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Aug 19, 2008

MITTS: The Surest Thing in the Stock Market

By Andrew Mickey, Q1 Publishing

There are no guarantees in life. And there are even fewer guarantees in the stock market.

Cheap, out of favor stocks look enticing. But what appears to be the bottom may not be the bottom.  It is impossible to completely eliminate all risk from a pure stock play.

Avoiding junior start-ups and micro-cap companies doesn’t protect you either.  The $25 billion espresso machine Starbucks (SBUX) looked like a safe bet in Nov 2006 at $39.43 (ever tried to quit drinking coffee?) but it is currently trading at $17.72 – down a whopping 55% despite solid earnings growth.

Most of the world’s most successful investors have won and lost fortunes over the course of their career.  You learn your lessons, lick your wounds, and start again.

MITTS: Make Risk Optional

But for many of us, losing our fortunes - however modest they may be - is an emotional journey that we are not willing to go on - for any amount of upside exposure.  And there’s no shame in that.  In fact there’s nothing more destructive to your mental health than pretending to be a shark when you are really a sunfish.

What if I told you there is a “no downside” security can be bought through any broker, doesn’t require your money to be tied up for years like a bank CD - and you can get started with as little as $100?

You’d probably think I was kidding.

But I’m not.

It’s called a MITTS (Market Index Target Term Security).

One of Wall Street’s best-kept secrets for risk adverse investors, the MITTS is a financial instrument that allows you to invest in the stock market with ZERO chance of losing a single penny of your original capital.

MITTS were first devised by Merrill Lynch a decade ago, but because they are hard to explain (and therefore hard to market) they haven’t really caught on. 

MITTS: Wall Street’s Moment of Genius 

The genesis of MITTS can be traced back to the 1980’s when the field of financial engineering was created. Mathematicians and computer programmers were brought into the trading desks of big brokerages. The financial world became a science. Complex stock trading programs powered by supercomputers are now standard on Wall Street.

Granted, the mathematicians made some things more complicated than they needed to be.  And a lot of their ideas didn’t add up. But the number-crunching geeks also introduced some fresh ideas.

One of those ideas was equity-linked securities, which are a hybrid of stocks and bonds.

MITTS are the combination of a zero coupon bond and an option contract.

A zero-coupon bond is a bond that will pay you a specified amount at a future date. If you buy a U.S. government zero-coupon bond with a maturity of 1 year, you will get no interest payments. All you get is the bond repaid at the end of the year.

For instance, you can buy a U.S. government zero-coupon bond for $900 and it has a face value of $1,000. When it matures, the U.S government will pay you $1,000. That works out to about an 11% interest rate.  Not bad - but it doesn’t get the heart racing.

MITTS in Action

A zero-coupon bond is purchased at, let’s say, 90% of face value. The remainder is used to purchase an option contract. The option contract, a right to buy or sell a certain stock or index at a specified future date and price, is tied together with the zero-coupon bond to create the MITTS.

If the option expires worthless, the zero-coupon bond reaches maturity and you get the full amount back.  If the option expires “in the money,” the payout is higher than the minimum. The value of the option depends on the ending value of the index the option is connected to.

That’s how MITTS are downside protected yet still offer the upside of the market.

MITTS are usually tied to major indexes. The most common MITTS are linked to the S&P 500 and Dow Jones Industrial Average.

MITTS: The Downside to “Zero Downside”

There are brokerage fees for paid out to the institution that created the MITTS.  So if the index goes up 60% over the term of the MITTS, your investment might only go up 50%.  That’s the price you pay for being guaranteed your principal back, regardless of the performance of the index it is tied to.

The Internal Revenue Service considers MITTS to be bonds.  You have to pay tax on them, although there is no payout.  And the profit from the index appreciation is considered income, not capital gains. Therefore MITTS will work optimally in tax-deferred retirement accounts.

MITTS: How to Get Your Mitts on MITTS

Buying MITTS is just like buying a stock. They trade on major exchanges like stocks. That’s the part of the beauty of them.

For instance, the Merrill Lynch Dow Jones MITTS is traded on the NASDAQ with ticker symbol MTBD. As I write, the MTDB is changing hands for $10.65 each.

On January 1, 2009 it will be liquidated and you will receive a minimum of $10. If the Dow rises, you could be paid $11, $12, $13, or more for each one you own. The end value depends on how much higher the Dow is in January of 2009. But with MITTS, if the Dow falls, you will receive a minimum of $10.

Also, if you need the cash and want to lock in any gains, you can sell them just like a stock.

MITTS: Are They For You?

To be honest, only you can answer that question. However, I can tell you MITTS are a little known investment opportunity that will fit into almost any portfolio.

If you’re an active exchange traded fund (ETF) or mutual fund investor, MITTS might just be perfect. The opportunity to go along for the ride in a market upswing while being protected from the downturn is enticing.

If you’re looking for a low-cost, low-risk way to diversify, MITTS are worth a look.

At Q1 Publishing, we’re always analyzing the downside of any investment idea.  In the case of MITTS, they pass this test with flying colors.

There aren’t many ways to get involved in the stock market, that will let you rest your head on your pillow every night and know that your nest eggs will survive any catastrophic event 100% in tact.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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