closing the position with a buy order at a lower price. Soinstead of the traditional long sequence of buy–hold–sell, short sellers do the opposite: sell–hold–buy. The concept of selling something you don’t own is foreign to many people, but in the market itis commonplace.Short selling is a high-risk strategy for two reasons. First, to sellstock short investors borrow shares from their brokers. The brokerage ﬁrm buys shares for the short seller and allows that short sellerto sell them short. As a result, short sellers pay interest to the brokerfor the time their short positions are open. This adds to the need fora proﬁt because the longer a short position remains open, the higherthe interest cost. In addition, short sellers have to demonstrate thatthey have the ﬁnancial means to cover their short sales if and whenthe transaction does not work out. Short sellers will proﬁt if thestock’s value falls, but if it rises they are required to increase theirdeposits with the brokerage ﬁrm. If the stock rises signiﬁcantly, therequirement can become quite expensive. Based on ﬁnancial capability, most investors are going to be limited in how much shortselling they can do.The second reason that short selling contains high risks involvesmarket price movement, especially in volatile stocks. If the pricefalls, the short position can be closed at a proﬁt. But if the stockprice rises, the short seller needs to cover the position, meaning
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closing it at a proﬁt or depositing more funds to satisfy the brokerage ﬁrm’s risk.Short selling can also be done ‘‘naked,’’ meaning the transactionis entered without borrowing stock from the brokerage ﬁrm. Conceivably, a speculator could sell a large number of shares withoutany constraints, but the Securities and Exchange Commission(SEC) limits this exposure, which was one of the contributing factors to the Crash of 1929. Regulation SHO is a regulation passedby the SEC in January 2005 restricting short (SHO) sales, notablynaked short sales. This regulation limits potential losses due tospeculators being unable to deliver inﬂated price shares. This requires brokerages to close out positions within a short period oftime when speculators’ positions have failed to deliver (i.e., theyhave not met margin requirements).Whether speculators borrow securities to go short or enter thetransaction naked, the widespread short selling of a stock can affectits volatility. For example, when a stock’s price has fallen dramatically, most short sellers close out their positions to take proﬁts. Forexample, if you sell short at $50 per share and the stock drops to$42, you are likely to place a ‘‘buy-to-close’’ order and take yourmoney. When a lot of this activity occurs, it creates the illusion ofincreased demand for the stock because a lot of buy orders appearat the same time. Short selling can have an artiﬁcial, short-termeffect on the market, causing more traditional buyers to believe thatthe buying activity is being caused not by short cover transactions,but by permanent demand.Volatility from shorting stock varies by the company and by theoverall number of shares involved. However, it is not really necessary to take such extraordinary risks when you believe a stock’sprice is going to fall. A far less risky approach is to buy put options.These options will increase in value as a stock’s price falls. However,options expire on their expiration dates, so there are risks involved.For many investors worried by the risk of selling stock short, buyingputs is a low-cost alternative, even with its special risks. Anotheralternative for anyone who owns short (other than selling when theprice has risen) is to sell a covered call. This specialized strategy ismore complex than many investors would like, and is only appro-
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priate for those who have studied options and understand the risksinvolved. However, covered call writing is an exceptionally conservative option strategy. Option trading has become quite popular inrecent years due to improved access to markets via the Internet andlow-cost transaction fees through online discount brokers.
Charting the Trading Range: Quantifying VolatilityThe causes of price volatility are complex and difﬁcult to anticipate.In fact, anyone who studies market trends knows that the entirematter is quite unpredictable. But even those investors who rely primarily on fundamental indicators (usually the more conservativeand traditional investors) can gain a lot of insight by understandingsome charting basics. A few of the basic charting patterns are described and explained in Chapter 4. For now, it is important only torecognize a particular aspect of charting: the trading range.The trading range is simply the space between the highest andlowest trading prices over a period of time. These boundaries arealso described as resistance (the top price) and support (the bottomprice). Resistance is the highest price at which sellers enter trades,whereas support is the ﬂoor, or the lowest price at which buyers willmake their move. These aforementioned tendencies between buyersand sellers establish speciﬁc boundaries within ‘‘normal’’ trading. Inhighly volatile stocks you ﬁnd a broad trading range, but in exceptionally volatile stocks the concept breaks down and trading patterns become erratic and unpredictable. In very safe, low-volatilitystocks, the trading range is typically narrow and predictable.The ‘‘ideal’’ trading range is moderate with a lot of price actionwithin the range and no violations above resistance or below support. For long-term investors the ideal trading range remains constant, but the trend is upward. This means that the number of pointswithin the range is constant, but the trend creeps upward consistently over time. Thus, a trading range and the existence of reliableresistance and support levels does not mean there is no price movement. It means the point difference is consistent even while pricelevels move.
