Want to make a bundle on stocks? And who doesn't? It's Wall Street's lure.
Then, suggest stockbrokers, you may want to consider dealing in "puts" and "calls" in the stock options market.
In the arcane language of the financial world, these are increasingly popular techniques to play the stock market when you don't have a lot of money to invest. You can make, they say, big bucks.
But be forewarned. You can lose your entire investment just as quickly.
Sounds an awful lot like gambling.
"Oh, I won't say that," replies Bob Kass, an investment broker with A. G. Edwards & Sons in Spring Valley. "But any time you try and anticipate something" --which is what "puts" and "calls" are all about -- "you're taking a risk."
Despite the dangers -- and they are very real -- the attraction can be seen in the startling profits potential, as revealed in a story that made the news recently:
According to the Securities and Exchange Commission, former Air Force Secretary Thomas C. Reed last March bought $3,125 worth of stock options in Amax Corp. When a merger with Standard Oil of California was announced the next day, Amax stock shot up -- and with it Reed's options. Waaaay up.
In 48 hours, he netted a profit of $427,000.
In this case, however, Reed didn't get to keep the money. The SEC charged that Reed had access to inside information about the proposed merger, and to settle the charges he agreed to pay back the entire amount.
"It's the promise of big gains on a minimum investment that makes options so alluring," writes ABC Radio financial commentator Gordon Williams, author of Financial Survival in the Age of New Money (Simon and Schuster, 382 pages, $14.95). "If you hit on only a few of the options you try, you're still nicely ahead of the game -- and of inflation. It can work for the small investor who's willing to spend the time learning the market."
But, he warns, in the kind of erratic markets we've been experiencing, "it's quite possible to lose on every trade." Whatever stockbrokers may say, "You gamble, pure and simple. It isn't a market for the faint of heart."
Nevertheless, since the first options exchange was established in 1973, the volume of transactions has grown almost to that of the stock market -- in part, perhaps, because playing the options game, says Kass, can be "tremendous enjoyment." Closing quotations for 300 stocks on the Chicago, Philadelphia, American and Pacific options exchanges are carried daily in the financial pages of many newspapers.
Here, at its simplest, is how the stock options market works:
You are interested in 100 shares of XYZ stock that currently is selling for $50 a share. You think it is going to increase in price within the next few weeks or months. But you don't have the $5,000 purchase price. Instead, you buy a "call" option on the stock, for which you may pay, let's say, a $5 premium per share or just $500. This gives you the right to buy the stock at $50 per share within a specified time -- up to nine months -- no matter how high it goes.
If you guessed right, and the stock goes to $60 a share, you have two alternatives. You can buy stock now worth $6,000 for only $5,000. Deducting the $500 premium you paid, that gives you a profit of $500. Or: As the stock price rose, so did the value of the option premium to $10 a share. Your $500 call option is now worth $1,000, which you can sell for a $500 profit. (Don't forget the broker's commissions in either case.)
If the stock did not go up or even went down within the specified time, you could be out your entire $500. But that $500 is the limit of your risk. Had you paid the full $5,000 for the stock, and it plummeted, you could have lost a whole lot more.
In buying a "call" option, sums up Kass, your reasons may be: potential gain; the predetermined limit of the risk; the leverage you get in controlling a "large quantity of stock with a small amount of capital"; or the ability to "establish a purchase price in advance" if you don't have the money immediately available.
When you bought a "call" option, somebody had to sell. In this example, it was the owner of 100 shares of XYZ stock who wanted to milk a little extra from his investment. This stockholder gets to keep the $500 premium (less commissions) you paid for the call option. If the stock does climb from $50 to $60 a share, and he must sell to you at $50, he loses the opportunity for a $1,000 gain (though he still has your $500). Even if the stock drops, your premium helps the stockholder offset any losses.
Selling "calls" (dubbed "writing" in market lingo) is considerably less chancy than buying them, says Kass, who offers prospective investors frequent seminars on the options market. "One nice thing about the options market is that it is all things to all people -- to the risk-taker on the buying side or the very conservative investor on the writing side."
A Washington stockbroker active in the options market describes the difference in risk between the buyer and the seller as similar to that between "a person who goes to the races and the guy who owns the racetrack."
Among sellers (or writers), Kass says, are often found such stock portfolio-holders as bank trust departments, insurance companies and pension funds.
"Puts" are the reverse of the coin. When you buy a "put," you are gambling the market is going down. You pay, to continue the example, a $5 premium for a "put" option on 100 shares of XYZ stock selling for $50 a share. You have bought the right to sell these shares at $50 no matter how much the price drops. As the stock drops to, say, $40, the premium on your "put" will increase to $10. You can sell the "put" for a $500 profit. (Most "puts," says the Chicago Board Options Exchange, are bought with the intention of selling them.)
"A portion of your investment portfolio should be in the options market," advises Kass, either for extra income or to risk money to make money. "We have clients who say, 'I have $1,000 to $2,000 I'm willing to lose.' Talk with your broker about your investment goals."
On the other hand, John Dorfman, former chief securities writer for the Associated Press -- who advises against buying options -- points out in his Family Investment Guide (Atheneum, 268 pages, $14.95) that brokers have two "strong incentives" to get you into the market:
"One is those high commissions; the other is that option traders are usually active traders -- which means a lot of commissions."
If you still want to get into the action, Kass suggests looking "for volatile stocks, sensitive stocks -- what's happening in today's news." You are hoping for movement; the stock owner is gambling on stability.
For example, "I might read where a company has come out with a new camera today people might want to own. There's public interest in the firm. We might buy some calls." For another stock, "a dividend cut might be coming up. We might buy puts.
"Things are all around us that may relate to stocks. With takeover rumors, a stock explodes. Unfortunately, most rumors appear not to happen."
Remember, warns Kass, "puts" and "calls" are a "wasting asset," because of the time limits involved. If the stock doesn't move, your investment "tends to waste away."
However, in a recent five-day period he recalls as "horrendous," Kass says, the market "went up 30 points and then came down 30 points. I wasn't sure whether I was a bear, a bull or a butterfly."
Which illustrates another of Dorfman's warnings:
"When you buy a call, you're making a double bet. You're claiming that you not only know which stock will go up, but when it will go up (i.e., before the option expires). That's asking too much of any mortal."