This is part one of a two-part article.
Read part two here.
The most singular feature of stock market literature to date has been title rather than content. The remarkable success of Nicholas Darvas’ How I Made Two Million Dollars in the Stock Market, and more recently, Morton Shulman’s Anyone Can Make a Million, can be owed, in part, to the clever way in which they appeal to those souls who believe that making money in the securities market is so extraordinarily simple that anyone can make a million. It is also interesting to note that given the wide circulation of these books and others like them, we are not experiencing a sharp increase in the number of millionaires in America. Being literate. it seems, doesn’t guarantee success on Wall Street.
The reader, therefore, should be forewarned. This article doesn’t promise unbelievable wealth without risk. It attempts to explain some of the speculative techniques practiced in the stock market, without risk. It attempts to explain some of the speculative techniques practiced in the stock market, and it should be emphasized that we are speaking of speculation, not investment. Most people believe that the only way to make money in the market is to buy a stock and hope that it goes up. Many of the sophisticated speculative techniques available to the market operator are unknown to the novice. The operators of the “go-go funds,”the people who trade for huge trust and corporate port folios, and the other money-manager tvpes that “Adam Smith" discusses in The Money Game understand and occasionally use the techniques outlined here. But this article is for the individual who doesn’t know all the rules of the game, and it is being written on the premise that in the years to come it will be only the dullest of conversationalists who will relate that they lost money by buying a stock which subsequently went down.
The word leverage really has two distinct definitions. Nevertheless both are important to the market speculator and should be understood by him. The first deals with corporate finance, while the second is concerned with trading techniques.
A leveraged company, simply stated, is a company whose capital structure is made up, in large degree, by debt. Since debt doesn’t represent ownership and interest on the debt is a pre-tax charge (unlike dividends paid to stockholders, which of course come out of profits) , this means that a small increase in sales or a similar reduction in costs can cause a large increase in per share earnings. To make this clear, let us take an example of two separate companies, both of which are involved in the manufacture of ladies’ undergarments.
Capitalization Structure of Unmentionables Incorporated
$500M at 5%/1998
50,000 shares of common stock marketed to the public at $10 per share.
Capitalization Structure of the Nightie Corporation
100,000 shares of common stock marketed to the public at Sio per share.
It should be pointed out here that both of these companies have original capital of one million dollars. Unmentionables Incorporated decided that best operating results could be achieved by a combination of debt and equity financing. The Nightie Corporation, on the other hand, felt that it would rather have no fixed obligations but a greater amount of shares outstanding. At the end of 1966 let us assume their earnings results looked something like this.
|Total cost of doing business||$300,000|
|Interest on $5ooM at 5%||25,000|
|Earnings before taxes||$175,000|
|Less taxes at 50%||$87,500|
|Net earnings||$ 87,500|
Earnings per share based on 50,000 shares: $1.75
The Nightie Corporation
|Less cost of goods||$300,000|
|Interest||- o -|
|Earnings before taxes||$200,000|
|Less taxes at 50%||100,000|
Earnings per share based on 100,000 shares outstanding: $1.00
Obviously Unmentionables Incorporated performed better for its shareholders even though sales, taxes, and costs of goods and services were the same as those of the second company. Let us now assume that companies in this kind of enterprise usually sell at about 10 times their earnings per share. Value judgments like this are ordinarily useless, but this kind of assumption serves a useful purpose in explaining the influence of leverage on the price of a stock. Accepting the 10 times earning hypothesis, we can readily see that Unmentionables Incorporated will sell at 17per share, whereas the Nightie Corporation will sell only at 10.
