90% TIPS/10% LEAP Call Option Portfolio

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ikkyu
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90% TIPS/10% LEAP Call Option Portfolio

Post by ikkyu » Mon Nov 02, 2009 1:02 am

Finally, this article represents a serious look at the famous 90:10 portfolio written about by Zvi Bodie and Nassim Taleb. This is written by Dr. Considine, who uses monte carlo simulations to consider the strategy and approximate the fair value of the options.

http://www.advisorperspectives.com/news ... anning.php

Here is the whole thing in PDF:
http://www.advisorperspectives.com/news ... anning.pdf

Highlights include:

"The obvious appeal of Bodie’s 90/10 strategy is that there is an absolute floor on portfolio losses that a decline in equities can cause, even in the worst market conditions. (This does not, however, mean that the portfolio cannot lose more than 10% of its value.)"

"Buying calls on a higher beta / lower yield index ETF adds some additional benefits to the 90/10 strategy. There is an additional change in the outcome of a 90/10 type of strategy in buying calls on options with beta greater than 100% relative to the S&P 500: One can further increase the effective leverage with respect to the S&P 500. Higher beta assets tend to further amplify moves in the S&P 500."

And:
"Conclusions

Bodie’s 90/10 strategy can be sanity-checked using Monte Carlo simulations and by benchmarking using the current prices of index options vs. the Monte Carlo model. Using this framework, it is straightforward to look at how variations of the strategy impact outcomes.

There has never been any doubt that the basic mechanism that Bodie proposed could work. The question has been whether such a strategy would work in practice, given the prices at which options are trading at any specific time. As the prices of options vary, the effective leverage changes. Given current options prices, the 90/10 strategy makes sense today.

A range of practical variations on the 90/10 type of strategy can make sense for retirement planning. Their main attraction for investors is the absolute floor that they provide on the equity portion of the portfolio.

One of the largest challenges to this type of strategy is its conceptual complexity. On the other hand, as Bodie has noted, equity-linked notes that provide this type of structure to retail investors have been adopted fairly widely in Europe. Advisors who take the time to create their own 90/10 and related strategies can provide a floor on equity market loss potential, while maintaining transparency and keeping costs down."

He also links this good article on Bodie and his thoughts this approach, which is apparently sold as a mainstream product in Europe!
http://www.advisorperspectives.com/news ... oducts.pdf

Cheers from Osaka,
john

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ikkyu
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With STRIP

Post by ikkyu » Mon Nov 02, 2009 2:27 am

A good variation on this would be to use a treasury STRIP bond of the same duration as the option to have a know minimum payout. This would be a true Equity Linked Note that could be structured to maintain principle protection.

Cheers,
john

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Post by Erwin » Mon Nov 02, 2009 2:31 am

Erwin

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Post by Verde » Mon Nov 02, 2009 7:29 am

As of this writing, this option costs $13.90 and SPY is at $109........... In the current market, you can buy 9.3 two-year at-the-money call options for the cost of one share of SPY.
109/13.9 = 7.84 options. What gives?

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Post by Rodc » Mon Nov 02, 2009 7:43 am

This article, IMHO, is just not all that. Read with a critical eye towards the limitations of Monte Carlo simulations, thinking that 10 years is "the long run", and author biases (consider how is toast is buttered).

Not that the message is all bad, just not really all that well backed up.

IMHO, this is light weight stuff, the sort of analysis we might see someone here bang out: worth something, but not fully fleshed out.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: 90% TIPS/10% LEAP Call Option Portfolio

Post by ddb » Mon Nov 02, 2009 8:51 am

ikkyu wrote:Highlights include:

"The obvious appeal of Bodie’s 90/10 strategy is that there is an absolute floor on portfolio losses that a decline in equities can cause, even in the worst market conditions. (This does not, however, mean that the portfolio cannot lose more than 10% of its value.)"
Isn't that true with any percentage of equities in a portfolio? A portfolio that has 80% equities also has an absolute floor on portfolio losses that a decline in equities can cause.


- DDB
"We have to encourage a return to traditional moral values. Most importantly, we have to promote general social concern, and less materialism in young people." - PB

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Post by ikkyu » Mon Nov 02, 2009 9:35 am

Greeting folks. Now that I have looked at it more closely, there may be several errors in this article.

Verde, $1390(100x $13.90/109 would yield .078 contracts per share. Also, he seems to assume a delta of one, when initial delta would be around .5 for ATM.

I will have to look at this in the daylight.

My apologies if I may have inadvertently advertised something that was incorrect!

