Author: A.T.

Friday I related reader Jonathan Huffman’s remarkable success running $4,000 up to $75,000 in twelve months trading options. (He did it in his spare time, while running the fundraising for a Miami arts organization.) At the same time, I offered my own dour thoughts on puts and calls — the occasional winner like Jonathan notwithstanding.

Still, I had a nagging curiosity, as you may have had, as to his method, so I gave him a call. “It’s a lot less science than instinct,” he told me.

And it’s been a little rough lately, he said. When the market’s zooming or crashing, you can do fine with options. But when it’s just sort of sitting, becalmed, buying puts and calls is a way to watch your dollars evaporate along with the “time premium” you pay for them. A becalmed market is a good environment in which to write (sell) puts and calls. But that’s an even riskier game (if you’re writing them “naked”) and not the cakewalk some think it is (if you’re writing them “covered.”)

Jonathan says he generally buys puts and calls that are within three to six months of expiration.

(I ordinarily prefer LEAPs, which are long-term options. LEAPs give you up to a couple of years to be right, plus the possibility of long-term capital gain tax treatment — and what seems to me often to be a less outrageous premium. They’re not available on all stocks, but on some. For example, I own some American Express January 1999 calls. If Warren Buffett is right about American Express, maybe these LEAPswill work out. Then again, in 1999 American Express could be temporarily in the tank, wiping me out — while Warren would still own the stock and would have been collecting dividends along the way.)

Jonathan also makes it a point to sell his options about 4 weeks prior to expiration, because after that, he says, the premium begins to evaporate very quickly.

(This assumes, perhaps rightly, that the premium in the option is irrational — that people are paying more for it with 4 weeks to run than it is really worth, and enough more to justify the costs of selling. Whether or not Jonathan is right about this, and he may be, this strategy has a hidden psychological cost: once in a rare while it will make you want to kill yourself. This happens when, shortly after you sell out, some major event occurs to make your just-sold option a huge winner. So, rightly or wrongly, I almost always hang on to my options until the bitter end.)

Jonathan diversifies by industry, because he finds that entire industries may move roughly in tandem. And he avoids buying options on stocks where there’s already a high put or call ratio — i.e., where a lot of other people already seem to be expecting the same thing.

Even so (like me), Jonathan couldn’t resist buying Presstek puts. In fact, knowing how crazy Presstek was, he recently bought a “strangle.” With the stock selling around 108 (up from 20 a few months earlier), he bought a June 100 put and a June 130 call. First he made money on the call, when Presstek rose to 200 on May 21 (not to say he sold out at the top, but he did make money); and then he made money on the put when it fell, a few weeks later, well below 100.

This is the stuff speculative dreams are made of, and it sounds easy with hindsight. But bubbles like Presstek don’t come along often; and when they do, the premium you pay for an option is enormous. Had Presstek just stalled between 100 and 130 through mid-June — as it certainly could have — Jonathan would have quickly lost every dime he bet on these super-expensive puts and calls.

Sensibly, he never puts more than 10% of his pot into any single trade. And the profit target he shoots for depends on the market environment, he says. He has a rule of thumb that involves targeting a profit equal to “one-fifth the expected annual move in the Dow.” (This part didn’t resonate for me.) In other words, he says, if the Dow is forecast to rise 1,000 points over the next year (by whom? who cares?), he’d be shooting for 200% profits on his options positions. But if it’s expected to move less, he would take profits earlier.

As for where he got his market intelligence, Jonathan says he managed to run his $4,000 up into $75,000 based on readily accessible sources of information — principally, The Wall Street Journal, Investors Business Digest, Barron’s, Business Week, and The Motley Fool.

He says his favorite kind of stock is not a high-flying “growth” stock, where the option premiums are high because growth and volatility are expected, but rather a “value” stock that seems to be showing signs of growth. I.e., an old plodder that seems now to be taking off. His favorite in this regard was GTE. He bought December 40 calls at 5/16 that he was able to sell at 3-5/8.