Another year goes by, ant! the market lor lingerie expands considerably. Che 1967 results look like this.
|Cost of goods||600,000|
|Earnings before taxes||$375,000|
|Taxes at 50%||187,500|
|Earnings per share: $3-75|
Earnings per share: $3·75
The Nightie Corporation
|Interest||- o —|
|Earnings before taxes||$400,000|
|Taxes at 150%||200.000|
|Earnings per share: $2.00|
Earnings per share: $2.00
Again, assuming that these companies would normally sell at 10 times their per share earnings figure, we see that Unmentionables’ stock will have risen to 37½, whereas the market price of the Nightie Corporation doubled to 20. Therefore, although sales increased by the same percentage for both companies, the market price of the first rose approximately 114 percent as opposed to the rise of 100 percent for the second.
Naturally, leverage can work in reverse. We could just as easily have had a recession in the ladies’ undergarment market, causing sales and earnings to drop. In this kind of situation the company with debt in its capital structure would have suffered a greater loss in earnings per share and consequently a greater loss in market price than the company whose capitalization consisted wholly of equity. If Unmentionables Incorporated had really fallen on lean times, and earnings, after deducting the cost of goods from sales, came to $25,000, there would have been nothing left for the common shareholder. The $25,000 would have been eaten up by the interest charges. On the other hand, the Nightie Corporation would still have had $12,500 after taxes that they could distribute to common stockholders.
A good example of the effect of leverage on the price of a stock can readily be seen in a comparison of the price action of KLM Royal Dutch Airlines and Western Airlines. Although KLM is a foreign carrier and Western flies domestic routes, the two companies are similar enough to prove the point. In 1963, KLM had total long-term debt of $134,300,000 and gross revenues of $164,150,000. At that time the company had 1,454,190 shares of common stock outstanding. Therefore, the longterm debt of the company was approximately 81 percent of revenues.
Western Airlines, on the other hand, had total long-term debt of $32,940,000 and total revenues of $99,430,000. In total shares of common stock it was very similar to KLM, with 1,430,730. Thus, total revenues exceeded debt by over three times, making the common stock far less leveraged than KLM’s.
In 1963, KLM had a deficit in earnings per share of $10.51, and the stock dropped to a low of 12. By 1965 revenues had risen 25 percent, but because of greater profitability and its unusual capitalization structure, earnings per share rose to a profitable $8.45. A year later, a further earnings gain was made, and the stock hit a high of 155¾ per share. An investor who had bought the stock in 1963 would have seen his capital increase over twelvefold.
Western had a similar experience as far as revenues were concerned. Between 1963 and 1965, gross revenues improved approximately 23 percent, but earnings per share rose only from $2.20 to $2.83. A year later, earnings hit a high of $3·79, and the lucky investor who bought at the low of 9¼ in 1963 had the opportunity to sell his shares at a high of 45 in 1966. Nevertheless, this represented only a fivefold increase as compared with the much larger one scored by KLM.
It is interesting to note that when problems arose for the airlines industry, KLM suffered a tremendous loss. The problems were compounded in October of 1966 by a rights offering during which the company issued additional common stock (this is a hazard when buying leveraged companies because additional financing of this sort reduces the leverage factor and makes the stock less appealing to speculators) , thereby causing the stock to suffer an initial loss that was soon to be followed by a much larger one. By 1968 the stock had dropped as far as 44¼. The low in Western Airlines, on the other hand, was 241/2 KLM had fallen to 28 percent of its value at the high, whereas Western could have been sold at 53 percent of its high value.
The reader shouldn’t infer from all of this that all companies with great amounts of debt are speculative, nor should they assume that firms without any bonds outstanding against them are safe investments. Because of the huge requirements for capital, both railroads and utilities normally have several bond issues. Most utilities, in fact, often have more than 50 percent of their capital represented by debt. But because of the nature of the business, these securities are generally considered most conservative, and the market prices of their stocks do not ordinarily fluctuate greatly.
Financial leverage should be important to the speculator who believes in the resurgence of a depressed industry, It is worth his while to study the companies within that industry to see the makeup of their capital structure. And he should realize that the one with the greatest amount of fixed obligations will probably be the one scoring the handsomest price increases should sales rise or costs drop.