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The gradual change in pricing can occur in an upward or downward direction. A stock displaying moderate volatility can increasein value over many years or it can decline. High volatility is not theonly threat to a stock’s overall value as a long-term investment.Some companies have experienced deterioration in their price rangeover time, even when volatility levels have been low. The ultimate‘‘value’’ of a company is not solely determined by its volatility. If yourely on long-term fundamental analysis of key factors (such as debtratio, revenue/proﬁts, and dividend trends, for example) combinedwith a study of volatility, the long-term action in price will be selfexplanatory. Market price trends always follow the strength orweakness in the fundamentals.For example, you can see how two stocks with relatively thesame volatility levels have performed quite differently. EastmanKodak and Wal-Mart are stark comparisons. Kodak, which was traditionally dominant in the ﬁlm market, was very late to enter thedigital camera revolution and actually resisted doing so for manyyears; they are paying the consequences more recently, both in fundamental and technical trends. Wal-Mart, the ultimate successstory, has reported unrelenting and steady fundamental growth andits stock price reﬂects it. Table 9-1 summarizes these two companies and their 10-year trends.The contrast is glaring. Before the well-known digital revolutionin technology, Kodak paid good dividends and reported highproﬁts, which reﬂected their market dominance in the stockprice—at least for the four years early on in the 10-year summary.Since then, their fundamental and technical status declined. Incomparison, Wal-Mart is a big success story. Proﬁts have risensteadily as the debt ratio remains unchanged, and the dividend yield,while small, has grown consistently. It is no surprise that their stockprice has followed suit.This comparison makes the point about volatility. The tradingranges of these two stocks have not been that different, but one hasshown a declining value while the other has grown during the sameperiod. It is far too easy to conclude that ‘‘low volatility means lowrisk’’ and ‘‘high volatility means high risk.’’ While there is sometruth to this in technical and short-term trends, the longer-term in-
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TABLE 9 –1. FUNDAMENTAL AND TECHNICAL TRENDS
CompanyEastman Kodak
CompanyWal-Mart
FiscalYear
Price Range
Net Proﬁt($ millions)
DebtRatio
DividendsPer Share
2006200520042003200220012000199919981997
$ 19–3121–3524–3520–4126–3824–5035–6857–8058–8953–95
$ 6001,45581238793761,4071,3921,3905
66%58334130372501116
$0.500.500.501.151.801.771.761.761.761.76
FiscalYear
Price Range
Net Proﬁt($ millions)
DebtRatio
DividendsPer Share
2007200620052004200320022001200019991998
$ 42–5242–5551–6146–6044–6442–5941–6939–7019–4111–21
$12,17811,23110,2678,8618,0396,6716,2955,5754,4303,526
33%363231333433383032
$0.670.600.520.360.300.280.240.200.160.14
Source: Standard & Poor’s Stock Reports
dicator is less reliable. Volatility cannot be used as the sole meansfor judging a company; you also need to track the fundamentals anddetermine whether the trend in overall value and strength is growingor diminishing.