Cheers from Osaka,
john

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Post by Wagnerjb » Mon Nov 02, 2009 10:15 am

Rodc wrote: Not that the message is all bad, just not really all that well backed up.

IMHO, this is light weight stuff, the sort of analysis we might see someone here bang out: worth something, but not fully fleshed out.
I read the article and came away with the same conclusion as Rodc. The author tests a two-year option strategy and finds that the strategy appears to work. But he ignores two non-trivial issues:

a) Time. You take 10% of your portfolio and invest the funds in two-year options. What if they expire worthless? I guess you take another 10% of your portfolio and repeat the strategy. What if the second batch expires worthless? Do this again, and you are suddenly down to 70% of your capital. Not good.

b) Taxes. If your options pay off, you end up paying immediate capital gains on your appreciation. So maybe you mirror the growth of an equity investor, but you have a huge tax drag compared to him. Some will be tempted to suggest putting the options in your IRA....but that means you just pushed the TIPs into your taxable account, which is tax inefficient.


I think there is a lot more "real world" that needs to be examined about his guy's ideas.

Best wishes.
Andy

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Post by Verde » Tue Nov 03, 2009 4:45 am

This article by the same author makes it clear that he – like Warren Buffett believes that option pricing is flawed and presents a free lunch.
http://seekingalpha.com/article/146466- ... ummer-2009
It is important to understand that options prices and the calculations of implied volatilities assume that stocks and indexes follow a random walk with zero expected return (this is a central assumption of the Black-Scholes model). QPP assumes that risky assets have expected returns greater than zero. This means that over time QPP’s expected value of call options will tend to have higher value than the prices at which these options are trading (the put options will be of less value).
As far as I know BS assumes the risk free rate of return.
It is also important for investors to understand the relationship between dividend yield and options prices. Dividends paid to investors reduce the upside potential for price appreciation. The owner of an un-exercised call option does not receive dividends. This means that higher dividends reduce the value of options. The larger the fraction of total returns than come in the form of dividends, the lower the mis-pricing in options that results from assuming that prices follow a random walk.
The BS model should be adjusted when options on dividend paying stocks are priced.
Thus the expected return in the BS model is risk free rate + dividend yield.

The above quotes prove to me that his MC model is based on the assumption that BS (and by implication the market) misprices options. This is not true. BS provides the arbitrage free option price.

Mssers Considine and Buffett will be well served by studying the principle of risk-neutral valuation. I’ll bet the BS bashing will stop once they understand it. Here is a great starting point:

http://homepage.mac.com/j.norstad/finance/twostate.pdf

(Granted in real life BS is not perfect, but for other technical reasons well understood and easily adjusted for by the markets, not because the assumption of risk neutrality is flawed)

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Post by Indexer88 » Tue Nov 03, 2009 8:44 am

The LEAP portion should be replaced by total stock market allocation in my view.

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Post by xerty24 » Tue Nov 03, 2009 3:42 pm

Wagnerjb wrote:he ignores two non-trivial issues:

a) Time. You take 10% of your portfolio and invest the funds in two-year options. What if they expire worthless? I guess you take another 10% of your portfolio and repeat the strategy. What if the second batch expires worthless? Do this again, and you are suddenly down to 70% of your capital. Not good.
But it sounds fine if you call it "rebalancing", right? That's really all that's happening.
b) Taxes. If your options pay off, you end up paying immediate capital gains on your appreciation. So maybe you mirror the growth of an equity investor, but you have a huge tax drag compared to him. Some will be tempted to suggest putting the options in your IRA....but that means you just pushed the TIPs into your taxable account, which is tax inefficient.
Yeah, this is kinda bad. 100% of your portfolio is in tax inefficient investments, although at least with >1 year LEAPS you can get long term capital gain treatment (although realizing your gains every 2 years is still worse for compounding than a longer term buy & hold).

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Post by Wagnerjb » Tue Nov 03, 2009 5:54 pm

xerty24 wrote:But it sounds fine if you call it "rebalancing", right? That's really all that's happening.
Yes, but "rebalancing" every two years under this strategy points out the extreme riskiness of the two-year option strategy. I can understand using LEAPs for VERY long-term options and this would dramatically reduce the risk of the strategy...since you don't need to "rebalance". (The problem is that you cannot buy very long term options in real life....but the authors don't seem bothered by real-world issues anyway. And, you don't stop investing in equities after you retire in 35 years either, so you will undoubtedly be rolling over the options multiple times - another practical issue to deal with).

It wouldn't be hard to imagine an entire decade during which five batches of two year options expired worthless. That will wreck your strategy. I suspect the 1970's would be such a decade.

