• Index your investments using ETFs, the best low-cost, modern method
of indexing.
• Adopt option-writing strategies to hedge your investments and enhance
returns.
Welcome to the twenty-first century of investing. Operating your own
hedge fund can be both fun and profitable.
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Chapter 11. Morningstar, Inc. is a global investment research firm, providing information,
data, and analysis of stocks, mutual funds, and exchange traded funds.
2. Sadly, recent disclosures show that some stockbrokers put their own interestsahead of those of the investor and recommend funds which provide the highestsales commission for the broker regardless of the fund’s ability to earn profitsfor the investor.
3. From 1926 through 2000, investing in the Standand & Poor’s 500 index returned
an average of 11.0 percent annually.
4. The risk-free rate is generally defined as the interest rate available from U.S.Treasury securities for the time period under consideration. These Treasury se-curities are (currently) as risk-free as an investment can be. There is no guar-antee this will always be true.
5. Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March
1952): 77–91.
6. The original work is summarized and expanded in Markowitz, Portfolio Selec-
tion.
7. William F. Sharpe, Portfolio Theory and Capital Markets (New York: McGraw-Hill, 1970); William F. Sharpe, Investments (Englewood Cliffs, NJ: Prentice-Hall,1978); Cootner, ed., The Random Character of Stock Market Prices; and Fama,“The Behavior of Stock Market Prices.”
8. Andrew Rudd and Henry K. Clasing, Jr., Modern Portfolio Theory: The Princi-
pals of Investment Management (New York: Dow Jones-Irwin, 1982).
9. Merton Miller also shared the prize, but his contribution was in the field of cor-
porate finance.
10. See, for example: Harry M. Markowitz., Portfolio Selection: Efficient Diversifi-cation of Investment (New York: John Wiley & Sons, 1959); Paul Cootner, ed.,Random Character of Stock Market Prices (Cambridge, MA: MIT Press, 1964);or Eugene F. Fama, “The Behavior of Stock Market Prices,” Journal of Business20 (1965): 34–105.
11. The prudent man rule consists of guidelines ensuring that a fiduciary invests aclient’s money as other prudent investors, with similar investment goals, invest.
216
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12. One such book is: Roger C. Gibson, Asset Allocation: Balancing Financial Risk(New York: McGraw-Hill, 2000). Another is: John J. Brown, Jr., Carl H. Rein-hardt, and Alan B. Werba, The Prudent Investor’s Guide to Beating the Market(Chicago: Irwin Professional Publishing, 1996).
13. Restatement of the Law/Trusts/Prudent Investor Rule (St. Paul, MN: American
Law Institute Publishers, 1992): ix.
14. As of July 2003, over 53.3 million American households own mutual funds, ac-cording to the Investment Company Institute (ICI), www.ici.org/shareholders/us/index.html.
Chapter 21. Timing the market refers to attempting to buy before rallies and/or sell before
declines.
2. From John C. Bogle, foreword in W. Scott Simon, Index Mutual Funds: Profit-ing  from  an  Investment  Revolution (Carnarillo,  CA:  Namborn  Publishing,1998).
3. Efficient market theory was introduced by Eugene F. Fama, “The Behavior of
Stock Market Prices,” Journal of Business 20 (1965): 34–105.
4. The expectation is that owning ETFs provides a performance that matches themarket. Adopting an options strategy (covered call writing) makes it likely youwill  perform  even  better,  based  on  statistical  evidence  of  the  past  16  years.Chapter 12 presents that evidence.
5. Data supporting this statement can be found in Baer and Gensler, The  Great
Mutual Fund Trap.
6. The performance of the S&P 500 has a greater than 99 percent correlation with
the results of the entire market.
7. For example, the largest index fund of them all, the Vanguard S&P 500 IndexFund, grew by 37, 23, 33, 29, and 21 percent from 1995 through 1999 respectively.8. For example, assume the fund managers must purchase 800 shares, but only 200shares are offered at the asking price. The price they must pay to buy those ad-ditional 600 shares could be significantly higher than the current price becausethere may be few, if any, shares offered for sale at any given time. That meanspaying too much for the shares. The same situation could occur when sellingshares. That is not efficient, and index fund managers must trade stocks effi-ciently to produce satisfactory performance.
