Part 5

It is almost invariably the case that when a great decline in stock prices occurs, the set-back is popularly attributed to some factor which, in reality, had little to do with the reversal. In the decline of 1907, thousands of people attributed the inability of railroads to borrow money at low rates of interest almost entirely to hostile legislation. Apparently these rapid-fire thinkers did not know or realize that interest rates had risen the world over, that there was not a free money market in the world, and that money, instead of being withheld from 4% issues, was fully employed in other lines. Such, however, was the case; British Consols, French Rentes,--all the choice securities of civilized countries had kept pace with the declines in our own bonds and stocks; but these facts seem to be unappreciated.

It is true that adverse legislation sometimes seriously impairs the value of a security. A public utilities company, for example, which is forced to reduce its selling rate, is unquestionably injured from an investment point of view. Such legislation, however, may be weighed correctly by a little calm consideration, and it may be said that action of this nature is usually for the purpose of correcting abuses, rather than as a revengeful and confiscatory attack on vested interests. Measures which prevent a fair return on capital will perish of their own iniquity. So far as measures which are formed to prevent extortion are concerned, it is impossible to criticize them.

In order to correctly weigh the effects of legislative measures on security values and prices, we must therefore examine fairly what the legislation seeks to accomplish, taking care not to allow a contemporaneous price movement which may be due to other causes, to act as a verification of a false view. This error occurs very frequently; in fact, one of the most remarkable things about speculation is that the true causes of great movements are fully appreciated by the majority _only in retrospect_.

The probable market effect of legislative and political affairs can be correctly gauged only by examining the nature and importance of the issue in question. This is true not only of state and municipal action, but in regard to presidential elections. There is a popular idea that it is dangerous to buy stocks on the eve of a new presidential campaign, but there is not much in history to uphold the view. True, in a majority of cases, a decline has preceded such a contest, but there have been frequent reversals of this action, and we have had too few elections to attempt any chart-playing on this influence. Such a guide would be empirical.

The issues involved in a presidential contest, however, may sometimes influence prices. Here again a careful examination of facts and probabilities will generally uncover the truth. If the nominee of one party stands on a dangerous platform and the outcome of the contest is in doubt, we may well dispose of shares if for no better reason than that the element of danger is present. Danger, whether or not it is finally realized, is a bear factor, just as safety is a bull factor.

Tariff agitation should be accorded careful consideration by the speculator. This is particularly true as regards the effect on industrial corporations. A reduction of the present tariff on Iron and Steel, for instance, would materially lower, if not destroy, the value of many of the common stocks of steel manufacturing corporations. A very clear and comprehensive work on this subject is mentioned in the bibliography on page 183.

No cut and dried rules or suggestions can be offered as to the effects of political or legislative issues on prices. Each point must be scrutinized as it arises, and judgment formed thereon. Sympathetic movements will sometimes occur because of apprehension or misunderstanding, but such effects will be short-lived.

_Crops and Crop Failures._

The question of crop failures is of great importance. It is not difficult to form a fairly correct idea as to the ultimate yield. The estimates of the Government sometimes go wide of the mark, but it must be remembered that they are _estimates_ and nothing more, and that conditions may change somewhat after the figures are compiled. The speculator is frequently confused by the conflicting opinions of private experts. It is probably safer to disregard the various authorities and pin one’s faith to the computations of the bureau at Washington. These official documents have been criticized at times, and no doubt the criticism has been warranted, but they form our most dependable source of information and will improve as time rolls on.

A crop failure, or a short crop, invariably brings forth much fallacious vaporing from the rooters of Wall Street. They are as bad in their efforts to obscure the truth as are the crop-killers with their fabrications. A crop failure is a serious thing and must be faced as such. The contention which is always heard in lean seasons, that the evil has been counter-acted because of the large reserves of Wheat, Corn or Cotton in farmers’ hands is ridiculous. Farm reserves are wealth. They have already found their place in the business structure. In many cases the money they represent has already been spent in the form of credits. Nor do high prices for cereals or cotton overcome the evils of short production. Small crops mean decreased employment for laborers; a diminution of per capita purchasing power, and increased cost of living. They also mean smaller tonnage for the railroads, and consequently decreased earnings.

And in examining crop prospects, we should consider the fact that each year’s normal crop should be larger than the one preceding it. This is distinctly shown by tracing production back for a term of years.

