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CreateYour OwnHedgeFund
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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Aus-tralia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.
The Wiley Trading series features books by traders who have survived themarket’s ever-changing temperament and have prospered—some by rein-venting systems, others by getting back to basics. Whether a novice trader,professional, or somewhere in between, these books will provide the ad-vice and strategies needed to prosper today and well into the future.
For a list of available titles, visit our web site at www.WileyFinance.com.
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CreateYour OwnHedgeFund
Increase Profits andReduce Risk with ETFsand Options
MARK D. WOLFINGER
John Wiley & Sons, Inc.
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Copyright © 2005 by Mark D. Wolfinger. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permissionof the Publisher, or authorization through payment of the appropriate per-copyfee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA01923, 978-750-8400, fax 978-646-8600, or on the Web at www.copyright.com.Requests to the Publisher for permission should be addressed to the PermissionsDepartment, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.
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Library of Congress Cataloging-in-Publication Data:
Wolfinger, Mark D.
Create your own hedge fund : increase profits and reduce risk with ETFs and
options / Mark Wolfinger.
p.
cm. — (Wiley trading series)Includes bibliographical references and index.ISBN 0-471-65507-4 (cloth)1. Hedging (Finance)
2. Stock options.
3. Exchange traded funds.
I. Title
II. Series.
HG6024.A3W65332.64'524—dc22
2005
Printed in the United States of America
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9
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5
4
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2
1
2004016625
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This book is dedicated in loving memory to my parents, Betty and Khiva Wolfinger. They would have loved to see their son become an author.
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Contents
Acknowledgments
Preface
PART I
Outperforming the Market
CHAPTER 1
Modern Portfolio Theory
CHAPTER 2
Can You Beat the Market? Should You Try?
CHAPTER 3
Hedge Funds
PART II
Exchange Traded Funds
CHAPTER 4
A Brief History of Mutual Funds and Exchange Traded Funds
CHAPTER 5
Traditional Mutual Funds
CHAPTER 6
Exchange Traded Funds
PART III
Options
CHAPTER 7
What Is an Option and How Does an OptionWork?
CHAPTER 8
More Options Basics
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CHAPTER 9
Why Investors Buy and Sell Options
CHAPTER 10 Option Strategies You Can Use to Make Money: Covered Call Writing
CONTENTS
69
80
CHAPTER 11 Option Strategies You Can Use to 
Make Money: Uncovered Put Writing
100
CHAPTER 12 Historical Data: BuyWrite Index 
and Volatility Index
PART IV
Putting It All Together
CHAPTER 13 Building a Portfolio
CHAPTER 14 Finding Your Style: Choosing 
an Option to Write
CHAPTER 15 Covered Call Writing in Action: A Year of
Trading
CHAPTER 16 Uncovered Put Writing in Action
CHAPTER 17 Odds and Ends and Conclusion
Notes
Glossary
Index
111
121
123
131
141
195
212
216
227
231
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Acknowledgments
Many thanks to my family and friends who provided guidance, sup-
port,  encouragement,  and  great  information,  particularly  LynnSeligman, Nancy Crossman, Gail Reichlin, and Camden McKinley.A special thank you to my life-partner, Penny Rotheiser, whose attention todetail proved invaluable.
And thank you to all the dedicated people at John Wiley & Sons whodid their jobs well and provided encouragement and answers to my manyquestions. Their input made the completion of this project both more en-joyable and more efficient: Jeanne Glasser, for encouraging me to submitthe book proposal in the first place; editor Kevin Commins; editorial direc-tor  Pam  van  Giessen;  editorial  assistant  Lara  Murphy;  editorial  assistantMatt Kellen, who found the help I needed on every conceivable topic; mar-keting manager Felicia Reid; and production manager Alexia Meyers, whocarefully transformed the raw manuscript into the finished product.
Thank you all.
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Preface
Everyone wants to make money in the stock market, and each indi-
vidual has reasons for owning stocks. Whatever your motivation—saving for retirement, saving to provide a college education for yourchildren or a home for your family, even trying to earn more money so youcan enjoy the good life—making money via investing is the goal of millionsof people all over the world.
Although everyone agrees that making money is the goal, not everyoneagrees on the best way to accomplish that goal. This book introduces youto a twenty-first-century style of investing that combines the best aspects oftwo important investment tools: exchange traded funds (ETFs) and stockoptions. You will learn to hedge, or reduce the risk of owning stock.