Best wishes.
Andy

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Re: 90% TIPS/10% LEAP Call Option Portfolio

Post by Roy » Tue Nov 03, 2009 6:55 pm

ddb wrote:
ikkyu wrote:Highlights include:

"The obvious appeal of Bodie’s 90/10 strategy is that there is an absolute floor on portfolio losses that a decline in equities can cause, even in the worst market conditions. (This does not, however, mean that the portfolio cannot lose more than 10% of its value.)"
Isn't that true with any percentage of equities in a portfolio? A portfolio that has 80% equities also has an absolute floor on portfolio losses that a decline in equities can cause.

- DDB
Yes that is true of any strategy that uses equities. Just different depths of sub-basement "floors".

The problem is that in an extended downturn, the "floor," in essence, always keeps lowering as you rebalance from the better performing fixed income to feed the losses in equities. OR, one does not rebalance and suffers other problems in upswings. Don't know what every 2 years rebalancing will do but these problems still appear to hold.

What is the maturity of TIPS used in this model?

Roy

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Re: 90% TIPS/10% LEAP Call Option Portfolio

Post by Wagnerjb » Tue Nov 03, 2009 7:43 pm

Roy wrote: Yes that is true of any strategy that uses equities. Just different depths of sub-basement "floors".

The problem is that in an extended downturn, the "floor," in essence, always keeps lowering as you rebalance from the better performing fixed income to feed the losses in equities. OR, one does not rebalance and suffers other problems in upswings. Don't know what every 2 years rebalancing will do but these problems still appear to hold.
The important difference here is that "equities" (using options as a proxy) can go to zero many times repeatedly. You rebalance into equities and they go to zero. Then you rebalance into equities and they go to zero again. In the real world, equities don't go to zero.....and they certainly won't go to zero twice in a row (like options can).

Best wishes.
Andy

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Re: 90% TIPS/10% LEAP Call Option Portfolio

Post by dandan14 » Wed Nov 04, 2009 12:05 am

Wagnerjb wrote: The important difference here is that "equities" (using options as a proxy) can go to zero many times repeatedly. You rebalance into equities and they go to zero. Then you rebalance into equities and they go to zero again. In the real world, equities don't go to zero.....and they certainly won't go to zero twice in a row (like options can).

Best wishes.
I've been thinking about this all day and spent longer than I want to admit building a spreadsheet for this. Using at the money calls, here's what I came up with:

1970s: 6.14% annualized for the 90/10. 6.62% annualized for index + dividends.
1990s: 10.38% annualized for the 90/10. 18.02% annualized for index + dividends.
2000's (1999-2008): .57% annualized for the 90/10. -1.34% annualized for index + dividends.


If you have any one year in a particular decade that is a huge loss (like 2008) or if you have a year where a medium loss is paired with inflation (like 1974) this strategy pays off. What are the odds? Well, in the last 4 decades -- at least 50%.

If you view this as a hedge against down side risk -- especially in the decade leading up to your personal retirement, I think this could make a lot of sense.

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Post by Lbill » Wed Nov 04, 2009 10:23 am

I'm not sure that Bodie is advocating a long-term "asset allocation" approach using equity LEAPS and TIPS. He's merely suggesting that you first invest as much as you need into one "bucket" of TIPS to assure that your present, or future, income needs are met. Any funds that you choose to designate as "surplus" can be invested in (preferably) a second "bucket" of actual or synthetic Equity Participation Notes (EPNs) instead of a stock index. You can construct a synthetic EPN yourself by investing enough in two-year STRIPS to assure principal preservation at maturity, and the remainder in 2-year equity LEAPS. This way, you have some exposure to significant stock market gains (which you would harvest when and if they occur), while at the same time preserving your original capital. You can keep "rolling over" this EPN strategy every two years. Of course, right now is not a great time to use EPNs because the low interest rates force you to invest a very high percentage of your "surplus" capital into 2-year STRIPS. It would be interesting to compare this approach to simply investing in a stock index as dandan14 did for the 90% TIPS/10% LEAPS strategy.
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Re: 90% TIPS/10% LEAP Call Option Portfolio

Post by ddb » Wed Nov 04, 2009 10:53 am

dandan14 wrote:
Wagnerjb wrote: The important difference here is that "equities" (using options as a proxy) can go to zero many times repeatedly. You rebalance into equities and they go to zero. Then you rebalance into equities and they go to zero again. In the real world, equities don't go to zero.....and they certainly won't go to zero twice in a row (like options can).