Eliminating Spikes: The Need for AdjustmentAnother important point to remember in any comparison amongstocks is the fact that real-time price movement does not move in
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predictable, straight lines. Short-term price change can be very chaotic, making analysis difﬁcult. This is why the use of moving averages is so popular among technicians. Combining a 20-period and200-period moving average is useful in predicting strength or weakness in current price, not to mention the likely future price trenditself. If you use a 20-day chart, the 20-period moving averageequals the 20 days.Because price movement is so erratic, it is important to ensurethat any study is made in a sensible and accurate manner. The widespread use of 52-week price ranges as tests of volatility is disturbing, because a simple point difference can mean vastly differentthings. Some comparisons demonstrate that it is impossible to judgeall companies by the same standard. Exxon-Mobil, for example, reported a 52-week trading range near the end of November 2007, of$69 to $95 per share. Based on the typical volatility formula, volatility for Exxon-Mobil was:($95  $69)  $69  38%
In comparison, McDonald’s reported for the same period arange between $41 and $60 per share, with volatility of:($60  $41)  $41  46%
How can you compare these two companies, given the similarityin their ranges? Exxon-Mobil had a 26-point spread and McDonald’s was 19 points, a fairly close trading range. The volatility is alsosimilar. However, Exxon-Mobil’s daily price movement tended tobe more volatile (within its trading range) than McDonald’s. Evenso, it’s one-year volatility rating was lower. So the traditionalmethod is ﬂawed. It would make more sense to apply a two-parttest to measure volatility. First, comparisons would be restricted tothe point spread within the 52-week range, and second, the testshould distinguish between rising and falling trends, or even trendswith little or no actual price change during the year.Even high-volatility stocks cannot be accurately compared.Google, which most people would agree is a very volatile stock, re-
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ported a one-year trading range between $747 and $437, or 310points. That is a lot of price movement. However, the stock’s traditional volatility is only 71 percent:($747  $437)  $437  71%
This is described as ‘‘only’’ 71 percent in the belief that Googleis far more volatile than some other stocks with lower prices andsmaller trading ranges. In fact, Google’s stock was so volatile thatbrieﬂy, the price spiked to its high level and instantly retreated morethan 50 points. This phenomenon—the spike—distorts outcomebecause it does not last. Google’s trading range with the spike removed was actually between $690 and $437, making volatility lookmuch different:($690  $437)  $437  58%
The difference between 71 percent and 58 percent is signiﬁcant,even by Google’s standards. If you remove the spike, volatility iscloser to the acceptable ‘‘middle range’’ of stocks like McDonald’s.This makes the case that even with adjustments to remove spikes,traditional volatility is inaccurate. The 310-point movement inGoogle, compared with the 19-point movement in McDonald’s,hardly makes these stocks comparable in terms of real market riskor volatility.Another problem with this traditional approach is that it doesnot make a distinction between stocks rising in value and those falling in value. Exxon-Mobil, McDonald’s, and Google all rose substantially in the 52-week period ending November 2007. However,Citigroup reported a trading range between $57 and $30, only a27-point change and hardly comparable to Google’s 310 points:($57  $30)  $30  90%
This 90 percent volatility is quite high. But unlike Google, Citigroup’s value fell during the period, with virtually all of that declineoccurring between September and November. Thus, a true analysis
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of volatility would have to make a few important observations. First,the stock was very low volatility for nine months, reporting littleactual change. The plummet in price occurred during a very briefperiod and reﬂected part of a market-wide credit problem aggravated by the subprime mortgage problems experienced by Citigroupand other ﬁnancial institutions. Historically, Citigroup was neverconsidered a volatile stock in terms of erratic trading range. Thefact that the stock declined in comparison to other ‘‘volatile’’ stocksrising at the same time demonstrates the unreliability of volatilityformulas.To more accurately study volatility, a few important analyticalobservations should be included, such as:1. Use the traditional test only as a starting point.2. Study companies in terms of price trend rather than simplevolatility. Some rise, some fall, and some remain unchanged.3. Adjust the analysis by removing spikes. These are deﬁned asexceptional price movements above or below a range when the pricereturns immediately to the previously established range.4. Compare price point movement rather than percentages.5. Be aware of the timing and extent of price movement as wellas its underlying cause. Identify differences between market-widestrength or weakness versus changes in a company’s fundamentals.
