Author: A.T.

Have you already recommended the ‘low expense no-load mutual funds’ that you like?

Not here.

If not would you? Thanks. — S. Ruch

Sure:

1. The various Vanguard index funds, because their super-low expenses mean you are almost certain to do better than the majority of your fellow stock market and mutual-fund investors — though you will never do exceptionally well.

2. The T. Rowe Price funds, especially if you’d like a little hand-holding.

3. The Twentieth Century funds, though this may not be the best time to start with aggressive funds that do best in bull markets — this one may be in its latter stages.

4. The Mutual Series funds, but hurry — they are about to be purchased by the Franklin group of funds, and for new investors will become “load” funds. (Existing investors will be able to make new investments without the load, they say.)

Tomorrow: My First Ostrich

Did you have fun last week?

“The U.S. stock market is behaving like a thermodynamic milkshake: there are easier ways to gain 9.25 points, as the Dow did Tuesday, than by exploring a 220-point range, with a stunning 680 million shares traded.”

— Mark Anderson, STRATEGIC NEWS SERVICE

(SNS is a high-level, high-tech industry $195/year weekly electronic newsletter targeted at CEO types and those sophisticated at high-tech investing. For a free one-month trial, e-mail to Markrander@aol.com.)

Tomorrow: Favorite Mutual Funds

“As a parent who oversees the contribution of $2,000 each to IRA accounts for two summer employed college student sons, I urge you to tell everyone to do the same. Or is there some new tax angle that would not make it as prudent as I think it is?”

Yesterday we cured the common cold, but this one may be even better. It won’t help you, but it could sure help your kids if you can afford it. And they don’t have to be college-age, either.

Say you have a 12-year-old earning $100 a week this summer cleaning pools or mowing lawns or teaching Windows 95. Have her set up an IRA with some good low-expense no-load mutual fund and put all the money there.

She will resist this idea strenuously, but there’s a way around that. Increase her allowance by the same $100, so it doesn’t cost her a dime. If she still doesn’t like the idea, you have a mentally challenged kid. (Or, if your powers of persuasion are a little better than that, tell her you’ll chip in $75, so it only costs her $25 in current cash to stash away $100-a-week in her IRA. That should sound pretty good, too, and gives her more of a stake in it.)

No one starts this early. But because “the power of compound interest” over a lifetime is so extraordinary, they should. So long as the money is earned in some legitimate arms-length way (not mowing YOUR lawn or cleaning YOUR pool or teaching YOU Windows 95), your child is entitled to put up to $2,000 of it a year into an IRA.

Clearly, the purpose wouldn’t be to save taxes in the short run. Indeed, there’s always the risk your kid will, irresponsibly, raid the IRA in a few years. That would just serve to transform today’s mostly nontaxable dollars (because on a kid’s meager income little or no tax is due) into taxable dollars (because by then he/she’ll be a taxpayer).

But look how it works if done right:

1. Your kid gets into a working/saving habit. This alone is priceless.

2. Maybe your kid learns a little about investing and capitalism. This can’t hurt, since it’s the foundation of our prosperity.

3. If your kid puts $1,000 a year into an IRA from age 12 through 21 and then stops, and if the mutual fund grows at 10% a year over the kid’s lifetime, then the income from those ten summer jobs — $10,000 — will grow by age 70 (when withdrawals must begin) to $1.7 million. Which would be enough to throw off an annual income of $200,000 for the following 20 years, to age 90. All for having done this at the outset.

Of course, figuring 3% inflation over the same period, $200,000 a year would really be only about $35,000 by then. And that’s pre-tax. But how many 70-year-olds do you know today who wouldn’t be glad for a $35,000 boost to their annual income?

(And because this money would be “locked away” in an IRA, college financial aid offices should not take it into account in determining available funds, which could make a difference in obtaining student aid.)

So, yes: if your kids are working this summer, or a few hours a week during the school year, you might consider something like this. And if they’re not working, maybe they should be.

The IRA can be set up, and 1996 income deposited, any time until next April 15. But better to do it today.

Robert Leroy Ripley was a sports cartoonist for the New York Evening Globe. He drew his first “Believe It or Not” December 19, 1918. It showed, among others, a Canadian who ran the 100-yard dash in 14 seconds — backwards — and a Frenchman who (believe it or not) actually held his breath underwater for more than 6 minutes. Soon he ventured beyond the sporting world (“Boy died of old age at age 7”) and an industry was born.

Growing up, one of my favorite books was Ripley’s Believe It Or Not. (I believed it.) And one of the stories in the book, although I can’t say I recall more than its gist, was of an auction at which a man paid a thousand pounds for a book billed simply as, “the secret of good health” — or something like that.

He won the bidding, grabbed the book, and found that all its pages were blank except the first. It said: “Keep your feet warm and your head cool” and you’ll be a healthy man. (Not an easy thing to do in a world where heat rises.) Well, he immediately got a hot head at having been taken this way, and cold feet about going through with the deal, but all sales were final.

But it’s not such bad advice. Here’s a little more. It may not be worth a thousand pounds to you, but has been to me — and it’s free.

You know that little tickling feeling you get at the back of your throat where it connects to your nose, and the next day you’re sneezing and pretty soon you’re coughing and it goes to your chest and the Contac is making you sleepy or the Sudafed is making you feet tingle at night and no amount of orange juice keeps the damn thing from running its course?

If you don’t know what I’m talking about, you are a lucky mammal.

Anyway, a friend seems to have solved this problem for me: apple cider vinegar. At the first hint of a tickle, I now just screw up my face and take a tiny, tiny sip of the stuff (it’s really not so bad — think of the dressing on a salad, sans the salad), tip my head back and let it swish around the tickle as much as I can before swallowing it. Then maybe a second or third time.

