Stock Market Wizards

by Jack D. Schwager

  In our example, we assumed short positions broke even. If a trader can make a net profit on short positions, then short selling offers the opportunity to both reduce risk and increase return. Actually, short selling offers the opportunity to increase returns without increasing risk, even if the short positions themselves only break even. * How? By trading long positions with greater leverage (using margin if the trader is fully invested)—a step that can be taken without increasing risk because the short positions are a hedge against the rest of the portfolio.

  It should now be clear why so many of the traders interviewed supplement their long positions with short trades: It allows them to increase their return/risk levels (lower risk, or higher return, or some combination of the two).

  If short selling can help reduce portfolio risk, why is it so often considered to be exactly the opposite: a high-risk endeavor? Two reasons. First, short trades are often naively viewed as independent transactions rather than in the context of the total portfolio. Second, the open-ended loss exposure of short positions can indeed lead to enormous risk. Fortunately, however, this risk can be controlled, which brings us to our next point.

  59. The One Indispensable Rule for Short Selling

  Although short selling will tend to reduce portfolio risk, any individual short position is subject to losses far beyond the original capital commitment. A few examples:

  A $10,000 short position in Amazon in June 1998 would have lost $120,000 in seven months.

  A $10,000 short position in Ebay in October 1998 would have lost $230,000 in seven months.

  A $10,000 short position in Yahoo! in January 1997 would have lost $680,000 in two years.

  As these examples make clear, it takes only one bad mistake to wipe out an account on the short side. Because of the theoretically unlimited risk in short positions, the one essential rule for short selling is: Define a specific plan for limiting losses and adhere rigorously to it.

  The following are some of the risk-control methods for short positions mentioned by the interviewed traders:

  A short position is liquidated when it reaches a predetermined maximum loss point, even if the trader’s bearish analysis is completely unchanged. As Watson says, “I will cover even if I am convinced that the company will ultimately go bankrupt…I’m not going to let [a 1 percent short in the portfolio] turn into a 5 percent loss.”

  A short position is limited to a specific maximum percentage of the portfolio. Therefore, as the price of a short position rises, the size of the position would have to be reduced to keep its percentage share of the portfolio from increasing.

  Short positions are treated as short-term trades, often tied to a specific catalyst, such as an earnings report. Win or lose, the trade is liquidated within weeks or even days.

  60. Identifying Short-Selling Candidates (or Stocks to Avoid for Long-Only Traders)

  Galante, whose total focus is on short selling, looks for the following red flags in finding potential shorts:

  high receivables (large outstanding billings for goods and services);

  change in accountants;

  high turnover in chief financial officers;

  a company blaming short sellers for their stock’s decline;

  a company completely changing their core business to take advantage of a prevailing hot trend.

  The stocks flagged must meet three additional conditions to qualify for an actual short sale:

  very high P/E ratio;

  a catalyst that will make the stock vulnerable over the near term;

  an uptrend that has stalled or reversed.

  Watson’s ideal short-selling candidate is a high-priced, one-product company. He looks for companies whose future sales will be vulnerable because their single or primary product does not live up to promotional claims or because there is no barrier to entry for competitors.

  61. Use Options to Express Specific Price Expectations

  Prevailing option prices will reflect the assumption that price movements are random. If you have specific expectations about the relative probabilities of a stock’s future price movements, then it will frequently be possible to define option trades that offer a higher profit potential (at an equivalent risk level) than buying the stock.

  62. Sell Out-of-the-Money Puts in Stocks You Want to Buy

  This is a technique used by Okumus that could be very useful to many investors, but is probably utilized by very few. The idea is for an investor to sell puts at a strike price at which he would want to buy the stock anyway. This strategy will assure making some profit if the stock fails to decline to the intended buying point and will reduce the cost for the stock by the option premium received if it does reach the intended purchase price.