So there you have at least an idea of how Jonathan did it.

All that said, and with great regard for Jonathan and appreciation for his sharing these ideas, I stand by my dour comment Friday. Avoid speculating in options. Sooner or later, you’ll lose your money.

Tomorrow: A Way to Make Money Almost All the Time

Jonathan Huffman, development director for an art museum, writes:

“I would appreciate your thoughts on investing in options. Last year I took a $4,000 initial investment and turned it into $75,000. This year, performance like that has been hard to match, but I’ve learned a few lessons and, hopefully, have some skills to bring to the practice of investing in equities options.

“I am not the only individual investor who has discovered the profit (and loss) potential of options and this is evident by the dramatically increasing numbers of options investors (as observed in the increase in small scale options purchases and subscriptions to options-oriented publications).

Do you purchase options yourself? [Occasionally.] and, if so, what criteria do you utilize for their selection? [Not yours, apparently, or I’d have done much better!] If you do not trade options, why not? Do you find the increase in the number of individual investors trading options to be disturbing from the standpoint of this phenomenon’s indication of excessive speculative activity? [Yes.]”

A lot of people play the lottery, too — a few with considerable success. The odds with options aren’t as bad, but they’re not good.

The fundamental difference between stocks and options is that with stocks, everyone can make money, because they represent shares in productive assets. Diversify a bit, and no one has to lose. It can be said with confidence (though no absolute guarantee) that someone who today puts $4,000 into a mutual fund will have considerably more money 20 years from now. With options, you’re not making a productive investment, you’re placing a bet. It can be said with confidence that someone who puts $4,000 to work in the options market will have none of it left in 20 years. And that he will have expended considerable energy, actual and psychic, losing it.

With options you are in a less-than-zero-sum game.

A coin toss is a zero-sum game. If you and a buddy are flipping coins all night at $1,000 a toss, it’s just not possible that one of you will win more than the other of you will lose.

But now imagine that you are flipping these coins down at an all-night diner, and with each toss the waitress (or in this case, the broker) grabs $120—$30 from each of you when you call out “heads” or “tails,” initiating the bet, and another $30 from each of you when the coin lands and you settle up, closing out your position. That makes it “heads you win $940, tails you lose $1,060.”

But it’s worse than that. In addition to the commission, there’s also the “spread” between “bid” and “asked” when you go to buy, and later sell, an option. Say you were buying a December call on Chesapeake Oil at 70. It’s quoted “six to a half,” meaning you would pay $6.50 to buy the call ($650 for a single call on 100 shares) or get $6 ($600) if you were selling it. So there’s another 8% or so the house clips from your potential profit.

Combining commissions and spreads, maybe it’s “heads you win $860, tails you lose $1,140.”

How long would $4,000 last in an all-night coin-tossing contest like that?

But it’s worse than that, because in a theoretical coin toss, there are no taxes. With options, on the margin, the bite into your short-term capital gains from options trading may very easily amount to 40% or more of your winnings (especially if you live in a high-tax state). Yet losses are deductible against ordinary income only up to $3,000 a year. So if you made a $71,000 profit the first year and paid $25,000 of it in taxes, but then lost it the next year, you’d only get about $900 of that $25,000 “back” via the value of the allowable $3,000 tax deduction. Yes, you could carry the remainder of the loss forward. But how soon would you get to use it all?

So maybe now the game looks like, “Heads you win $550 [the $860 above, minus some taxes], tails you lose $900 [the $1,140 up above, minus some cushion from the tax loss].”

The exact numbers will vary all over the lot, but you get the idea. It’s a tough game to win.

Of course, if you actually knew which way a stock were heading, this would all be a quibble. If you knew a company were about to announce surprisingly good earnings, or a takeover bid, then there’d obviously be a load of money to be made in options. But it would be made with inside information, so it is not the kind of money YOU would make, for two reasons: (1) you don’t want to go to jail; (2) you don’t have information like this in the first place.

But some people do have inside information — and use it to trade options. That makes the odds for the rest of us even a little worse than described above, because the playing field isn’t entirely level.