End of story.

Obviously, I can’t say it will work for you, or continue to work for me. But it’s worked for the friend who turned me onto it, and I’m convinced it’s worked for me. Placebo effect? Perhaps — that’s just fine with me. At least it hasn’t cost you a thousand pounds.

Tomorrow: Your Kids’ Summer Jobs

Yesterday I told you a little about naked puts and calls — games you always win (until you go broke). But what of writing “covered calls,” where you own the underlying stock against which you sell the calls?

Covered calls are perceived to be much less dangerous than naked calls (where you don’t own the underlying stock) — and they are. At least you can’t lose everything. Normally, they are a way to enhance your return. Here was a stock paying a 3% dividend and appreciating maybe 6% a year. You decide to write calls against it every couple of months, pocketing a couple of hundred bucks each time that might add another 15% a year to your return. Ain’t hay!

The calls you choose to write, in this example, are always at a strike price high enough above the current market price that they’re not likely to be exercised. And even if they were — well, what would be so awful about that? You bought the stock years ago at 40, say. Now it’s 60. You agree to sell it at 65 any time in the next couple of months — and are paid a couple of hundred bucks for making that agreement (writing the call). Now the stock jumps to 80. Well, you get your $65 for a stock that was 60 when you wrote the call, and you get to keep the couple hundred bucks. The only “downside,” if you can call it that, is that your profit is less than it otherwise would have been — you get $65 instead of $80 — and you’re forced to “realize” and pay tax on the gain.

(Actually, there are ways to avoid that. You can either buy back the call before it’s exercised or, if you miss that chance, buy new shares at $80 and deliver them at $65, rather than deliver the shares you bought years ago at 40.)

So why isn’t this one a money machine? It usually is. But not only do you limit your “upside” — at 65, in the example above — you retain the full “downside.” What if the market tanks, or just this stock, and it drops from 60 to 14?

So even covered calls, in the long-run — though not remotely the gamble naked puts or calls are — are a true money machine for one party only: your broker.

Tomorrow: A Cure for the Common Cold

We’ve been talking about options the last couple of days, so I wanted to warn you about a couple of ways to make money with options almost all the time.

NAKED PUTS

I met this guy in the Eighties who was trading naked puts. His broker — a genius — had turned him on to this money machine. Basically, there was the stock market is a powerful, long-term upswing. So say a stock of some solid company was 60. If you wrote (sold) a put on it at 50 — well, what was the chance it would fall that far in the two or three months til expiration? Very low. At the end of those two or three months the put expires, and you get to keep the premium you were paid to write it. Ka-ching!

Yes, there can be occasional nasty surprises even in a bull market. Say you were paid $300 to write a put obligating you to buy 100 shares of this currently-$60 stock at 50 and that — drat! — some scandal erupted that caused the stock to plunge to 35. Rarely happens, but then you’d be on the hook to buy it at 50 (paying $5,000 for 100 shares) even though it is only worth 35 (meaning you have a $1,500 paper loss, less the $300 you were paid to take this risk, plus commissions).

To avoid even this small risk, my friend was well diversified. And that made it pretty much a money machine. Month after month, he’d pocket the premiums on these “far out of the money naked puts” he was writing. His broker enjoyed the commissions. And, in truth, since virtually all of the puts expired worthless, there were only half the commissions there normally are in a trade — i.e., just the commission for writing the put, but no commission at the other end. The puts would expire worthless, the premium was my acquaintance’s to keep (and pay ordinary income tax on).

He made about a million dollars doing this.

And because he was so well diversified, there was really no risk. His broker calculated that the Dow would have to fall something like 300 points — in a day! — for him really to get burned, and that was . . . well, c’mon — back then 25 points was big move and 75 was jaw-dropping front-page news.

Smug may not have been exactly the right term for my acquaintance, but the Christmas gifts he was sending his broker were probably even more lavish than the Christmas gifts his broker was sending him. It’s =nice/= having a money machine.

And then of course, in the fall of 1987, the market dropped not 300 points but 508 in one day. He lost the million he had made and millions more.

It turned out to be one of those strategies that always make money — until you go broke.

There are others.

Naked puts are scary. So, too, naked calls. (There, with a stock selling at 60, you’d write a call obligating you to sell it to someone at 65, say, even though you don’t own it. No sweat! Unless it rises above 65, you’re cool. But if it rockets to 90, someone will in effect say: “OK, here’s my $6,500. Gimme my 100 shares.” And you will have to pay $9,000 plus commission to buy and deliver them.)

Really, you can construct lots of games at which you will almost always win a little, but eventually lose it all. Here’s one more. Go to Las Vegas with $2,000. Bet $1 on red. If you win, you’ve made $1. Do it again. If you lose, bet $2. If you win, you’ve still made $1 (the $2 you win less the first dollar you lost). Now start again at $1. If you lose that $2 also, double your bet again, to $4. Sooner or later you will win (it can’t =always/= come up black) and so sooner or later you will win $1 more than you lost. Then just start all over again betting $1, doubling, as needed, until you win.

This is a virtual printing press for dollar bills. You will just keep winning them all night. And you will even get free drinks. The only conceivable problem would be if it came up black 11 times in a row. The chances of that happening are almost nil, of course. But at that point you’d have lost $2,047 and — to win it back and make your dollar — you’d need to double your previous bet ($1,024) and bet $2,048. But you ain’t got it. (Or the table limit may not allow it.) You’re wiped out.

It’s one of those deals where you always win until you go broke.

Tomorrow: Covered Calls

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