Most investors who make their own investment decisions overestimatetheir results and, if asked, would say their methods produce market-beatingresults year after year. They are not exactly failing to tell the truth, becausemost believe they  can  (and  should)  consistently  outperform  the  market.And if they didn’t do especially well this past year or two, well, that’s okay,for they know their performance during the next few years will more thancompensate for any recent underperformance.
The truth is that individual investors, on average, consistently under-perform the market. That’s sad because many people love making those in-vestment  decisions  and  being  actively  involved  with  trading.  If  youcurrently make all your own investment decisions, this book shows you analternative method for handling your investments—a method that reducesoverall risk at the same time it increases your chances of beating the mar-ket. And for those who enjoy being active traders, this methodology is fun.There  are  decisions  and  trades  to  make  every  month,  although  you  canmodify the method to trade less frequently (every three or even every sixmonths), if that’s your preference.
A  great  many  investors  have  neither  the  time  nor  the  inclination  tomake their own investment decisions. They feel more comfortable depend-ing on others, and there are many professional money managers eager to
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take their money and make those investment decisions. These investors,who ordinarily do meticulous research before spending money on a vaca-tion, a car, or even a home computer, and who seek every opportunity todetermine which product provides the best performance or which receivedthe best reviews from consumers, often invest money based on informationgleaned  from  advertisements  that  gloat  over  recent  good  performance.They place their future financial security entirely into the hands of peoplethey  haven’t  bothered  to  research  thoroughly—specifically,  mutual  fundmanagers. The fund managers who do achieve above-average results ad-vertise  those  results  to  a  public  eager  to  invest.  Unfortunately,  evidenceshows that recent track records bear little resemblance to future results.It’s impossible to predict in advance who the successful fund managers willbe this (or any) year. But, no matter, there are millions of investors eager tothrow billions of dollars at those fund managers. The question is: Do thosemanagers  perform  any  better  than  individual  investors?  Are  they  able  tooutperform the market year after year? We’ll take at look at the evidence,but  the  short  answer  is  no.  They  perform  no  better  than  individual  in-vestors, yet they are not bashful about charging fees to manage investormoney.
The recent scandals involving after-hours trading and allowing favoredcustomers to buy and sell shares without incurring fees that individual in-vestors  would  have  to  pay  make  it  even  more  unlikely  that  mutual  fundmanagers can provide individual investors with the service they deserve.Fortunately,  there  are  viable  alternatives,  and  you  don’t  have  to  acceptthose poor results any longer.
There are several ways a public investor can earn better returns thanare available by entrusting hard-earned savings to professional mutual fundmanagers. One simple way is to invest in index funds. At least these fundsmake no attempt to beat the market; they are content to match the perfor-mance of the averages. With fewer commissions and no research, this man-agement style results in significantly lower annual expenses for the fund,and the savings are passed on to the investor. Average performance is bet-ter than underperformance, and paying smaller fees is better than higherfees.
But  indexing,  by  itself,  is  not  the  final  answer.  There  is  more  an  in-vestor can do to enhance investment returns. This book shows how to ac-complish that goal.
You will learn to choose an investment advisor who is entirely trust-worthy and capable of handling all your investment decisions. That advisorfollows  the  teachings  of  modern  portfolio  theory  (MPT).  That  advisorbuilds  a  well-diversified  portfolio  of  stock  market  investments  and  man-ages those investments without charging a fee. That advisor uses methodsthat increase the probability of beating the market averages and does so
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with a reduced chance of incurring losses. That’s right: Enhanced earningsand reduced risk. So where do you find such an advisor? That’s easy: Lookin the mirror. You can make your own investment decisions. You can beyour own fund manager.
There is no magic formula involved, nor some high-risk hocus-pocus.There are no promises of getting rich in a hurry. The success of this invest-ment  methodology  is  based  on  the  steady  growth  of  capital  that  comesfrom doing well on a consistent basis. It is based on combining two readilyavailable  investment  tools  into  one  cohesive  strategy.  Exchange  tradedfunds, the modern version of the traditional mutual fund, and stock optionsare the tools used to manage your investment portfolio.
