you the right, but not the obligation, to sell a stock at a certain price within a certain timeframe. That certain price is called the strike price and the timeframe ends at the expiration date, which is the third Friday of the month for which you bought the call. Each option you buy is called a contract and controls 100 shares of the underlying stock. For example, 1 contract of Home Depot AUG $40 calls would give me the right to buy 100 shares of HD for $40 per share anytime before the end of trading on the third Friday of August.

Why would I want a call? Well, calls are comparatively inexpensive. The HD $40 AUG call might cost me $100. Prices are quoted for a single share, so the call would be listed at $1, which would cost me $100 since the contract is for 100 shares. Let’s assume that Home Depot was trading around $35 when I bought the call. If HD stock starts going up, so will the value of my call. You might think that the price would have to go above $41 before the expiration date to make any money. That would be true if you planned to hold your calls until expiration. The other possibility is that you sell your call before expiration. Let’s say that Home Depot stock goes up to $37 within a few days of buying the call. That’s a 5.7% gain for the stock. The option might also go up by $2. In that case the option has gone from $1 to $3, which is a 200% gain.

One way options make you money is that for a smaller initial investment, you can control a larger amount of stock. Instead of spending $3500 for 100 shares of HD, you can buy the right to the gains on the stock above $40 for only $100. Of course the downside is that if the stock is trading at less than $40 when the option expires, you lose all the money that you spent on the option. Remember, though, that you could always sell your call before expiration to limit your loss.

Why would I want a put? Let’s say there’s a stock that I think is going to tank. If I own the stock, I would probably sell it. But if I don’t own the stock, I can still profit from it going down. One way to do that is to sell it short and then buy it back at a lower price. But to me, short selling is really risky, because if the stock takes off I could be out a lot of money. So an alternative to selling the stock short would be to buy a put. If the stock was lower than the strike price at expiration, I could buy the stock at the low market price and then exercise my put to sell it at the higher strike price. Of course the alternative would be to just sell my option before expiration so that I would not have to get involved with the actual stock.

My strategy for options:

I’ve seen many of my stocks dip down to about 90% of my purchase price while I’ve held them. So in a sense, I’m OK with, and somewhat tolerant of, a 10% loss in my stocks. So instead of spending all of the money I had allocated for a particular stock, I might only spend 10% of that and use it to buy options. The worst case scenario there is that the options expire worthless and I lose all of my money. But remember, I’ve only spent 10% of what I was planning on spending, so losing all of my money is really only losing 10%. The best case scenario is that the underlying stock takes off and I make a large gain on my options. I have been buying options to sell them within a few days or weeks, as opposed to holding them until expiration. So I’m looking for small moves in a stock to let me cash in faster through the use of options.

Here’s an example of my first option trade:

The S&P Mid-Cap Spider (MDY) was had been down for a few days in a row. It was trading around $132. I bought two MDY $135 calls at $2.80 which were set to expire in about 40 days. Within two days, MDY peaked at $136 and I sold my options for $3.50. So in the course of three days I took $560 and turned it into $700. That’s a 25% gain in three days. I had set up a limit order to sell my calls at $3.50 and I’m glad I did. That day, only 10 options exchanged hands at that price and mine were among them. The window of opportunity to sell at that price was only about 5 seconds, so my limit orders really paid off. I knew what limit price I wanted because I had calculated what sell price I would need in order to get the gain I wanted, even considering commisions and taxes. If, instead of buying options, I used my $560 to buy MDY, I would have been able to buy 4 shares of MDY for $528. If I had sold them three days later, I would have gotten $544 for them. So instead of making $16 (hardly enough to cover commissions), by using the leverage of options, I made $140.

There are many more advanced strategies using options than the ones I’ve described here. There is a lot of good information available through websites and books on the subject. As long as my way of doing it keeps making me money, that’s the way I’m going to continue doing it.

One last note about options: Because there is always the risk of losing all of the money you put into them, there are usually some additional forms that you have to fill out with your broker before they will let you trade them.