There will, of course, be fluctuations in this gradual increase, but the tendency is certain. We may also consider that as railroads are constantly extending their lines and increasing their facilities, it follows that increased production in the commodities they transport is necessary to their well being.

And short crops the world over in the same year have the same elements of economic evil. The purchasing power of the world is reduced, and even if we ourselves make fair crops and export them at high prices, the world’s poverty is felt in lack of demand for other exportable surplus. The civilized world is too closely knit together in its affairs to permit of the entire localization of the effects of a serious property loss.

A lean crop year can probably do more to temporarily injure the actual _value_ of railroad shares than can any other single influence bearing on prices. Tonnage is affected both ways, so is passenger traffic. There is less grain or cotton to haul to the markets, and, as purchasing power has been reduced in the affected localities, there is less freight to haul back to the producers. In the last analysis, the products of a community represent to a great extent the mere exchange of these products for other luxuries and necessities, and the effect of decreased production is a two-edged sword, so far as the transporting companies are concerned.

_Accidents._

The effect of accidents on stock prices has been fully discussed in a former work, and the contention offered that accidents could no more be provided against, or considered, in the investment or speculative world than in any other walk of life. It is also thought that accidents are more frequently the _excuse_ for movements than the _cause_ of them. If a market is in a bad technical or general condition, the slightest adverse happening may create panic; while if the foundation is sound, even a great calamity, such as the San Francisco earthquake, will cause only a temporary halt. The man who speculates correctly has little to fear from accidents.

In the following section of this work, the writer has undertaken to touch on such features as appear of most interest and benefit to the speculator or investor. Some of the matter presented, such as the question of dividend dates, will appear to many readers so simple as to be unnecessary, but it is true, nevertheless, that many very elementary facts are misunderstood or unappreciated by a large class of public participators.

VI

Puts and Calls

Puts and Calls, or “privileges,” have long been popular with a certain trading element, either as a protection against loss in commitments already made, or as a positive method of trading.

The theory and operation of privileges may be easily understood by considering them in the light of insurance, the money paid for them as a premium, and the funds received in case the privilege is exercised, as a loss paid by the insurance company. It will be understood, that in speaking of the _seller_ of puts or calls, the insurance company is referred to, and that the _buyer_ represents the insured party.

The _buyer_ of a call has the right to _call_ for his shares or commodity, at the price named in the contract at any time before its maturity. The _seller_ of a call fixes a certain price at which he agrees to _deliver_ stock, specifies the duration or time limit of the contract, and receives from the buyer a certain sum or premium.

For example: United States Steel Common is selling at $40 per share; A, the seller, offers a call on 100 shares at 43, good for ten days, at a price of say, $100. B, the purchaser, pays the $100 and receives a contract from A as specified above. Now suppose that at any time before the expiration of the period named, Steel Common advances to 50. B can call for the delivery of 100 shares of Steel at 43, and by selling it, reaps a profit of $700, less the cost of the privilege, ($100), and the brokerage. Used as a protective measure on short sales, the result would be the same, as $700 would have been saved. That is to say, if A is short of Steel at 40 and it advances to 50, his call has acted as insurance against any loss over and above the $300 represented by the rise from 40 to 43.

The “put” is exactly the reverse of the “call,” and is insurance against a decline; or, in other words, an agreement to receive shares at a specified price on or before a certain date.

Using the same illustration as before, let us assume that the price of Steel Common is 40, and that A, the seller, offers a put at 37, good for 10 days, at a price of $100. B, the buyer, is now insured against any loss which may accrue through a decline below 37 in the ensuing ten days. If he is long of the stock and it declines to 30, he may deliver his shares to A at 37, or if he has purchased the “put” as a speculation, he may buy 100 shares in the market at 30 and deliver to B at 37, netting a profit of $700, less the price paid for “put” and brokerage.

One of the favorite methods of trading in privileges is to buy or sell against them when the price named is reached. For example, say B holds a ten day “put” on Steel Common at 37, and the market for the stock declines to 36 in five days. He may now buy 100 shares at 36 on the theory that he has regained his original outlay of $100 and has a possibility of profit through market action in the remaining five days, while there is no possibility of loss. If the market advances to, say 38, he may sell the one hundred shares purchased, and on another decline to 37 or 36 may again purchase, repeating the operation indefinitely during the life of his put. The “Call” is, of course, made the basis of short sales on an exact reversal of this process. This fashionable form of exercising privileges is facilitated by the fact that “puts and calls” issued by members of the New York Stock Exchange, are generally accepted by brokers as “margins”; B having paid A $100 for a “put,” as illustrated above, could, if Steel declined to 37 or below that figure, buy 100 Steel and give his broker the privilege issued by A, in lieu of a marginal deposit. The broker is satisfied, as he gains a commission, and in the event of a further decline in the price of Steel can call on A to receive the stock at 37 when the option expires.