You’ll learn why ETFs are a more efficient investment vehicle than tra-ditional mutual funds for most individual investors. They have tax advan-tages,  charge  lower  fees,  and  essentially  match  the  performance  of  themarket averages. No more paying fees for underperformance!
Options are a misunderstood investment tool. Options were designedto reduce investment risk, but too many investment advisors tell their cus-tomers that options are dangerous and should be used only by speculators.We’ll clear up that misconception, and you’ll learn to use options to both re-duce risk and enhance profits.
By combining these two tools into one investment methodology, youessentially create and run your own hedge fund. And the best part is that it’snot complicated. You can readily learn to manage your investments your-self, but if you are a busy professional who believes there is not enoughtime to intelligently make your own investment decisions, you can turn thewhole process over to a broker or financial planner you trust to follow yourinstructions.
Many investors reaped rich rewards during the strong stock market of thelate  1990s,  but  a  large  percentage  of  those  investors  gave  back  all  thoseprofits (and then some) during the ensuing bear market at the beginning ofthe  new  millennium.  Many  are  searching  for  the  elusive  holy  grail  of  in-vesting, namely finding a way to consistently outperform the market aver-ages  with  limited  risk.  This  book  shows  those  investors  such  a  path  tofinancial  security.  Investors  are  no  longer  forced  to  rely  on  mutual  fundmanagers  because  they  don’t  feel  there  is  any  alternative.  The  methodstaught here require some effort, but the rewards are worth it.
Investing is not a game. It’s a project that must be taken seriously, as yourfuture financial independence is at stake. It requires an understanding ofthe  risks  and  rewards  of  investing.  Successful  individual  investors  whomake their own decisions devote a great deal of time and effort to avoidmaking bad decisions. Some spend countless hours poring over annual re-
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ports and 10-k filings in an effort to find companies that have the potentialto  earn  great  profits  in  the  future  (fundamental  analysis).  Others  spendtime with charts and graphs, attempting to use price and volume data topredict future stock prices (technical analysis). If you follow the methodstaught here, you can be spared those hours of research. Individuals, on av-erage, are not able to find those great companies, and unless you have aproven track record of consistently outperforming the stock market aver-ages, it’s less risky to own a diversified portfolio, such as those representedby  ETFs.  Those  investments  can  be  hedged  with  options,  reducing  riskeven further.
The methodology taught in this book does not guarantee profits. But it doespresent an investing strategy that increases your chances of being a suc-cessful investor. It increases the odds that your portfolio outperforms themarket averages on a consistent basis, and it reduces your overall invest-ment risk. Those are not just idle claims, and statistical evidence is includedto support those claims. The path to investment success discussed in thisbook uses neither fundamental nor technical analysis. The recommendedstrategy  is  one  that  you,  an  individual  investor,  can  readily  adopt  foryourself.
That investment method involves:
• Asset allocation: Determine the portion of your assets to be invested inthe stock market and in other asset classes, such as bonds, cash equiv-alents,  real  estate,  collectibles,  and  so  forth.  The  methods  discussedhere are limited to working with the funds allocated to investing in thestock markets of the world.
• Diversification: Using the teachings of modern portfolio theory, youbuild a portfolio of stock market investments. Building an appropriate,diversified portfolio (diversification reduces risk) is much easier to ac-complish than you might believe. You’ll learn to use the modern versionof the traditional mutual fund, the exchange traded fund, as the back-bone of your portfolio.
• Stock options: We’ll explode the myth that options are dangerous. Thisversatile investment tool can be used conservatively and intelligently toenhance the performance of your stock market portfolio. You’ll learn toadopt an easy-to-understand options strategy that both enhances per-formance and reduces risk even further.
The journey begins with a brief discussion of MPT—what it is, why it’srelevant to you, and how you can use its teachings to compile a portfoliothat provides two substantial benefits: reduced risk and a better return on
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your investment. We’ll take a look at the record and examine how well in-dividual  investors  and  professional  mutual  fund  managers  have  fared  intheir  attempts  to  outperform  the  market.  Then  we’ll  move  on  to  discusshow you can use modern mutual funds—but not traditional mutual funds—to  achieve  the  goals  of  MPT.  You’ll  learn  why  ETFs,  or  the  twenty-first-century version of the traditional mutual fund, are superior to traditionalfunds and how you can use them to achieve your investment goals. Finally,you’ll learn about the versatile investment tool: the stock option. After aprimer  for  those  unfamiliar  with  stock  options,  you’ll  see  how  to  adopteither (or a combination) of two conservative options strategies to help youenhance your stock market success. We’ll take time out to examine the his-torical evidence proving that these option strategies really do enhance in-vestment profits and simultaneously reduce risk.