Best wishes.
I've been thinking about this all day and spent longer than I want to admit building a spreadsheet for this. Using at the money calls, here's what I came up with:

1970s: 6.14% annualized for the 90/10. 6.62% annualized for index + dividends.
1990s: 10.38% annualized for the 90/10. 18.02% annualized for index + dividends.
2000's (1999-2008): .57% annualized for the 90/10. -1.34% annualized for index + dividends.


If you have any one year in a particular decade that is a huge loss (like 2008) or if you have a year where a medium loss is paired with inflation (like 1974) this strategy pays off. What are the odds? Well, in the last 4 decades -- at least 50%.

If you view this as a hedge against down side risk -- especially in the decade leading up to your personal retirement, I think this could make a lot of sense.
Out of curiosity, what data did you use to derive the above historical rates of return on the "call option" side of the portfolio. Also, what data set did you use for the bond side of the portfolio? TIPS didn't exist until 1997.

Also, your 1999-2008 return of 0.57% annualized for a 90% bond portfolio seems way too low. The BarCap 1-5 Year Treasury Index has an annualized return of 5.19% from 12/31/98 to 12/31/08. The BarCap US TIPS Index has an annualized return of 6.78% over the same time period. Your data suggests that the 10% option part of the portfolio leads to an annualized drag of around 500-600bps on the bond component - is this possible?

- DDB
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Post by Lbill » Wed Nov 04, 2009 11:55 am

For those interested in implementing Bodie's synthetic EPNs, here is an online tool he provides:

http://www.wealth2k.com/downloads/zb/epn.html
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

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Post by stratton » Wed Nov 04, 2009 6:52 pm

Lbill wrote:For those interested in implementing Bodie's synthetic EPNs, here is an online tool he provides:

http://www.wealth2k.com/downloads/zb/epn.html
Thanks!

This is something I would like to play with without spending hours reading up on options.

Paul

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Post by Lbill » Wed Nov 04, 2009 7:00 pm

Paul - I hope you post your findings.
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Some general comments

Post by Quantext » Sun Nov 08, 2009 11:00 am

Hi guys:

I am very pleased that you guys have taken up this discussion because I increasingly think that Bodie is on to something important--not that its the only way to invest but rather that it is important to consider this. For what its worth--and this is not advice for anyone else--I am increasingly implementing variations on this strategy and other long-term options strategies in my own investing and you clearly lean a lot by doing so.

There are some subtle issues in Bodie's original analysis of stock risk and his later paper on the 90/10 strategy that you cannot understand without really thinking about it. I dismissed this approach just as most of you are for years when I ran across it.

While many of you are concerned about Monte Carlo and what it means, I will first note that the conclusions of the MC are more illustration than anything else--its a way to look at second-order effects. Bodie's basic logic is simply confirmed by the MC but neither his original logic nor the MC is in any way proof of anything. For those who actually want to learn more about MC, I have written something like 130 articles on this topic over the years and many of them pertain to various forms of validation and testing.

There are a few obvious things that I would like to respond to from the posts here. First, the basic arithmetic: it is correct. I have checked it and I also use options regularly. The $13.9 cited earlier in your posts here was for the 2.2year option and the 9.3 year leverage ratio was for 2 year options. I believe that this is clear in the original article.

The biggest hurdle that I had to get over with this strategy is the rolling of options--and that has been mentioned here. I am working on examples to further eludicate this issue.

You guys are the most financially literate group of individual investors out there. My overall suggestion would simply be to educate yourselves about options and what they can provide. Even if you never use options yourself, they can provide valuable insight into what is going on in the markets. As I have noted in the years prior to the crash, one of the most worrisome signs out there was that long-dated options had implied volatility far higher than trailing historical volatility: the market was signaling for a volatility shock well before it happened. Sadly, the vast majority of investors and advisors do not pay attention to the options market as a source of information.

Cheers,

Geoff

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Post by Lbill » Sun Nov 08, 2009 12:09 pm

Geoff- Thanks for your post. I believe you are correct that it would be a good idea to educate ourselves more about the use of options as part of an overall portfolio strategy. What do you think about Bodie's idea of using synthetic Equity Participation Notes as a way of gaining market exposure? This is different from a 90% TIPS, 10% LEAPS approach. As I understand it, you would, for example, allocate the 10% to synthetic EPNs and not to LEAPS, per se. Provides an extra layer of security because that 10% portion would never decline lower than it's original principal value; whereas, you can lose your entire 10% invested in LEAPS if they expire worthless.
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Post by leftcoaster » Mon Nov 09, 2009 10:08 am

Lbill wrote:For those interested in implementing Bodie's synthetic EPNs, here is an online tool he provides:

http://www.wealth2k.com/downloads/zb/epn.html
Anybody able to help me understand the output of this tool a bit better? I input 21% volatility, 1% risk-free rate, 2.1% dividend rate, 108 index, 100 strike, 2 year maturity, and 10% loss of principal.