9. For example, three stocks were added, and three removed, from the DJIA in
April 2004.
10. Larry E. Swedroe, The Successful Investor Today: 14 Simple Truths You Must
Know When You Invest (New York: St. Martin’s Press, 2003).
11. For example, see: Baer and Gensler, The Great Mutual Fund Trap, or Burton G.Malkiel, Random Walk Down Wall Street (New York: W. W. Norton, 2000).
12. Source: Investment Company Institute, www.ici.org.13. Ken Gregory and Steve Savage, “When Funds Behave Badly,” Kiplinger’s Per-
sonal Finance (November 2003): 53–4.
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14. They are careful to tell investors that past performance is not an indicator of fu-ture performance. But the very fact that they promote past performance showsthey  want  to  convince  investors  that  past  performance  is  indeed  such  an indicator.
15. Brad Barber and Terrance Odean, “Too Many Cooks Spoil the Profits: The Per-formance of Investment Clubs,” Financial Analyst Journal (January–February2000): 17–25.
16. Brad M. Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: TheCommon Stock Investment Performance of Individual Investors,” Journal of Fi-nance 55, no. 2 (April 2000): 773–806.
17. Frank A. Armstrong, The Informed Investor: A Hype-Free Guide to Construct-
ing a Sound Financial Portfolio (New York: Amacom, 2002): 78.
Chapter 31. Source: Hedge Fund Research.2. Neil  Weinberg  and  Bernard  Condon,  “The  Sleaziest  Show  on  Earth,”  Forbes
(May 24, 2004): 110–118.
3. See www.better-investing.org.4. http://www.bivio.com.
Chapter 41. The Templeton Emerging Markets Fund once traded with a 20 percent premium.The presence of a “hot” fund manager coupled with owning stocks in the “hot”emerging market arena convinced some investors that it was a good idea to pay$1.20 for stocks worth $1.00. Source: David Lerman, Exchanged Traded Fundsand e-Mini Stock Index Futures (New York: John Wiley & Sons, 2001): 65.
2. Cited in Joseph Nocera, “The Age of Indexing,” Money Magazine (April 1999):
103–112.
3. Jason Zweig, “The 75 Year History of Mutual Funds,” Money Magazine (April
1999): 94–101.
Chapter 51. The rules stipulate that no one can buy or redeem shares after the market closesfor business on a given day. When very bullish news appears after the close oftrading, unscrupulous traders who can purchase shares of a fund after the mar-ket has closed and pay the closing price established earlier have a huge advan-tage,  as  the  fund  is  very  likely  to  trade  higher  the  next  day  (because  of  thatbullish  news).  The  privileged  buyer  then  sells  the  shares  to  lock  in  an  unde-served profit. The other shareholders are left holding the bag for the expensesof the trade.
2. Mutual funds have admitted allowing privileged clients to use market timing tobuy and redeem shares whenever they pleased. Public customers either werenot allowed to redeem shares soon after purchase or were charged a stiff fee fordoing so. Today, forced by public opinion, more and more funds are leveling the
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playing  field  by  imposing  the  same  fee  on  everyone  who  makes  an  early redemption.
3. A one percent management fee (and most fees are higher) on $200 billion ofmanaged assets provides income of $2 billion per year. That’s real money.4. These examples are taken from Ken Gregory and Steve Savage, “When Funds
Behave Badly,” Kiplinger’s Personal Finance (December 2003): 53.
5. An eye-opening book that provides evidence supporting the statement that pro-fessional  money  managers  fail  to  beat  the  market:  Gregory  Baer  and  GaryGensler, The Great Mutual Fund Trap (New York: Broadway Books, 2002).