Leverage as a Form of InvestingVolatility in a stock is certainly a key indicator of market risk. However, you can also affect market risk in the way that you use capital.If you buy only when you have the full price of stock, you are actingin a prudent and conservative manner. The most popular form ofmarket leverage, trading on margin, is high-risk and expensive. Ifprice movement takes longer than you expect, or worse, moves inthe wrong direction, your leveraged portfolio can easily lose valuein a brief amount of time.Leverage means using a speciﬁc amount of money to increase
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your holdings. It is the third form of investing, after equity and debt.When you are an equity investor (stockholder), you have ownershipin a company. When you are a debt investor (owner of bonds andother debt instruments like savings accounts, CDs, or shares ofmoney market mutual funds), you have loaned money to someoneelse with the expectation of earning interest and getting all of yourmoney back.You can act as either equity or debt investor (or combine thetwo) by buying shares of mutual funds. An equity fund focuses onstock ownership, whereas an income fund tends to buy bonds thatpay good interest rates. Balanced funds seek to provide both equityand debt, often with a focus on income from dividends on the equityside and interest on the debt side.The third method, leverage, is based on the premise that by borrowing money you can increase your opportunities. This is a greatidea in markets that rise quickly. If you have $10,000 and you borrow another $10,000 on margin, you put $20,000 to work. Evenafter paying interest, your higher level of equity holds out the promise for twice as much proﬁt. But what if the market price of yourstocks falls? In that case, your $20,000 portfolio may easily declinein value. If you had put the entire $20,000 in Countrywide (CFC)and Citigroup in August 2007, you might have lost one-third toone-half of your portfolio’s value. Because $10,000 was borrowedto create the $20,000 portfolio, you could end up with a zero basis.If your portfolio’s value fell to $10,000, you would have to repay theleveraged portion, leaving you with nothing. The potential return istwice as much with 50 percent leverage, but the potential loss istotal:$20,000Proﬁt: $10,000 cash plus $10,000 marginProﬁt of 50%$10,000 gainNet outcome: Initial $10,000 at risk is doubledLoss:
$10,000 cash plus $10,000 margin$20,000Loss of 50%$10,000 lossNet outcome: Initial $10,000 at risk is wiped out
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Leverage is beyond the risk tolerance of most people as a strategy, at least in its most popular form. Online brokerages make margin investing so easy that assuming too high a risk can occurwithout much effort at all. Anyone thinking only about the proﬁtopportunities of leverage are wise to consider the risk element.An alternative and safer form of leverage is found in the use ofoptions. These enable you to control 100 shares of stock per option,but for only a fraction of the cost of the stock. For example, it is easyto ﬁnd options for $60 stock for $600 or less. By buying options at$600 instead of 100 shares of stock at $6,000, you reduce yourmarket risk and use leverage effectively. It is one of the few ways toemploy leverage while lowering your market risk.
Options as a Form of Effective, Low-Risk LeverageMany people would like to leverage their capital but avoid doing sobecause of the risk. Borrowing money to invest is a bad idea formost people, so they limit their investment risk to cash they haveavailable to place at risk. However, with options you can have thebest of both approaches: low-risk leverage for a small amount ofmoney.Options are intangible contracts granting certain rights to theirbuyers. There are two kinds of options: calls and puts. A call grantsyou the right, but not the obligation, to buy 100 shares of a speciﬁcstock at a ﬁxed price. A put is the opposite; it grants you the right,but not the obligation, to sell 100 shares of a speciﬁc stock at a ﬁxedprice.Options expire at some time in the future. After expiration theyare worthless, which is the major disadvantage of options. You needto realize proﬁts before the expiration date, or you lose the moneyyou spend to buy the option. In fact, 75 percent of all options expireworthless, so there are risks involved. Even so, there are many instances in which option plays make a lot of sense. If you are holdingstock that has declined in value to a degree you consider unreasonable, you may buy more shares. But that requires putting moremoney into a stock whose value has fallen. Alternatively, you can