So how is it possible someone could run $4,000 into $75,000? Well, if he happened to get interested in buying calls in a year when the market surprised most people by zooming 30%, instead of its more typical 6% (plus dividends, for an overall 9% or so), then he would have done extraordinarily well. (Someone buying puts or selling calls would have done extraordinarily badly.)

Having said all this, yes, I occasionally buy options. I made a killing on Merrill Lynch calls decades ago. They cost me 3/8 and were eventually worth 15 at expiration (although I had sold most of them on the way up). A couple of months ago I bought some Presstek puts when the stock was 150 and sold them when it fell to 65. But over the years, I’m pretty sure I’ve lost money with options.

If more and more people trade them, Wall Street will get richer but the nation won’t — any more than if we had 20 times as many casinos. Indeed, gambling for the sake of gambling, though it has entertainment value, saps resources from productive enterprise.

I’d suggest Jonathan continue to play the options market, despite the odds — but beginning fresh with just $4,000 each year. If he loses it, big deal. In light of a $71,000 profit, who cares? (And Uncle Sam will pick up part of the tab.) And if he keeps winning, that’s just one more reason for the rest of us to steer clear: he’s better at this than we are.

Monday: How He Did It

There’s nothing quite like leaning back in your bark-a-lounger (spelling? a dog’s recliner?) and reading a nice scrunched up copy of The Wall Street Journal. Let the other boys and girls go outside to play; I want my kids, when I have ‘em, reading the editorial page of The Wall Street Journal. Make ’em savvy little reactionaries by the age of 8.

But as you doubtless know if you subscribe to the Journal, it’s not only one of the finest papers in the world, it’s also $164 a year plus tax. And it means cutting down a lot of trees to make them, including all those stock tables you don’t read any more now that you have your computer, and all those full-page ads that have nothing at all to do with your life.

So, like me, you have probably considered switching to the “on-line” edition instead. Click here to subscribe — just $29.95 a year if you’re already a subscriber, $49.95 a year if you’re not.

I signed up. My thinking: for $29.95 a year, why not? I travel a lot; this way I can check out the Journal from anywhere without having to go down to the hotel lobby to buy one.

Indeed, I figured: if I like it, I can drop the “real” version altogether. That will save me $125 a year.

But so far, I will admit, I haven’t dropped the real version. I’d love to save all those trees. I’d love to save the fuel and the labor required to truck the trees to the mill and then truck the newsprint to the printer and then truck the Journal to my house — and from there to the recycler. Not to mention the fuel and labor required to make the truck and run the mill and the press and the recycler.

(Imagine if each episode of Friends or Seinfeld had to be delivered one-by-one on video cassette. Tens of millions of them for each episode! Not efficient.)

I’m just not ready to abandon newsprint quite yet. Compared with simply running your eye across the front pages of each of its “real” sections every morning, reading the on-line Journal is slow. And it’s hard to read on the train. But I do think the on-line version — and all its little on-line brothers and sisters, like the Washington Post that just went on-line recently — are almost surely here to stay. It’s just so much more efficient. And hey: every $125 helps.

Tomorrow: He Turned $4,000 into $75,000 in a Year

You’ve seen the little notice charities stick on their postage-free envelopes. In one variation or another, it reads: “Your stamp HERE helps us even more!”

But did you know how much? Putting your own 32-cent stamp there saves The Whales (or whomever) 76 cents. [10/96: WRONG! Mike Wyson of ZPG says it’s usually just 2 cents extra, worst-case 10 cents. And they’re charged the 2 cents anyway, so the stamp really saves only 30 cents.]

So you can give an extra 76 cents at a cost to you of just 32 cents. That’s an instant 143% “return” on your added social (or cetacean) investment.

Tomorrow: Forget the Whales — Save $125

Who needs horses when you’ve got the market?