6. Baer and Gensler, ibid. p. 70.7. John  C  Bogle,  foreword,  in  W.  Scott  Simon,  Index  Mutual  Funds:  Profitingfrom an Investment Revolution (Carnarillo, CA: Namborn Publishing, 1998).8. Prem C. Jaji and Joanna Shuang Wu, “Truth in Mutual Fund Advertising: Evi-dence on Future Performance and Fund Flows,” Journal of Finance 15 (April2000): 937.
9. Alfred Cowles III constructed the precursor to the S&P 500 index. He also dis-covered that the best market forecasting methods did no better than an equalnumber of random selections would have done.
10. Quote taken from: Peter Bernstein, Capital Ideas (New York: Free Press, 1992),
pp. 35–6.
11. Jim Rogers SFO Magazine, “Back From the Global Highways, The Adventure
Capitalist Speaks Out” 2 (October 2003): 22–31.
12. The institute evaluated fee trends using a comprehensive measure that repre-sents the cost an investor incurs when buying and holding mutual fund shares.
Chapter 61. Some  funds  allow  trading  at  specified  times  during  the  day,  but  that  is  the 
exception.
2. A front-end load is paid when you buy the shares. Some funds use a back-endload instead, where you pay the sales charge when redeeming your shares. Usu-ally the longer you own the fund, the lower the back-end load.
3. Even though the fund may be losing value, whenever the fund managers sell astock bought at a lower price, they earn a taxable profit. That profit representsa capital gain and is distributed to the shareholders.
4. It’s possible to buy 100 shares of an ETF and pay a commission as low as $1.Other discount brokers charge only $5 to $8 to purchase any number of sharesbetween 100 and 5,000. Full-service brokers charge much higher commissions.5. Comparing fees for traditional mutual funds and ETFs, “The average index fundis  at  least  100  basis  points  (1%  per  year)  cheaper,  and  the  average  exchangetraded  fund  (ETF)  is  cheaper  still.”  David  Lerman,  Exchange  Traded  Fundsand e-Mini Stock Index Futures (New York: John Wiley & Sons, 2001): 8.
6. OPALS (optimized portfolios as listed securities) trade on the Luxembourg Ex-change and are available for many indexes and single country indexes. Ameri-can investors are not allowed to trade OPALS.
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7. Morgan Stanley Capital International (MSCI) developed the EAFE as an equitybenchmark  for  international  stock  performance.  The  index  includes  stocksfrom Europe, Australasia, and the Far East. The S&P 100 Global index consistsof large-capitalization transnational companies from around the world. Ameri-can companies are well represented in this index. General Electric and ExxonMobil are currently the two largest holdings.
8. The price-to-book ratio is the stock price divided by the book value per share.Half of the stocks (with the highest ratio) are considered to be in the growthcategory and half are considered to be value companies.
9. The market capitalization of each stock in the index is calculated by multiplyingthe total number of shares outstanding (for each stock) by its market price. Theindividual market caps are totaled. The percentage of that total for each stockrepresents the percentage of shares of each stock in the index.
10. New ETFs are constantly being listed. See www.amex.com for a current listing.11. For the most up-to-date listing of iShares, visit www.ishares.com.12. The first HOLDR was TBH, a compilation of 12 “baby bras.” These 12 companieswere the result of the breakup of the Brazilian telecommunications companyTelebras. Merrill Lynch decided to “reassemble” Telebras into one trading vehi-cle. It was a big success. Merrill followed by introducing other HOLDRs in Sep-tember 1999.
Chapter 71. For  beginners,  I  recommend  my  recent  book:  Mark  D.  Wolfinger,  The  ShortBook  on  Options:  A  Conservative  Strategy  for  the  Buy  and  Hold  Investor(Bloomington, IN: 1stBooks Library, 2002). A more thorough text is: LawrenceG. McMillan, Options as a Strategic Investment, 4th ed. (Englewood Cliffs, NJ:Prentice-Hall, 2001). I encourage you to spend some time in your local library orbookstore for other appropriate titles.
2. Selling  short  means  selling  a  security  that  is  not  owned.  The  shares  are  bor-rowed from the broker and delivered to the buyer. The seller is obliged to re-purchase those shares at some (unspecified) time in the future.