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buy calls. One call grants you the right to buy 100 shares of stock.For example, if the stock is currently selling at $30 per share, youcould buy a 35 call (meaning the ﬁxed price, or the ‘‘striking price,’’is $35 per share). If the stock rises above that level, you can buy100 shares at $35 per share.Most people who buy options don’t actually exercise them, butsell them at a higher price than they paid. For example, let’s say youbought a call with a striking price of $35 and the stock rose to $40.Assume you paid $200 for the call. Right before expiration, the callwould be worth $500, because the stock is worth $40 per share butyou can buy it for $35. Most people would sell the call and get$500 on their $200 investment rather than exercise. (If you wantedanother 100 shares of stock, you would have the right to exerciseand buy 100 shares at $35 per share; your basis would be $37, thecost of stock plus the payment you made to buy the call.)Puts work in reverse. They increase in value as a stock’s pricefalls. For example, if you buy a put when a stock is $50 per shareand it falls to $45 before the put expires, it will be worth $500, againreﬂected in the difference between the stock’s current value and theoption’s ﬁxed striking price. Puts are very useful to anyone whoowns stock. For example, if you have 100 shares of a stock whosevalue climbs, you may be tempted to take proﬁts, fearing the pricewill retreat. But if you prefer to continue holding the stock, youcould buy a put instead. This is a form of insurance. If the stock’svalue falls, then the put will increase in value, offsetting your paperloss.These examples of calls and puts protect portfolio positionswithout requiring you to put additional capital into depreciatedstock, or take proﬁts when you would rather continue holding thestock. In this application of calls and puts, they are excellent portfolio management tools. And if you invest $200 and sell for $500, thatis a 250 percent return! It is even possible to realize such returnsvery quickly if and when a stock’s price moves. However, offsettingthis is a reality: If the stock does not move in the desired direction,the loss of an option is likely to be 100 percent. As dire as thatsounds, remember that the cost of the option is quite low, commonly less than 10 percent of owning shares. (The actual cost de-
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pends on the time left until expiration and the proximity betweenthe striking price and current market value.) The leverage is valuable, given the limited capital requirements. You may hesitate toinvest as much as $5,000 for a $50 stock but you can have the samecontrol as a stockholder for only a few hundred dollars. If the pricechanges in the direction you anticipate, your return is also leveraged.For example, you can buy 100 shares of a $50 stock and pay$5,000, or buy a call for $500. If the stock moves up 21/2 points,the outcome between stock and option is quite different upon sale:Stock: $250Option: $250
$5,0005%$50050%
You leverage capital with options in the capital requirement itself. For example, if you have $5,000 to invest, you can buy 100shares of a $50 stock or 200 shares of a $25 stock. Or, you can buy10 options at $500 each or 20 at $250 each. You could even spreadyour capital among many different stocks. For conservative investors, this is not necessarily a prudent approach, remembering that75 percent of options expire worthless. However, it makes the pointthat options are valuable supplementary tools for managing a portfolio, especially in volatile markets.The fact that 75 percent of all options expire worthless pointsto a different approach of making options even more valuable. Youcan sell options, which places you on the other side of the transaction. Just as short sellers of stock can sell shares they do not own,option sellers can also sell options. Of course, simply selling an option would be considered very high risk by itself. But if you own 100shares of stock, you can sell (or as it is called, write) a covered call.This means that if the stock’s value rises above the striking price,the call will be exercised and your 100 shares will be called away atthe ﬁxed striking price.For example, if you bought 100 shares of stock at $30 per shareand the stock has been selling recently around $40, you can write acovered call with a striking price of $40. This means that if the stockrises higher, the option will be exercised and your stock will no
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longer belong to you. Upon exercise, you will get $4,000 for your100 shares. Even if the stock’s value rises to $60 or $70, exercisealways occurs at the striking price.Given the reality that most options expire worthless, the chancesof exercise are small. It happens, but not every time. This strategywould make sense based on your original purchase price, so that inthe event of exercise you make a proﬁt on the stock. In this example,you would make $1,000 (purchase price of $30, exercise price of$40). In addition, you keep the option premium and any dividendsearned before exercise. In the entire history of ownership of thisstock, for example, you would earn the following (assuming optionvalue at time of writing the covered call of $400, dividend yield of 3percent based on $30 per share, a holding period of exactly oneyear, and not including transaction costs):Exercise price of stockLess: original cost