The textbook definitions of leverage undoubtedly concern themselves with the type of financial leverage I have endeavored to explain. Nevertheless, there is another definition which applies to the stock market which is extremely important. Leverage can be gained in situations where the speculator is able to realize large gains although he puts up a small amount of cash. In essence, it is a way of realizing an abnormally large return on one’s capital. Through the use of margin, puts and calls, warrants, and low-price stocks, the speculator can assume high risk with the prospect of high reward. It is to these speculative vehicles that we now turn.
Buying on Margin
Margin is a very inadequate way to achieve leverage because brokerage firms will lend their clients only 20 percent of the market price of the security they buy. In addition, interest rates on that portion are extremely high at the present time, making the cost of doing business on margin fairly substantial.
In essence, margin allows the speculator to buy securities without putting up too percent of the purchase price. At the present time, the margin requirements state that an individual may be loaned only 20 percent of the purchase price on stocks he buys and 40 percent for convertible bonds. In addition, to maintain a margin account, a person must have a minimum equity of $2000.
The margin requirements are controlled by the Federal Reserve Board and may be raised or lowered as it sees fit. In addition, stocks not traded on an exchange cannot be purchased on margin, and very often extremely volatile securities are put under 100 percent margin requirements until activity in them begins to subside. This means that the full purchase price must be paid if someone wishes to let purchase these securities.
Actually, margin gives the spectator only one real opportunity for profit. If the original stocks or bonds he buys on margin go up in price, additional funds are released. These can be used to purchase other securities on margin, and while things are going well for the speculator he can do quite handsomely. This practice is called pyramiding and becomes more important as the margin requirements are lowered. If the price of the stocks that the speculator has on margin drops below a certain point, he can be “called” for additional funds. It the margin call is not satisfied, the broker might be forced to sell his customer out.
I hesitate to mention margin as a speculative technique because it is such an integral part of the securities industry. Nonetheless, for those who want to spread their capital as far as possible, it offers the opportunity of buying stocks on credit. Or, since all short sales are carried on in a margin account, it gives the speculator a chance to sell something he doesn’t own.
The stock market would be a very unfair place if it allowed only those who thought that it would go up to make profits. It you believe that the market as a whole or an individual security is about to experience a sharp drop in price, you sell that stock short. In essence you are selling something you don’t own in the hope of buying it back later at a cheaper price. The mechanics of this are fairly simple. When someone buys a stock on margin, the certificate is held in street name. That is, the name of the brokerage firm rather than that of the buyer is on the certificate, and it is held in that firm’s vault. It is these street-name certificates that are delivered to the buyer when a stock is sold short. At this point the short seller owes his brokerage firm the stock he sold short, and he puts up funds as collateral. When the stock is bought back, the shares are again put into street name, and the short seller has the appropriate amount of money credited to his account. It can readily be seen that the short seller assumes a great deal of risk. The person who buys stock at $50 a share can lose only $50 a share plus commissions. The short seller, on the other hand, can have infinite losses, whereas his gain is limited to the price at which he sold the stock short.
In addition, much of the effectiveness of the short sale has been lost by the “up-tick rule,” which states that short sales can take place only at prices higher than the last different sale. In other words, if a stock is trading at 49 and is followed by sales at 49⅛, 49&38539;, and 49, both sales at 491/8 could be short (the last different sale being the original one at 49), but the last sale taking place at 49 could not. This eliminates the short seller’s ability to drive down the price of a stock through his own selling.
The amount of shares sold short in any given issue is totaled up each month by the various stock exchanges. This figure, termed the short interest, is an important concept for a trader to know. A high short-interest figure is usually considered bullish because it means that there is a substantial buying power in an individual issue. For example, let us say that the Pie in the Sky Uranium Company listed on the New York Stock Exchange has one million shares of its common stock in the hands of the public. The short-interest figure at the end of September, 1967, was 100,000 shares. Therefore, 10 percent of the shares outstanding have been sold short. In order for the people who sold the stock short to make a profit or stop a loss, these shares must be bought back. Since 10 percent of the capitalization must be bought back, there is substantial demand for these shares, and they should go up in price. If the short-interest figure for the month of September is significantly higher than the figure for August, the stock might rise immediately. The short-interest figures are always worth looking at, although they by no means predict with any degree of certainty the price movement of an individual issue.