3. The  description  of  every  option  includes  the  month  of  expiration.  Example:IBM Apr 95 Call. This option represents the right to buy 100 shares of IBM at thestrike price of $95 per share any time before the option expires in April. Chap-ter 8 presents a more detailed explanation of the description of an option.
Chapter 81. The U.S. options exchanges are the Chicago Board Options Exchange, Ameri-can  Stock  Exchange,  Philadelphia  Stock  Exchange,  Pacific  Coast  Stock  Ex-change, International Securities Exchange, and Boston Options Exchange.2. The  current  list  includes:  Advanced  Micro  Devices  (AMD),  AMR  Corporation(AMR),  Applied  Materials  (AMAT),  AT&T  Wireless  Services  (AWE),  BrocadeCommunications Systems (BRCD), First Data Corporation (FDC), Calpine Cor-poration (CPN), EMC Corporation (EMC), El Paso Corporation (EP), E*TradeFinancial Corporation (ET), Juniper Networks (JNPR), Liberty Media Corpora-
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tion (L), Lucent Technologies (LU), Motorola (MOT), Micron Technology (MU),Nortel Networks Holding Corporation (NT), Oracle Corporation (ORCL), Sun Mi-crosystems (SUNW), Tenet Healthcare Corporation (THC), Time Warner (TWX),Tyco International (TYC), JDS Uniphase Corporation (JDSU), and Xerox (XRX).3. For example, a trader with a short position in the underlying stock might exer-cise a call option that is exactly at the money in order to buy stock at the strike,thereby eliminating the short position. Similarly, a trader who owns a stock po-sition might exercise an at-the-money put to eliminate the long position.
4. If exchange members or public customers request that the short-term option belisted, the exchanges usually comply, even if there are fewer than 30 days beforeexpiration.
5. If the stock moves as hoped, the option owner often decides to sell and collecta profit. If it does not move as hoped or if it does not move at all, the optionloses value. When the stock does not move as anticipated, the option owner cancut losses by selling the option to recover part of the purchase price. Knowingwhen to cut losses is a trading skill that traders who are new to options lack.Many option buyers continue to hold the option, hoping the stock finally willmake a move in the right direction. Thus, too many newcomers to options holdtheir positions until options expire worthless.
Chapter 91. If the option is in the money, the entire investment is not lost—only the timevalue of the option is lost. Don’t be concerned with this detail at this point inyour options education.
2. Selling the option before expiration could have salvaged part of the investment.However, it is not an easy decision to sell a call option (especially at a loss) asthe stock is rallying.
3. A short position occurs when investors sell stock (or other assets) they do notown in anticipation of buying that asset at a later date and at a lower price. Sell-ing stock short can be transacted only in a margin account, and prior approvalby the broker is required.
4. In theory, the price of a stock can rise forever. The naked call writer may even-tually be forced to repurchase the call option or buy stock. The higher the re-purchase price, the greater the loss.
5. The stock price can only fall to zero. Thus, the maximum loss per share is thestrike price minus the option premium. When selling naked calls, there is nolimit to the loss.
Chapter 101. Commissions are very important when trading options. If you are able to makeyour own investment decisions, seriously consider trading online using a deep-discount broker. However, using a full-service broker may be appropriate forsome investors as low commissions are not the only consideration.
2. Unless you are assigned an exercise notice before the stock goes ex-dividend.Remember, the option owner has the right to exercise the option any time be-fore it expires.
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3. Some  online  brokers  make  this  information  available  on  Sunday.  All  brokersmust provide this information before the market opens on Monday. Don’t takeany  chances.  Don’t  make  any  assumptions.  If  you  cannot  find  out  onlinewhether you have been assigned an exercise notice, call your broker and ask.4. The OCC is a clearinghouse for information about who owns, and who has sold,every outstanding option contract. The OCC verifies that the exerciser owns theoption and has the right to exercise it. Next it selects, at random, one of the ac-counts that currently has a short position in the identical option. That accountowner  is  assigned  an  exercise  notice,  and  must  fulfill  the  conditions  of  thecontract.