It tells me that the call price should be 14.87 -- OK.

What's the participation rate of 79.24%? I see how it's calculated, but what does it mean?

I also don't understand how to read the points on the chart. If, in 2 years, the index is at 130, the payoff is 121. How do I correlate that with the cost of the call (14.87) ?

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Post by fluffyistaken » Mon Nov 09, 2009 11:42 am

leftcoaster wrote:
Lbill wrote:For those interested in implementing Bodie's synthetic EPNs, here is an online tool he provides:

http://www.wealth2k.com/downloads/zb/epn.html
Anybody able to help me understand the output of this tool a bit better? I input 21% volatility, 1% risk-free rate, 2.1% dividend rate, 108 index, 100 strike, 2 year maturity, and 10% loss of principal.

It tells me that the call price should be 14.87 -- OK.

What's the participation rate of 79.24%? I see how it's calculated, but what does it mean?

I also don't understand how to read the points on the chart. If, in 2 years, the index is at 130, the payoff is 121. How do I correlate that with the cost of the call (14.87) ?
Participation rate is what percent of the market's gains your options will return to you (i.e. what percent of the market's advance you will "participate" in). Think of it as 1 call option "participating" in the advance of 1 market share.

Example of full (100%) participation, assuming 0% risk-free rate and 0% dividends for simplicity:
Suppose the market is currently at 100 level and (Scenario A) you can buy a 1-year call @100 for $10, which works out to $1000 for a lot of 100 calls giving you "participation" in 100 shares. Alternatively (Scenario B) you can "participate" in 100 shares by actually buying them for $10,000. Now consider what happens in different situations...

Market drops to 0.
Scenario A. Your options expire worthless. Lose $1000.
Scenario B. You lose everything -- $100/share. Lose $10,000.

Market drops to 80.
Scenario A. Your options expire worthless. Lose $1000.
Scenario B. You lose $20/share. Lose $2000.

Market drops to 90.
A. Your options expire worthless. Lose $1000.
B. Lose $10 in each of your 100 shares. Lose $1000.

Market stays at 100.
A. Lose $1000.
B. Break even.

Market goes to 110.
A. Break even.
B. Gain $1000.

Market goes to 120.
A. Make $10/call. Gain $1000.
B. Gain $2000.

Market goes to 150.
A. Make $40/call. Gain $4000.
B. Gain $5000.

Market goes to 200.
A. Gain $9000.
B. Gain $10,000.

So, for any market level above the initial strike price of 100:
gain(A) = 100% * gain(B) - cost(A)
where cost(A) is the initial cost of the options ($1000). In other words, A participates in 100% of the market advance, minus cost of options. Below 100 level A's loss is $1000 while B's loss could be up to $10,000 depending on how much the market declines.

Now, same scenario but you only want 50% participation which means scenario A buys a lot of only 50 calls (total investment of $500 -- not doable in practice, of course, since smallest lot is 100, but good enough for this example). Scenario B is as before. Again, consider what happens in different scenarios...

Market drops to 0.
Scenario A. Your options expire worthless. Lose $500.
Scenario B. You lose everything -- $100/share. Lose $10,000.

Market drops to 80.
Scenario A. Your options expire worthless. Lose $500.
Scenario B. You lose $20/share. Lose $2000.

Market drops to 90.
A. Your options expire worthless. Lose $500.
B. Lose $10 in each of your 100 shares. Lose $1000.

Market stays at 100.
A. Lose $500.
B. Break even.

Market goes to 110.
A. Break even.
B. Gain $1000.

Market goes to 120.
A. Make $10/call. Gain $500.
B. Gain $2000.

Market goes to 150.
A. Make $40/call. Gain $2000.
B. Gain $5000.

Market goes to 200.
A. Gain $4500.
B. Gain $10,000.

So, for any market level above the initial strike price of 100:
gain(A) = 50% * gain(B) - cost(A)
where cost(A) is the initial cost of the options ($500). In other words, A participates in 50% of the market advance, minus cost of options.

... errr this post ended up a lot longer than I wanted but hope it helps anyway :lol:

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Post by DriftingDudeSC » Mon Nov 09, 2009 12:58 pm

Huh oh....what happen to KISS?

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Post by Lbill » Mon Nov 09, 2009 8:44 pm

DD - don't forget the last "S" stands for stupid. :)
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