Short selling must never be undertaken by a novice or by someone who isn’t in constant communication with a brokerage firm. It is, in my opinion, a very unsatisfactory way of speculating because the high degree of risk is not commensurate with possible rewards. It is like betting on the underdog for even money.
Puts, Calls, Straddles, Spreads, Strips, Straps, Bankruptcy?
Puts and calls have come into some prominence recently, and they give the speculator the attractive opportunity of accruing immeasurable profits with limited risk. Many individuals trying to understand this curious aspect of speculation become entangled in the rhetoric and try to figure out who does the calling and who does the putting. Actually, puts and calls are extremely simple, and if one is willing to abandon any preconceived ideas about them, a few short sentences should explain them to satisfaction.
Puts and calls are options, and they give their holders the right to do certain things. A call is an option which gives its holder the right to buy 100 shares of a certain stock at a certain price before a certain time deadline. A put option gives its holder the right to sell 100 shares of stock at a particular price for a certain time period. For example, a recent advertisement for a call might read like this:
Radio Corp. of America $48 95 days $300
This simply means that for $300 one can have the right to buy (call for) 100 shares of Radio Corporation of America at $48 per share within the next 95 days. If before the 95 clays are up, the price of the stock has advanced to $60 per share, the owner of the call option might decide to exercise it. He will buy the stock at $48 from whoever issued the call and will sell it immediately on the New York Stock Exchange at $60. Disregarding commissions which he normally would have to pay, along with the $5 tax on the purchase of options, the owner would have made $1200 less the $300 price of the call. His final result would have been a $900 gain. If, however, after purchasing the option, the price of RCA went down, his option would have become worthless. After the 95 days, it would have expired, and the unhappy speculator is out $300. But the important concept to remember here is that regardless of what catastrophes befall RCA, the holder of this option can lose no more than the price of the option. In this respect you know your potential loss upon purchase of the option.
If this same advertisement had been for a put rather than a call, its owner would have had the right to sell (put) RCA stock to whoever sold him the option at $48 per share. Therefore, if the stock dropped to $40, the holder of the put would have sold the stock at $48 and immediately purchased it in the open market, giving him a profit of $800 less the price of the put, or a net figure of $500 disregarding commissions and tax.
Puts and calls can be purchased through regular brokerage houses which do business with put and call dealers. It should be noted that it is ordinarily a good idea to buy options in only those stocks which are listed on an exchange and which have a good deal of interest in them. Prices for options on unlisted securities or stocks with a small amount of shares outstanding can run as high as 30 percent of the price of the stock. The put and call market is a negotiated one, and a speculator can haggle with a put and call dealer over the price of an option. Options are often listed in the New York Times and the Wall Street Journal, but these represent only a limited number. Anybody can get a price on an option by having his broker contact a put and call dealer for a quote.
Most options extend either 65 days, 95 days, fi months and 10 days, or one year. The price of the option is determined by the volatility of the stock, the length of time, and the sentiment in the market.
A straddle is a unit consisting of one call and one put, and it gives its holders the right both to buy and sell a hundred shares of stock at a particular price for a certain length of time. The speculator hopes that the stock is volatile enough so that he can make money on both sides of the option. Naturally, a straddle costs more than either a put or a call on the same stock, but it offers a certain amount of protection in that the stock can go either up or down sharply for the speculator to make money. A variation of the straddle is the spread option, which consists of a call option which gives the holder the right to buy stock above the present market and a put option giving him the right to sell a hundred shares at a price below the existing market.
A strip is a unit consisting of two puts and one call, and a strap is a unit consisting of two calls and one put. Frankly, I have never seen strips and straps advertised and have never met anyone who has ever owned one. Nevertheless, they do exist and add a bit more variety to the whole option spectrum.