Have you heard that options are dangerous and only for speculators?Options are not dangerous, and, in fact, you’ll learn to use them to reducerisk. You’ll see how to combine the best qualities of stock options with thebenefits of investing in ETFs to achieve a portfolio with the potential to out-perform  portfolios  managed  by  professional  money  managers—and  youwon’t have to pay professional money managers to achieve those results.Not only that, but your investment portfolio will be less volatile, reducingyour stress level. You can expect to earn substantial profits when the mar-ket rallies, you’ll love your profits when the markets are stagnant, and you’lllose less (and may even show a profit) when the markets decline.
You can easily learn to manage your own portfolio better and more ef-ficiently  than  professional  money  managers.  Instead  of  paying  someoneelse to provide for your future financial security, you get to own and oper-ate your own mutual fund—really a hedge fund.
If you are tired of paying excessive fees to others to (mis-)manage yourmoney, it’s time to make your own decisions. If you accept the fact (manydo not) that it’s difficult to beat the market averages, here’s a method thatgreatly increases your chances to do so. If you love trading and want to beinvolved with the decision-making process, then this methodology is cus-tom made for you. And if you are a financial planner, here’s a method youcan use to enhance the profits of your clients.
Those who currently invest in index funds understand the folly of at-tempting to beat the market by buying individual stocks or mutual funds.They can do even better by adopting the strategies taught in this book.
Each of you may even come to cherish the time you spend working on
your investments.
Get ready to update your investment methodology.
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PA R T   I
Outperformingthe Market
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C H A P T E R   1
ModernPortfolio Theory
People  invest  money  in  the  stock  market  with  one  primary  goal  in
mind:  to  earn  a  satisfactory  return  on  that  investment.  Some  con-sider investing to be a full-time occupation with the goal of earningenough  to  provide  for  their  day-to-day  living  expenses  on  a  continuingbasis. Some will be retiring soon and must plan to begin using their invest-ment nest egg to meet expenses. Others have a much longer time horizonand are planning 30 or 40 years into the future.
With such a variety of time frames and purposes, there is no single in-vestment strategy that suits all investors. There is no single “best” portfolioof investments to own.
INDIVIDUAL INVESTORS
Many individual investors decide for themselves which specific stocks toown. Whether the buying decision is based on sound research into the fun-damentals, including a thorough reading of the various financial reports is-sued  by  the  company,  or  whether  price  history  charts  are  studied  in  aneffort to perform a thorough technical analysis, or whether an investmentdecision  is  based  on  a  tip  received  from  a  stockbroker,  bartender,  chatroom,  or  a  talking  head  on  CNBC  or  Wall  Street  Week,  investors  seldomconsider their entire portfolio when making a new purchase. The buying de-cision is often based on investors’ belief (hope) that some information hasbeen uncovered—information not yet known to other investors—that willsoon make the price of the newly purchased stock soar.
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Some investors make investment decisions alone, shunning the adviceof others. Some rely on the camaraderie of an investment club. Some listento the advice of professionals before making the final decisions themselves.Some blindly follow the advice of a stock market advisory newsletter whileothers do everything their stockbrokers suggest. Regardless of the sourceof an investment idea, most individual investors never think twice aboutwhether the new investment is suitable or whether it helps them achievetheir  overall  investment  goals.  In  fact,  many  have  no  overall  objectivesin mind and simply make new purchases to produce a portfolio based onchaos.  Some  investors  are  happy  with  their  results,  while  others  arenot. Modern portfolio theory (MPT) teaches us that this is a poor way toinvest. With so many investors accumulating stocks and building a portfolioin this haphazard manner, it’s important to know: Are individual investorsgenerally  successful?  The  answer  to  this  question  is  postponed  untilChapter 2.
Investing in Mutual Funds
Many millions of other investors don’t want to take the time or make the ef-fort to choose their own stocks. Instead, they rely on financial profession-als to make investment decisions for them. Some of these investors followthe advice of a guru who sells stock market advice for a fee (e.g., newslet-ters and advisory services), while others accept the investment advice of fi-nancial planners or stockbrokers. But the vast majority of these investorsbuy shares of mutual funds.