Yesterday I told you about Jeff Schatz, who’s up $190,000 in a few months riding trends for quick gains. It’s a less-than-zero-sum game (because of the transaction costs), but that doesn’t mean there won’t be winners, and Jeff is clearly winning. More power to him.

Indeed, winning on Wall Street seems so easy these days it’s scary. Many of you are too young to remember, but from 1968 to 1974, winning was a lot tougher. Indeed, in 1973 through much of 1974 it was hard to find almost anyone who was winning. Guys like me had to write articles that all started out: “If the world doesn’t end — and it usually doesn’t — ” and then go on to extol the virtues of long-term investments in stocks. With the Dow down from an intra-day 1,000 in 1966 to 577 in the summer of 1974, no one wanted to hear it.

It’s almost as hard to find people losing money these days. But just wait. No bull market lasts forever.

In the meantime, here’s a sobering message I received from one of you (thanks, Donald Steinmann):

Many of the people visiting BOB’z investment site are really into speculation. It just really makes me sad when I read about all the ‘hot tips’ people have, and exhortations to day trade. One woman recently was talking about how she day trades with borrowed money. Her husband suggested Gamblers Anonymous after she lost $5,000 in one day.

Can you suggest any books besides yours and Burton Malkiel’s Random Walk Down Wall Street that might make it clear to these people? Sometimes I just want to grab them and shake them. My most powerful ammunition so far is pointing out that there is no day trader equivalent to Warren Buffett.

Books besides mine and Malkiel’s? How about Dostoyevsky’s The Gambler? (Or, perhaps, Dostoyevky’s The Idiot.)

“Those who can, do,” a friend once told me; “those who can’t, write about it.” I thought it was insensitive to say the least — I was still at Harvard Business School, getting ready to take a job writing. But he went on to earn $40 million a few years later — his earnings for that single year, mind you — so I guess a certain arrogance was perhaps justified (and here I am writing about it, so I guess he was right).

This was brought to mind by a message from one of you — Jeff Schatz — who wrote in mid-April:

Am I nuts?

Ever since I discovered the amount of information, news, tips, etc. available online I’ve become a short term trading junkie — mostly momentum plays. I’m up over $53,000 since January and I’m waiting for the bubble to burst. In your experience is getting in and out of stocks quickly (1 day to 2 weeks) a valid investment approach?

[No! You get killed by transaction costs and taxes.]

I have about $250,000 in a high-yield moneymarket fund and $100,000 in four growth Mutual Funds w/Schwab that I use as margin or as trading capital.

My trades are typically 1000-5000 shares in stocks like Iomega (IOMG), America On Line (AMER), Cisco Systems (CSCO) and some smaller issues ($5 and under) like AMTX, AERN, etc. I’ve made 25 trades with a record of 18 winners, 4 losers and 3 breakevens. I look at charts and it seems possible to ride trends successfully.

I have access to real time quotes and use both a discount broker (Ceres $18 a trade) and Schwab (StreetSmart software, excellent service, quick fills, $66-150 per trade).

I use stop limits and follow trades very closely and can almost always “bail out.”

The answer I most wanted to give Jeff was, yes, you are nuts. In the long run, the odds are against you (because of the transaction costs and taxes). You’re not investing; you’re just playing trends which, in an amazing up market of the kind we’ve had from the time you started with this in January, has made anything seem possible.

But — smug — I figured I’d wait a few weeks and let him find out for himself.

A few weeks later I asked Jeff for an update, and on June 10 he wrote back:

I have continued my short-term trading activities and have been devoting more time to it, about 5 hours a day. My profits, since Feb. now stand at $190,000 or so, with commissions subtracted. My account at Ceres alone has grown from $20,000 to $68,000.

I now have Signal (an FM real-time quote feed), TickerWatcher (Mac charting and quote software). A lot of my information is gained online — Investors Business Daily and Wall Street Journal electronic editions and America On Line investment forums.

