Accentuating the Negative

Mark Cook doesn’t know when, or even if, his house near East Sparta, Ohio, is going to burn down. Yet he pays thousands of dollars a year for insurance just in case.

On the other hand, the veteran options trader believes he does know--with the conviction of a man whose family has traded professionally on Midwestern commodity exchanges for 100 years--that the stock market is about to burn down, figuratively speaking. So he is not just insuring his profits of the last several years against the possibility of a 30% plunge in the broad market, but laying plans to profit from it.

Cook’s trading stance for 1997 might be extreme--it’s tantamount to betting on the iceberg as the Titanic approaches. But his decision to buy protective “put” options on major market indexes, a strategy called hedging, offers important lessons for many individual investors anxious to safeguard sensational gains earned in the stock market’s 7-year bull run.

To be sure, there are other ways to protect one’s gains: You could cash partly or entirely out of stocks, for example, or you could “short” major indexes using futures contracts, a strategy that would produce gains to offset your portfolio’s losses if the market indeed dives.

Some conservative money managers, however, believe that the best thing to do during periods of extreme market volatility is nothing at all: Just buy shares in fast-growing, dividend-paying large companies at a good price for the long term, they say, and wait for burned speculators to pile into your shares during the storm.

The beauty of options, though, is that they offer a way to continue to be fully invested in the market in case it soars instead of sputters. Because of options’ cost, a hedged portfolio using options typically won’t rise quite as much as an unhedged one if the market takes off--but it also won’t crater during a market rout.

In other words, hedging limits your downside risk while preserving most of your upside potential.

Cook, who counts managers of multibillion-dollar institutional funds among his consulting clients, believes it is the downside risk that investors should most beware of today. Leading indicators favored by options traders, he says, are flashing warnings of a debacle so great that private investors could be scared out of the market for a generation, as they were after the great crash of 1929. He’s no Chicken Little, either, having accurately predicted the market’s tremendous upward surge following last July’s correction, whereas other prognosticators, like well-known pundit Elaine Garzarelli, turned bearish too early.

The strategy proposed in his Mark D. Cook Twice-Daily Fax Service is simple: Buy “out-of-the-money” stock index put options every month this year until the crash.

“This market will go down as soon as any bad news hits,” he says.

So what is an out-of-the-money put option, and how do you buy one?

An option is a so-called derivative--a financial instrument that is neither a share of a company, like a stock, nor a debt obligation, like a bond. Instead, an option is a contract between investors that trades on exchanges. Options’ prices are only linked to, or derived from, real shares. A “put” option is an option to sell a certain number of shares by a certain future date at a certain price, which is called the “strike” price. Likewise, a “call” option is a right to buy a certain number of shares by a certain date at a certain price.

Options were developed centuries ago specifically for portfolio insurance but are used today primarily by speculators. When you expect the price of the underlying stock to rise in the future, you buy a call option; when you expect the underlying stock to fall, you buy a put option.

A big attraction of options is that they offer a way to leverage investment dollars; you put up far less money for most of the rights that shareholders enjoy.

When major traders like Cook hedge, however, they typically buy options on major market indexes rather than on individual stocks. The most widely optioned index is the Standard & Poor’s 100, symbol OEX, which is made up of the 100 largest stocks in the S&P; 500.

The downside of options is that, unlike stocks, they become absolutely worthless if your price expectations are not fully met in your expected time frame. You can be 90% right and still lose 100% of your money.

That’s why it is critical to understand that option prices vary greatly depending on the amount of time until their expiration, the volatility of the market during that period, and the difference between the current and expected future price of the underlying stock or index.

An option that would pay off if the market fell 5% from today to Feb. 21, for instance, would cost much more than an option that would only pay off if the market fell 10% or more by that date.

The first type is called an “in-the-money” option, the latter, an “out-of-the-money” option. Consider the first to be similar to an expensive home-insurance policy that has no deductible. The latter is more like disaster insurance, which costs less upfront but only pays if there’s a real catastrophe.

Approached correctly, Cook says, the impending market dive offers a “once-in-a-lifetime opportunity” for windfall profits for aggressive traders, in addition to the insurance. But investors following his lead will require the guts, patience and money to stick to the strategy even if it does not pay off for months.

“You could buy puts in January, February, March and April and nothing happens,” he says. “But don’t give up, because it could happen in May. It’s just like you don’t know when your house is going to burn down, so you insure it continuously.”

Cook said he is advising clients, such as the managers of the Lindner family of mutual funds in St. Louis, to cover at least 1% to 5% of their portfolios this year with put options. He believes an individual with $100,000 in stocks, in other words, should consider paying $1,000 to $5,000 a month for insurance.

Here’s a typical scenario:

Suppose your portfolio consists of $100,000 in an S&P; 500 index mutual fund and you want to spend 2% of its value each month as insurance against the possibility of a 30% drop in the market.

Cook advises buying three next-month put options that are 20, 25 and 30 points away from the underlying index. That is, if the S&P; 100 were at 720--as it was last week--you would buy OEX February 700, 695 and 690 puts.

Options are sold in contract values of 100, in which one contract equals 100 shares of stock. For the sake of the illustration, let’s say the price of each OEX February 700 (symbol OEX NT) was $8 per contract; then a purchase of one was $800, not including commissions. To use rounded figures that are close to the market prices, say the February 695s (OEX NS) were $7, or $700, and the February 690s (OEX NR) were $5, or $500. The total outlay would thus be $2,000, not including commissions.

Option contracts expire on the third Friday of each month, which usually is the reason for heavy trading on stock markets that day.

If the S&P; 100 declined 10% between now and Feb. 21, that would equal a 72-point plunge. To determine the possible gain for the trade, subtract 72 from 720. That’s 648. Subtract that number from your highest put option, 700, to get 52 points. In turn, the 695 puts would be worth 47 points and the 690 puts would be worth 42 points. Those add up to 141. Multiply by 100, and your $2,000 investment would be worth $14,100--a net gain of $12,100.

Therefore, while your S&P; 500 index mutual fund portfolio value declined by 10%, or $10,000, in that period, your insurance policy left you with a net gain of more than $2,000. (The S&P; 100 option is more liquid than the 500 option, and rarely varies significantly from the 500.)

Of course, a greater decline would enhance the value of the strategy. The market declined 23% in three days in October 1987. If a 20% plunge occurred by Feb. 21, the OEX would have fallen 144 points and your $2,000 in options would be worth $35,700.

While your portfolio value fell to $80,000, the insurance gambit would leave you up almost $16,000.

One caveat: The strategy works best only if a crash occurs within a single month. Cook believes that will happen because spike advances in a market--such as the one that carried the Dow Jones industrial average up 1,200 points from July to November--”only end with spike declines.”

Another top options consultant, Terence Bedford, agrees that a 20% decline is probably in store for the market in 1997. But the Toronto money manager believes it will occur over six to nine months as a “long, sickening, painful slide” in which the Dow Jones industrial average falls a little week by week rather than in a single cataclysmic event.

The best way to duck that kind of catastrophe? Either take money off the table and wait it out, he says, or pursue Cook’s strategy this year only in months that follow months of major market jumps.

Street Strategies explores investment tactics. Jon D. Markman is a Times staff writer. He may use strategies discussed in the column for his own account. He can be reached at jon.markman@latimes.com

* ON S & P STRATEGY

Wrinkles on an earlier Street Strategies column. D7