  For example, let’s say XYZ Corporation is trading at $24 and you want to buy the stock at $20. Typically, to achieve this investment goal, you would place a buy order for the stock at a price limit of $20. The alternative Okumus suggests is selling $20 puts in the stock. In this way, if the stock fails to decline to your buy price, you will at least make some money from the sale of the $20 puts, which by definition will expire worthless. If, on the other hand, the stock declines to under $20, put buyers will exercise their option and you will end up long the stock at $20, which is the price that you wanted to buy it at anyway. Moreover, in this latter event, your purchase price will be reduced by the premium collected from the sale of the options.

  63. Wall Street Research Reports Will Tend to Be Biased

  A number of traders mentioned the tendency for Wall Street research reports to be biased. Watson cites the bias due to investment banking relationships—analysts will typically feel implicit pressure to issue buy ratings on companies that are clients of the firm, even if they don’t particularly like the stock.

  64. The Universality of Success

  This chapter was intended to summarize the elements of successful trading and investing. I believe, however, that the same traits that lead to success in trading are also instrumental to success in any field. Virtually all the items listed, with the exception of those that are exclusively market-specific, would be pertinent as a blueprint for success in any endeavor.

  APPENDIX

  Options—Understanding the Basics

  There are two basic types of options: calls and puts. The purchase of a call option provides the buyer with the right—but not the obligation—to purchase the underlying stock (or other financial instrument) at a specified price, called the strike price or exercise price, at any time up to and including the expiration date. A put option provides the buyer with the right—but not the obligation—to sell the underlying stock at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, whereas selling a put is a bullish trade.) The price of an option is called premium. As an example of an option, an IBM April 130 call gives the purchaser the right to buy 100 shares of IBM at $130 per share at any time during the life of the option.

  The buyer of a call seeks to profit from an anticipated price rise by locking in a specified purchase price. The call buyer’s maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price were above the prevailing market price. For example, if IBM were trading at $125 when the 130 option expired, the option would expire worthless. If at expiration the price of the underlying market was above the strike price, the option would have some value and would hence be exercised. However, if the differenct between the market price and the strike price was less than the premium paid for the option, the net result of the trade would still be a loss. In order for a call buyer to realize a net profit, the difference between the market price and the strike price would have to exceed the premium paid when the call was purchased (after adjusting for commission cost). The higher the market price, the greater the resulting profit.

  Adapted from Jack D. Schwager, A Complete Guide to the Futures Market (New Yo
rk: John Wiley, 1984). Reprinted by permission of John Wiley & Sons, Inc.

  The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Like the call buyer, his maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the market price by an amount greater than the premium of the put at purchase (after adjusting for commission cost).

  Whereas the buyer of a call or put has limited risk and unlimited potential gain, the reverse is true for the seller. The option seller (often called the writer) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position at the strike price if an option is exercised. For example, if a call is exercised, the seller must assume a short position in the underlying market at the strike price (because, by exercising the call, the buyer assumes a long position at that price).

  The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call provides the most attractive trading opportunity. However, if the trader expected a large price decline, he would be usually better off going short the underlying market or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market.

  Some novices have trouble understanding why a trader would not always prefer the buy side of the option (call or put, depending on market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurrence, (i.e., prices in the vicinity of the market price when the option trade occurs) would result in a net gain to the option seller. Roughly speaking, the option buyer accepts a large probability of a small loss in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain. In an efficient market, neither the consistent option buyer nor the consistent option seller should have any significant advantage over the long run.

  The option premium consists of two components: intrinsic value plus time value. The intrinsic value of a call option is the amount by which the current market price is above the strike price. (The intrinsic value of a put option is the amount by which the current market price is below the strike price.) In effect, the intrinsic value is that part of the premium that could be realized if the option were exercised at the current market price. The intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic value, a trader could buy and exercise the option and immediately offset the resulting market position, thereby realizing a net gain (assuming that the trader covers at least transaction costs).