Mutual  funds  serve  a  great  purpose.  They  allow  investors  to  quicklyown a diversified portfolio of stocks without being required to buy sharesin each of the individual companies. This is especially important for smallinvestors  who  lack  the  funds  to  own  a  properly  diversified  portfolio  ofstocks. It has been known for a long time that proper diversification is astrategy that reduces the risk of investing in the stock market. It’s one of thecornerstones of MPT.
Having decided to buy shares of mutual funds, investors must rely onthe ability of fund managers to make intelligent investment decisions andearn a good return on investor capital. Some investors make a careful studyof mutual funds before selecting which to buy. They study how well mutualfunds have performed in the past; they check out Morningstar’s1 rating onthe funds, or they accept the advice of a stockbroker.2 Some investors gofurther and choose funds that invest in the type of stocks they want to own.For example, some funds only buy stocks of large companies; others spe-cialize by investing in smaller, growing companies. Some funds buy stocksfor income (dividends); others buy stock for long-term growth. Some fundsspecialize in the companies in one specific industry (sector funds); others
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are more diversified. Some buy stocks in American companies; others in-vest in businesses from around the world. There are many mutual funds inexistence, each with its own investment strategy, and the public investorcan choose any of them.
Some who buy shares of mutual funds invest their money, close theireyes, and, placing their trust in the fund’s managers, hope for the best. Oth-ers take the opposite approach and constantly monitor the performance oftheir funds and hop from one fund to another, chasing those with the bestrecent performance.
Most of those who invest in mutual funds would be better served if theyhad an understanding of how to construct a safer and better-performing in-vestment portfolio on their own. Our goal is to show you, the individual in-vestor, how to do just that.
Some investors are sophisticated enough to know how to avoid payinga  sales  commission  (load)  when  buying  funds;  others  pay  that  load,  notknowing there is any alternative. The bottom line for the vast majority ofmutual fund investors is that once the decision to buy a fund is made, nofurther thought goes into the process. They leave it to the fund managementteam to produce superior returns on their money. Over the years, most in-vestors  have  been  satisfied  with  this  methodology,  especially  since  thetrend of the American stock market has been bullish over the long term.3With so many Americans relying on mutual funds to meet their investmentobjectives, two important questions must be considered: Are mutual fundinvestors  generally  successful?  Are  they  well  served  by  the  managers  ofthose funds? Let’s postpone a discussion of the answer until Chapter 5.
MODERN PORTFOLIO THEORY
Investors seldom, if ever, consider their entire portfolio as anything but acollection  of  individual  investments,  regardless  of  whether  those  invest-ments are individual stocks, mutual funds, or any of numerous other assets,such as bank certificates of deposit, bonds, or coin collections. Few con-sider whether adding a new investment to a portfolio affects the overall riskparameters of the portfolio, or whether it helps to diversify their holdings.Usually asset allocation is totally ignored. This is not a good thing.
There exists a large body of knowledge that has collectively becomeknown  as  modern  portfolio  theory.  MPT  tells  us  that  investors  can  suc-cessfully (and easily) use a scientific approach to compile an investmentportfolio. It’s worthwhile to make a brief study of this collection of knowl-edge because it contains ideas you can easily adopt to make your own in-vesting  more  efficient  and  more  profitable.  One  of  the  great  benefits  of
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MPT is that it shows how to increase the expected profits and lower over-all risk at the same time
MPT  is  concerned  with  the  methods  used  to  compile  an  investmentportfolio and with the performance of that portfolio. Investors can easilyearn the risk-free rate of return by purchasing U.S. Treasury bills.4 But toearn  more,  investors  must  accept  the  fact  that  a  certain  amount  of  riskmust be accepted. It’s generally understood in the investment world thatthe greater the risk of an investment, the greater the potential reward. Thismust be true, or else no one would ever knowingly accept greater risk. It’simportant to point out that the term “risk” is usually considered to repre-sent the chances of losing money from an investment. According to MPT,risk is much more than that; it’s also a measure of how much the return onan investment varies from the expected return. Thus, risk is a measure ofthe uncertainly of the future.
The  work