The advanced student will readily see how two speculative techniques already mentioned can be used to supplement each other and to offer some protection. Let us assume that you decided that Radio Corporation of America is in for a large drop sometime within the next six months. As we have already learned, to take advantage of a break in the market, one must sell stock short in the hope of buying it back at a lower price sometime in the future. However, as I have pointed out, the short seller assumes abnormally large risk. You wish to limit the potential loss and yet take advantage of the impending drop in RCA. What do you do?
You sell short your hundred shares of RCA at the price prevailing in the market. Let us assume that that price is $50 per share. At the same time you buy a call on 100 shares of RCA for six months. Let us assume that this option costs $500. You have now protected yourself. Regardless of what happens to RCA in the next six months, all you can lose is $500 plus commissions. However, if the stock drops drastically, you can still make a nice profit. The only problem is that the stock has to go down at least 5 points, or 10 percent, before you break even. This is the price you must be willing to pay for the “insurance policy” you get when you purchased the option. Of course, in an ideal world, the stock could go down to points, whereupon you cover the short position and then soar up 15, making it possible to realize a profit on the call. This rarely happens.
Puts and calls can provide safety, but they can also give their holders enormous leverage. Assume for a moment you felt that the market was in for a large turn upward but you had a limited amount of cash—say $5000. For that amount you might be able to buy 10 calls on RCA giving you the right to buy 1000 shares of the stock over the next six months. If you were to buy 1000 shares of RCA in a margin account, you would be required to put up $40,000 or 80 percent of the purchase price. If you are correct and the stock goes up, you can either sell the option back to the option dealer at a substantial profit or exercise by selling the 1000 shares at the same time that you call for the stock at the lower price. To do this you must have 30 percent of the purchase price of the stock with your broker. This is quite a distance from the 80 percent normally required.
Although puts and calls may sound rosy on paper, and seem to offer many opportunities that individual securities do not, only the most sophisticated speculator should tangle with them. In the first place, when someone starts fooling around with puts and calls, he is dealing with the experts. In the stock market you buy and sell to people who are as ignorant as you; in the option market the amateur can get into serious trouble. In the market one can live with his mistakes because he feels that the inherent value of his securities and the fundamental strength of the American economy will bring his stock’s price back to the record peak at which he bought it. With options, there is a time limit. The firm f work for has found that 85 percent of the options purchased by our clients are never exercised, and we make it a policy to discourage people from becoming involved in that aspect of speculation.
Many people don’t realize that individuals may also sell options. The return is limited, but it offers large portfolios the opportunity of receiving a high return on their capital without undue risk. Let us assume that the owner of too shares of American Airlines feels that although the stock has good long-term potential and is an inherently safe investment, the short-term outlook isn’t too bright. Rather than sell the stock, the owner decides to sell a call on the hundred shares that he owns. If the stock is selling at $30 per share, it is quite possible that he’ll receive $300 for a six-month call on the stock. He has now given somebody else the option of acquiring his stock at $30 per share over the next six months, and he delivers the security to his broker. If the stock goes up, his too shares are called at the stipulated price of S30. Tin’s is better than selling the stock originally because lie receives the $300 premium. If The stock stays at approximately the same price, he may retain Lhe stock at the end of six months, along with the $300 price for the opLion, and he may elect to sell another option against it. The only way the owner can get seriously hurt with this operation is for American Airlines to drop drastically. IS this should happen, he would have been better off selling the stock outright.
The option seller should be concerned only with the premium being paid him for the option. The proper way to approach this is to hope that whoever it is who buys the option makes money too. The faster the stock goes up and the sooner the owner loses the stock, the happier he should be. People who sell options should merely be concerned with the high return they receive for their option and should have no desire to retain the security.
In the above example the owner of American Airlines received to percent on his money for six months. If he has a large enough portfolio, be can continually turn it over by buying stocks and then immediately selling options on them. The greater the amount of transactions, the smaller the overall risk, and a relatively high return on invested capital can be achieved.