I’ve expanded my stock list to include lower-priced stocks and have been following the hot pennies, as well as my consistent winners like Iomega and America On Line. My strategy is to catch rising stocks — forget the top or bottom — ride them for a few points and get out. I set tight stop limits on the downside and try to let winners run, although I tend to be very fast on the trigger. I average over 3 trades a day and Ceres’ low commissions and web site are a godsend vs. Schwab, etc.

It’s very exciting and not as risky as I thought when I wrote to you — if you have the discipline to cut losers fast. I use 8% as my guideline on losses and 20% as a sell signal on gains.

I don’t worry too much about taxes. I’m already in the 30-40% range anyway. I view my gains just like salary.

If you have the fortitude, there appears to be a lot of money to be made.

Hmmm. It’s hard to argue with a $190,000 profit, even if it does take 5 hours a day to earn. So I guess the first thing to say is that some people do seem to have a knack for trading — for sensing the rhythm of the market, “reading the tape” and so forth. But clearly, over long periods this has to be a less-than-zero sum game. Unlike long-term investing, where everyone could theoretically come out ahead (from dividends and general growth in the economy), with quick trading, over the long-run, the odds will more than catch up to most people (though not all — Jeff may really have a knack for this).

The three most obvious pitfalls:

1. Transaction costs. It’s not just the commission, it’s the spread. Iomega sells for one price if you’re buying, an eighth or a quarter more if you’re selling.

2. Discontinuities. It’s fine to put in stop-loss orders designed to get you out of a position when you’ve lost 8%. But what if a stock gaps open down 30% as sometimes happens? Then you’ve lost more than you planned — and in case you’ve been juicing up your return with margin, more still.

3. A downtrend. What if they forget to sound the bell that signals the end of this bull market and the market as a whole drops 30% over the next year or two? If you know in advance that’s what it’s going to do, no problem — you can keep on making a fortune trading as you have been, only with puts or short sales. But it’s only easy (at least for me) to know these things with hindsight. So there’s the market “correcting” more than it’s rebounding — more bad days than good — and lots and lots of 8% losses with almost no 20% gains. So you switch to the short side, but now the market begins recovering, so you’re still racking up 8% losses before being stopped out of your short positions. (And on the short side you might even have occasional dividends to pay, although not, I expect, with stocks like Iomega.)

Having said all this, you should presumably keep on doing what you’re doing as long as it works for you. The only important suggestions I’d make, and I suspect you’re way ahead of me, are, first, to avoid margin and, second, to set, in your mind, an “overall stop loss.” That is, promise yourself you’ll quit this game altogether if you ever lose a third (say) of your accumulated peak profit. (And then keep that promise!) In other words, if you’re up $600,000 at some point, but that ever shrinks to $400,000, fold your tent. In this example, you’d get to keep $400,000 (before tax), save 5 hours a day, and avoid the possibility of losing the remaining $400,000 — and then some.

(Remember: if you make $600,000 this year and lose $600,000 next year,
you have not broken even, you’ve lost $230,000 or so. Why? Because in the 40% tax bracket you had to pay $240,000 in tax on the short-term gain, but get to deduct only $3,000 a year of the loss, which saves you only about $1,200 a year.)

Good luck! (And as you hit each new million, could I it you up for one of my charities?)

Tomorrow: The Other Side of This Story

Yesterday I rattled on about John MacArthur, so cheap he used to run his insurance company in his skivvies on broiling Chicago afternoons rather than spend money on air conditioning.

Today the heat wave continues as I quote a page from The Earth Pledge Book (Cronkhite Beach, Building 1055, Sausalito, CA 94965). Each page has a quote at the top and a pledge at the bottom.

The quote:

“The United States consumes more energy for air conditioning than the total energy consumption of the one billion people in China.” — Robert O. Anderson (oil company CEO)

The pledge:

“I pledge to plant trees for shade, which can reduce air conditioner needs by 50%.”

In the meantime, pledge to me you will find a beach somewhere tomorrow, or some other cool and wonderful place (a movie theater?) to enjoy the day. We’ve got our problems in this country, certainly, but boy are we ever lucky to live here. (My favorite thing about tomorrow is the way the New York Times always prints the Declaration of Independence on its back page. Well worth re-reading.)