5. In-the-money options are more expensive than other options, and the extra cashreduces the break-even point, thereby increasing the amount the stock can dropbefore a loss in incurred.
6. Profit is $400 ($0.80 per share; 500 shares). Investment is $14,600 ($32.50 minus$3.30 for each of the 500 shares). Return = 2.74 percent. In this discussion, an-nualized returns are not compounded. Thus, the annualized return is 12 timesthe monthly return.
7. As discussed earlier, the time premium in the price of the option represents themost you can earn when selling that option. Options close to the strike pricehave the highest time premium.
8. Stock price, strike price, option type (put or call), volatility of underlying stock,interest rates, and size of dividend all are factors in determining the price of anoption. The most important factor of all is supply and demand. When there is apreponderance of option buyers, prices rise. When sellers outnumber buyers,option prices decline.
9. Your broker should provide this data, but 20-minute delayed option quotes arereadily available. One site offering the data is the CBOE: http://www.cboe.com/delayedQuote/QuoteTable.aspx.
10. If you are extremely bearish, it’s not advisable to be fully invested in bullish po-sitions. (Covered call writing is a bullish strategy.) Covered call writing signifi-cantly reduces losses during down markets, but if you are able to predict a bearmarket,  you’d  be  best  advised  to  own  few,  if  any,  bullish  positions  when  themarket  is  declining.  Those  of  us  who  are  unable  to  predict  market  directionshould remain fully invested.
11. Traders with a short time horizon must first buy stock and write a call. To closethe position, they must then buy the option and sell the stock. Thus, they makefour trades, incurring trading expenses. On top of that, often they must buy atthe offer price and sell at the bid price, again increasing expenses. These addedtrading  costs  often  make  this  strategy  unprofitable  for  the  short-term  trader.The trader who holds a position for a short period does not hold long enough tobenefit from the passage of time, as does the investor.
Chapter 111. As with covered call writing, you can expect to earn a better return than thatprovided by the market averages, except when the market surges. Even thenyou do well, but usually less well.
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2. Reminder: The volatility of a stock is one of the factors used to determine theprice of an option. The options of more volatile stocks are more attractive toown than options of non-volatile stocks, and buyers willingly pay higher pricesto obtain them.
3. It’s possible to lose money if the stock keeps declining in price while you ownit. But this loss is less than any other stockholder incurs, since that stockholderdoes not collect premium by writing covered call options.
4. A margin call is a demand for cash or marketable securities to be deposited intoyour account. If you fail to meet a margin call, your broker will liquidate somepositions (you have nothing to say about which positions) to raise cash to meetthe obligation. For most investors this is a very bad situation and can be verycostly. Avoid margin calls.
Chapter 121. Options on the SPX differ from options on individual stocks because they expireat the opening of the market on the third Friday of the month rather than at theclose.
2. For  the  most  recent  data,  visit  the  CBOE  site:  www.cboe.com/micro/bxm/
index.asp.
3. It is not in every investor’s best interest to adopt this slightly bullish strategy ofwriting out-of-the-money calls. For some investors, the safety that comes witha reduced potential profit potential coupled with additional downside protec-tion is more important. As discussed in Chapter 10 those investors would dobetter to write at-the-money or slightly in-the-money call options.
4. See  www.croftgroup.com.  The  data  are  available  at  the  site  of  the  MontrealStock Exchange: www.me.org/produits_en/produits_indices_mcwx_en.php.5. Richard Croft’s Option Commentary, September 2003. The variance in returns isreduced by 25 percent. Option Commentary is available through E*Trade Canada.
6. See www.cboe.com/LearnCenter/pdf/bxmqrg.pdf.7. When only eight days remain until expiration, the soon-to-expire options are nolonger  used  and  the  VIX  value  is  calculated  using  data  from  the  second  andthird months.
8. See www.cboe.com/micro/vix/vixwhite.pdf.
Chapter 131. If you buy 435 shares, for example, you will be able to write only four call op-
tions, leaving 35 shares unhedged.