  Options that have intrinsic value (i.e., calls with strike prices below the market price and puts with strike prices above the market price) are said to be in the money. Options that have no intrinsic value are called out of the money options. Options with a strike price closest to the market price are called at the money options.

  An out of the money option, which by definition has an intrinsic value equal to zero, will still have some value because of the possibility that the market price will move beyond the strike price prior to the expiration date. An in the money option will have a value greater than the intrinsic value because a position in the option will be preferred to a position in the underlying market. Why? Because both the option and the market position will gain equally in the event of a favorable price movement, but the option’s maximum loss is limited. The portion of the premium that exceeds the intrinsic value is called the time value.

  The three most important factors that influence an option’s time value are the following:

  1. Relationship between the strike price and market price. Deeply out of the money options will have little time value, since it is unlikely that the market price will move to the strike price—or beyond—prior to expiration. Deeply in the money options have little time value because these options offer positions very similar to the underlying market—both will gain and lose equivalent amounts for all but an extremely adverse price move. In other words, for a deeply in the money option, risk being limited is not worth very much because the strike price is so far from the prevailing market place.

  2. Time remaining until expiration. The more time remaining until expiration, the greater the value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specified amount prior to expiration.

  3. Volatility. Time value will vary directly with the estimated volatility (a measure of the degree of price variability) of the underlying market for the remaining life span of the option. This relationship results because greater volatility raises the probability of the intrinsic value increasing by any specified amount prior to expiration. In other words, the greater the volatility, the greater the probable price range of the market.

  Although volatility is an extremely important factor in the determination of option premium values, it should be stressed that the future volatility of a market is never precisely known until after the fact. (In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the implied volatility.

  Copyright

  STOCK MARKET WIZARDS. Copyright © 2007 by Jack D. Schwager. All rights reserved under International and Pan-American Copyright Conventions. By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this e-book on-screen. No part of this text may be reproduced, transmitted, down-loaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any form or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of HarperCollins e-books.

  EPub Edition © APRIL 2007 ISBN: 9780061857188

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  *Pseudonym

  *This chapter contains some references to options. Readers completely unfamiliar with options may find it helpful (although not essential) to first read the four-page primer in the appendix.

  *The facts related to Fletcher’s employment at Kidder Peabody were obtained from court-case summaries and articles appearing in Business Week (October 24, 1994), Fortune (July 5, 1999).

  *Readers unfamiliar with options may find it useful to consult the short primer on options in the appendix.


  *The strike price is the price at which the option buyers could buy the stock by exercising their options. Of course, they would exercise their options only if the market price was above the strike price at the time of the option expiration.

  *As of March 2000, Lescarbeau’s average annual compounded return had risen to 70 percent.

  *Although bonds pay a steady return, many less sophisticated investors do not sufficiently appreciate the fact that price declines in bonds due to higher interest rates can outweigh interest income, resulting in negative total returns. With interest rates at long-term lows, the danger of negative total returns in bonds is significant, particularly if Masters is correct in his expectations for increased inflation over the long term.

  *It is recommended that readers unfamiliar with options first review the brief primer on options in the appendix before reading this chapter.

  *A probability distribution is simply a curve that shows the probabilities of some event occurring—in this case, the probabilities of a given stock being at any price on the option expiration date. The x-axis (horizontal line) shows the price of the stock. The y-axis (vertical line) shows the relative probability of the stock being at different prices. The higher the curve at any price interval, the greater the probability that the stock price will be in that range when the option expires. The area under the curve in any price interval corresponds to the probability of the stock being in that range on the option expiration date. For example, if 20 percent of the area under the curve lies between 50 and 60, it implies that there is a 20 percent chance of the stock being between 50 and 60 on the option expiration date. As another example, if 80 percent of the area under the curve corresponds to prices under 60, the 60 call option, which gives the holder the right to buy the stock at 60, would have an 80 percent chance of expiring worthless.