You think you’re hot today? (Someplace on the Internet it’s hot today. Apologies to our friends in Cape Town and Santiago who are freezing their butts off.) You think you’re careful when it comes to blasting the air conditioner (and thus your electric bill and “the environment”)?

Well, what about John D. MacArthur? MacArthur was the grade-school graduate who paid $2,500 to buy a bankrupt insurance company in 1935 and died a billionaire in 1978 — one of only two American billionaires at the time, as far as I know (the other: reclusive shipping magnate D.K. Ludwig).

He is remembered particularly for the “genius grants” that the MacArthur Foundation awards each year.

How’d he get so rich? Well, for one thing, he refused to spend any money on air conditioning. Reportedly, he was often seen conducting business at the executive offices of Bankers Life & Casualty in the heat of summer wearing just his underwear.

Not a pretty picture.

Of course, frugality alone does not a billionaire make. MacArthur’s own explanation, once: “I’ve been in the right place at the right time . . . It was kind of like the Braille system. I’d stumble around, bump something and make money.”

Meanness and dishonesty played a role, too. Once the company was going to host a Palm Beach week-end extravaganza for its 300 top-performing salesmen of 1961 — all expenses paid. All through the year notices went out to the sales force getting them to compete for this prize. What they were not told is that they’d be staying at MacArthur’s own hotel, the Colonnades, to keep the cost down. In November, when the rooms would have gone empty anyway. But the real surprise came when, after they’d competed all year for the prize and the winners had long since been selected — he just canceled the whole thing. Spend all that money just to reward his 300 top salesmen? (He owned 100% of the company, so it was his money.) No way!

To keep them from quitting, word went out that the cancellation had been made out of a concern for safety — it was around the time of the Cuban missile crisis.

But this was just a trifle. Where the bucks really piled up wasn’t in short-changing his employees, but in shortchanging his customers: collecting premiums against all manner of mishaps but then not paying off.

My favorite story concerned some truly atrocious escape clause he had inserted into the middle of a dense insurance policy. The only way anyone would ever become aware of this needle in a haystack of fine print was when the company pointed to it to decline a claim. The Illinois Insurance Department, alerted to these callous dealings, insisted that, at the least, this egregious clause be printed in 10-point type, to stand out. MacArthur complied by printing the entire policy in 10-point type.

“The darkest day in insurance history,” said his brother Charles, president of a more respectable insurance company, “was when my brother entered the business.”

Not a pretty picture, either — though no reason, I should think, if you happen to be awarded a MacArthur grant yourself, to turn it down.

Have a happy and not too hot July 4th weekend!

“I would be interested in your thoughts on selling a losing stock. One where you don’t expect the loss to turn around for, say, at least a year. Is it best to sell and write off the loss or hang on and keep the paper loss from becoming real? I am assuming here that you don’t need the money for the near term.”

Gosh. I didn’t think anybody but me had any losers these days.

Well, one thing you can do is sell it now, for a tax loss; then wait 31 days and buy it back. (You have to wait 31 days or the I.R.S. will deem your sale-and-repurchase a “wash sale” and disallow the loss.)

At a deep discounter, the cost of selling-and-buying-back would be negligible, though the “spread” between bid and asked could cost much more, especially if the stock is illiquid. Not to mention that the stock just might zoom in those intervening 31 days, to spite you, making it expensive to buy back. (So another tack is to buy the extra shares first, doubling up, wait 31 days and then sell your original shares for the loss. The risk with that, of course, is that the stock could keep falling and you’ll now lose twice as much as it does.)

The presumption in either case is that you think this stock represents a really good value at today’s price. Otherwise, why not just sell it and buy one that you think does? (Or, if you can’t find a really good value, just sit on the sidelines for a while?)

One other alternative: Stop trying to beat the averages by doing this yourself and buy shares, instead, in low-expense no-load mutual funds. Most of them won’t beat the averages, either; but at least they’ll save you time.