“Dark Equities: Secret of the Wealthy 1%”

By Travis Johnson, Stock Gumshoe, January 22, 2008

This one comes in from Karim Rahemtulla, and it’s my favorite kind of teaser: The one where they invent a fancy new term for a relatively commonplace investment strategy, and use it to convince you that the newsletter provides a connection to the deep, hidden world of Wall Street that can unlock the riches that you know you deserve.

He’s selling a subscription service called “The 400 Report,” which will run you $1,155 at the special “discount price” (normally $2,500). And apparently, that service specializes in a special kind of investment called “Dark Equities.”

“99% of Americans Are ‘Clueless’ About This Investment… the Other 1% Is Wealthy.”

Of course, your broker is going to have no idea what “Dark Equities” are, since Rahemtulla invented the term — so your friendly neighborhood Gumshoe is here to help. Though I must confess that even though I’m quite familiar with these securities and therefore must be in this 1%, I’m afraid that I’m less than wealthy. Though my life is rich with rewards.

In the ad’s words, “Rarely does the mainstream media mention [Dark Equities]. I’ve never seen them talked about on the mainstream business shows – and I’ve been a guest on them! …”

Apparently, these trades are “… executed typically by only the most savvy and seasoned traders – people who understand you can’t make real money buying stocks the way everyone else does … I will admit, though, that when I talk to investors who do know about it (typically they’re big money types… Wall Street insiders), voices are hushed and we’re usually alone. Never in a crowd.”

OK, so do you feel like you’re super important yet? “Voices are hushed and we’re usually alone?” Seriously? OK, I don’t usually editorialize like this, but if someone tries to sell you on something with language like that either it’s illegal, or they probably think you’re not too bright.

I’m sure there are plenty of “smoke filled rooms” where secrets still change hands, but the investment being teased here is clearly no such secret — even if it is somewhat less common than regular stock and options trades.

The ad says these “Dark Equities,” which sound kind of menacing to me, frankly, are “… something like a stock… and something like an option… But this investment gives you the safety of blue chip stocks, with the explosive profit potential of options… That’s why it’s the perfect investment.”

And that there is “No better way to siphon double-, triple- and quadruple-digit gains off the market – while drastically reducing your downside risk.

Karim says he learned about the importance of this asset class from a guy named “Hank” who headed a public company and was a “Wall Street Warhorse.” I’d really like to think this is Hank Paulson, former CEO of Goldman Sachs and now Treasury Secretary, but I don’t know that.

So … what else do we know? Well, we know that Karim Rahemtulla describes himself as “one of the country’s foremost specialists in options trading.”

And from the examples he gives of using this “Dark Equity” strategy, including trades in the “Dark Equity” versions of AMD, Tyco, Interactive Corp and several others, the Gumshoe can be fairly certain that the “dark equities” being teased here are …

LEAP options.

Kind of boring, eh? Actually, there’s a bit of a giveaway in that Karim does tell us in passing that these are called “long-term equity anticipation securities” — which is actually the real name of LEAP options.

But in common practice, they are essentially stock options that are the same as other put and call stock options that you might be more familiar with — it’s just that they go further out in the future (thus the “long term” bit).

LEAP options all expire in January, and they can go up to three years into the future, though one and two years are more common.

If you’re not familiar with an option — and these are “American style” options, not the less flexible variety generally available in European bourses — they are contracts that confer the right to buy or sell a particular stock at a particular price before a particular date. Just the right, not the obligation, which means the maximum risk is fully defined.

So an IACI 2009 $30 LEAP option, for example, would give you the right to buy 100 shares of IACI on or before the expiration date in January, 2009 for $30 per share. You can exercise that right any time in between now and the expiration date if you choose (in which case you have to put up the cash to buy those shares at $30), or, as is more commonly done, you can just sell the contract to reap your (hopefully) profits.

If you bought such an option today, it would cost you something between $120 and $155, or $1.20-1.55 per share (that’s the current bid and ask for that option, and one contract is 100 shares). IACI is currently trading just under $24, so if you buy that option you’re betting that the shares will go up by something over 30% in the next year (the shares have to go to at least $31.20 for the option to break even, though they almost always trade at a premium to the actual intrinsic value — that premium is the time value, or what you’re paying for the time to wait for the stock to appreciate).

LEAP call options are certainly more likely to be considered as relatively long term options than are regular options, which usually have expirations within the next six months or so — and you pay more for them, because you’re buying more time for your price to be hit. Buying the right to buy 100 shares of IACI at $30 in April of this year instead, for example, would cost considerably less at somewhere between $15 and $35.

And if you want to be even safer — though by risking more money — you can buy “in the money” LEAP options. This is still far from being equivalent to a “blue chip” in terms of safety, I would argue, because it’s still quite easy to lose money, but you could, for example, buy the $20 strike price IACI Jan 2009 calls for something between $550 and $620 per contract at the current bid and ask. That means your option is already in the money, and you’re only paying about $2 per share in time premium to get any of the share’s appreciation this year. Of course, if you’re wrong and the shares drop to $22 at expiration from the current $24, your call option’s vaue would be expected to fall by 70% or so instead of the 10% that the shares dropped.

For those of you who already trade options and know them well, I apologize for simplifying — I just like to try to share the basic facts as I understand them. If you want to subscribe to an options trading service, more power to you — but don’t subscribe just to find out what a long term option is … sorry, I mean, what a “dark equity” is.

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What’s the benefit? The same as with all options: Leverage without borrowing, and a predetermined maximum risk. So you get to control 100 shares for a fraction of the price of 100 shares, and you cannot lose any more than you paid for the option — for our example above, if IACI remains well below $30 for all of the next year, you’ll be out your $155 or whatever you paid, but no more. On the flip side, it is of course quite easy — and commonplace — to actually lose your entire investment with “out of the money” options (the ones with a strike price above the current price — the ones that really give you a big leverage boost if you make the right call on the direction of a stock).

That said, options are often a significant trap for individual investors — which is why trading services like this can often convince people to give them a try. The combination of outsize returns (it’s certainly well within the realm of possibility to have 4,000% returns on one trade as is teased in this ad), and controlled risk, and the feeling of being a super special extra in-the-know trader can often get even a rational investor excited enough to get too heavily involved in options trading.

And just to put in a small warning, the thrill of a 10,000% gain on a single trade can easily be the worst thing that ever happened to an individual investor in the long run — because then you want more and more gains like that, and you put more and more of your cash into options. It is a very addictive form of gambling, in many ways.

And if we happen to have a year — as some people think is coming right now — when stocks go down or tread water for months and months and months, it’s quite possible for your whole portfolio of LEAP options — should you choose to build one — to go to zero, either slowly or quickly, depending on the individual stocks. In those markets (and most of the time, in the opinion of many professionals), the people who make money are the ones who sell option contracts and reap that incre