$4,0003,000
Proﬁt on stockSale of covered callDividend, 3%
$1,00040090
Total proﬁt
$1,490
Based on the original investment of $3,000, this $1,490 returnrepresents overall proﬁt of 49.7 percent—not bad for a one-yearhistory. This is the ‘‘return if exercised’’ calculation including allforms of income: capital gain, option, and dividend. However, giventhe reality that most options expire worthless, the outcome is quitedifferent. Considering the option by itself and assuming it expiredworthless, the return would be:$400  $3,000  13.3%
The original basis of stock is used based on the rationale thatthe covered call is made possible by the investment in the stock andits basis is $30 per share. Some would argue that the calculation ismore accurately based on the striking price of $40 per share:
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$400  $4,000  10.0%
In either case, the return is impressive. It is also worthwhile tonote that after selling a covered call and waiting until expiration,you are able to repeat the process. You can sell covered calls indeﬁnitely. There are three possible outcomes. First is exercise, secondis expiration, and third is closing out the call at a proﬁt. For example, if you sell the covered call for $400 and it is later worth only$150, you can enter a ‘‘buy-to-close’’ transaction and close out theposition. In this transaction, your proﬁt would be $250.All three outcomes are impressive and relatively safe. The onlyreal risk you face is the risk that the stock rises far above strikingprice and you give up shares below current market value. Most people will gladly accept that risk and the occasional lost opportunity inexchange for the certainty of double-digit returns every year.Options point out the reality that there are alternatives to simplybuying and selling shares of stock. A sophisticated approach recognizes the value of using options in several ways: as tools for pureprice speculation in volatile markets; protection of paper proﬁts;taking advantage of exceptional price declines; and of course, covered calls. There are many other ways to invest in the market without actually buying shares of stock. The next chapter explores someof these alternatives.
C H A P T E R
1 0
ALTERNATIVES TO DIRECTOWNERSHIP OF STOCKS
T
here are many ways to own or control stocks beyond direct ownership of shares. The popularity of mutual funds cannot be ignored,as these enable diversiﬁcation by sector or between stocks andbonds. The newer form of mutual fund, the exchange-traded fund(ETF), helps investors to further diversify a portfolio and still enjoyliquidity by trading shares on the exchanges just like stocks.Mutual fund fees can be complex because they come in manyforms, some of which are hidden. This makes comparison difﬁcult.This chapter provides guidelines for making valid comparisons between funds. Other investment alternatives include trading in indexfunds on the market where proﬁts are earned if and when a marketindex rises, or placing funds into sector ETFs.The options market also enables investors to control shares ofstock for only a fraction of the cost of buying shares. The potentialproﬁts and risks of options are also explained in this chapter.
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The Mutual Fund AlternativeMutual funds are vastly popular for many reasons, including lowcost, historical performance, and convenience. When you placemoney in a mutual fund, you allow professional management tomake decisions about which stocks to buy or sell. The fund itself isa conduit investment, meaning proﬁts or losses are passed on toindividual shareholders. The mutual fund company is a conduit between the market and investors. The fund itself does not accumulateproﬁts or losses other than the compensation paid to its professionalmanagement.Making comparisons between different mutual funds is difﬁcult.The most popular way that one fund is picked over another is onthe basis of past performance. But as the disclosure warns, ‘‘pastperformance is no indication of future performance.’’ So a fund thatoutperformed the market last year might do poorly this year, andvice versa. When looking at performance as a method for picking afund, you may want to also focus on funds that did well when markets fell, and not only those that succeeded as markets rose.Another means for comparison is size, measured in dollar valueof assets under management. An exceptionally small fund may offera lot of growth potential, and a fund that limits the amount of dollarsit accepts from investors may be more easily managed in the future.In comparison, funds that have grown to exceptionally high assetlevels may have difﬁculty in moving money around quickly inchanging markets. These funds tend to invest broadly, so out ofnecessity their proﬁt or loss is going to approximate the overall market, at best.Fund comparisons are further complicated by the fees theycharge, and fee structures are not always comparable. Before youdetermine in which funds to invest, always read