2. The worth of the company’s common stock as it appears on a balance sheet. It’sequal to total assets less all liabilities, including preferred stock and goodwill. Ifthe company were to go out of business today, the book value represents thevalue of anything remaining.
Chapter 141. Because several holidays are celebrated on Monday, if the exchange is closed,Tuesday morning is the appropriate time to initiate new covered call positions.
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It’s OK to wait a few days, but if you are following the precepts of MPT, you al-ways want to be fully invested.
Chapter 151. The fee is charged every time you receive an assignment notice. Thus, if you areassigned on 10 MDY calls, the commission is $20. If you are assigned on 3 MDYand 5 VTI, the commission is $40.
2. Reminder: Time value for an option increases as the stock price gets nearer the
strike price.
3. The amount of downside protection (in this specific example) equals the maxi-
mum percentage return.
4. If you’re the type of investor who doesn’t watch the market closely, but pays at-tention only when a statement from your broker or mutual fund manager arrivesin the mail, checking in once per month (expiration Friday and the followingMonday) may work for you here—but try to watch more frequently.
5. I received an assignment notice and sold my EFA shares at $134. I also paid an
assignment fee (commission) of $20.
6. Calls increase in value as the price of the underlying increases and decrease in
value as the underlying declines.
7. If the market heads higher and I can write the (currently) OTM option when itbecomes at the money, I’ll get a higher selling price and make additional profits.On the other hand, if the ETF declines in price, I’ll be forced to sell the optionthat is currently in the money when it becomes at the money. If that happens, I’llbe forced to accept a lower price when selling compared with the price I can getnow. I’m not going to take that chance because I don’t believe in attempting totime the market.
8. It may be trivial to mention, but each quarter of the year is 13 weeks long. Thus,two of every three expirations are four weeks long, and the other is five weeks.9. If the broker is unable to execute both the buy and sell at prices that allow myconditions (credit of $2.75 or better) to be satisfied, then the order will not befilled and I will continue to own my current position.
10. Limit orders are not always filled because you cannot receive a price worse thanyou stipulate. Entering a market order guarantees the order is filled at the “bestavailable prices,” but you run the risk of getting very poor prices.
11. Remember,  the  more  time  remaining  until  expiration,  the  more  an  option  is
worth and the more you receive when selling.
12. Why don’t call prices get crushed when the market heads lower? Call prices dodecline, but not nearly as rapidly as one would expect. Arbitrageurs buy calls,sell puts, and sell stock short, creating a position with almost zero risk. Whenput prices increase, they are willing to pay higher prices for calls. This call buy-ing decreases the rate at which call prices decline. If put prices go high enough,then call prices can rise as stocks fall. This occurred to an incredible degreewhen the market crashed in October 1987.
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13. Implied volatility is an estimate of how volatile stocks will be from the currentmoment until options expire. Higher implied volatility produces higher optionprices.
14. At expiration, all options have zero remaining time premium. They are worth the
intrinsic value only.
15. See, for example, www.mdwoptions.com/OptionCalculator.html or www.cboe
.com/TradTool/OptionCalculator.aspx.
16. Many options traders went out of business overnight in 1987 because they wereshort too many options and were unable to cover at reasonable prices. Therewas a great shortage of options for sale. But there was no shortage of optionbuyers. This imbalance, coupled with fear of the future, raised option prices tounbelievable levels.
17. Rolling options one point in either direction does not pay because commissionsrepresent  a  significant  portion  of  the  potential  benefit,  and  there  is  too  littlecash available from rolling.
18. Traders are whipsawed when they take a position, then quickly have to reversethat position, locking in a loss. Often the market moves in the original directionagain, and the second trade must be reversed, locking in another loss.
Chapter 161. Legging  refers  to  the  process  of  making  a  trade  for  one  portion  (a  leg)  of  ahedged  position  (e.g.,  buy  200  ETF  shares)  and  then  entering  an  order  (e.g.,write two calls) for the second part of the position. When legging, there is al-ways  the  risk 