Another popular form of trading in privileges is to buy or sell half the amount named in the privilege when it becomes “good” through market action. If B holds a “put” on 100 Steel at 37, he may, at that price or below, buy 50 shares. He is now in a position to profit by either an advance or a decline. If the price advances to 40 he has three points profit in the 50 shares purchased. If, on the other hand, the market declines to 34, he still gains 3 points on 50 shares, for his “put” protects him against a loss in the 50 shares purchased and he can purchase another 50 shares at 34 and deliver to A at 37. In short, when he makes his 50 share purchase at 37, he is both short and long of the stock and must gain on a movement either way in the market price.

A “Straddle,” as the term is applied to privileges, is a combined “put and call”. The purchaser gains on a movement in either direction. The general rule is that the gain is to be represented by a market change representing an excess of the amount paid for the “Straddle.” Thus if A sells to B for $250, a straddle on 100 shares of Steel, when the current market for the stock is 40, B is in a position to gain by either an advance above 42½ or a decline below 37½.

The purchasers of privileges are sometimes perplexed by market changes which are brought about by dividend payments. The rule is that the dividend always goes with the stock. The simplest way to arrive at correct figures is, to mentally lower the price of either the “put” or “call,” by the exact amount of the dividend payment. Thus, if B holds a “call” on Steel at 43 and a dividend of 2% is paid on the stock during the life of his option, his “call” becomes operative at 41 as the dividend goes to him. If he holds a “put” at 37, and 2% dividend is paid on the stock, his “put” is not operative until 35 is reached, as the dividend goes to the maker of the “put.”

Privileges in grain or other commodities are based on the same general rules and principles as those on stocks. These privileges are heavily dealt in on wheat and corn in Chicago. They are designated, however, as “ups” and “downs” in order to evade local laws prohibiting transactions in “puts and calls.” The “ups” are calls; the “downs” are puts. Most of the grain privileges handled in Chicago, or based on Chicago prices, are of a day to day character, insuring only for the next day’s price changes. The ordinary charge is $1 per thousand bushels. For $1, therefore, the small gambler, or speculator, may purchase, say a call on 1,000 bushels of wheat at 90½ when the last price recorded was 90. If wheat reaches 91½ during the next day’s session, he has a gain of $10 less the cost of the “call” and brokerage.

The small capital required for this form of trading, the fact that loss is limited to the original cost of the privilege, and the great possibilities in case of extreme movements, make “puts and calls” very popular. It may be said, however, that they are, as a rule, poor property. The writer kept account of the transactions in “puts and calls” handled through a large concern for almost two years and found that only about 35% of the money paid for these privileges returned to the purchasers. That is to say, the profit shown to purchasers of “puts,” “calls,” and “straddles,” was only about $350 out of each $1,000 received by the sellers. After deducting the item of commission charges, it was found that the sellers of privileges reaped over 50% profit each year. The experiment referred to was based on grain privileges, but would probably hold good in stocks. The _sellers_ of these “puts and calls” are among the brightest men in the street, and when they make prices they do so on the absolute basis that they have the best of the bargain and the buyers are usually a public element. In the test referred to, there were never three consecutive days when either “puts” or “calls” were good. There was on one occasion in the period consulted, an advance of over 20 cents a bushel in wheat in three days, but “calls” were good only on the first day of the advance. On this occasion the “calls” were good for about 2 cents per bushel on the first day’s rise, but the sellers offered nothing for the second day, except at prices far above the market, and although the market advanced 6 cents per bushel, wheat was not “called.” On the third day, prices for “calls” were prohibitive, ranging from ten to twenty cents above the closing price and again wheat was not called, although the market advanced 8½ cents.

In the accounts examined, one seller of privileges on wheat had an open order to sell 100 puts and 100 calls every day at the ruling price. He thus received $200 daily and invariably “took his loss” whenever the privileges operated against him. That is to say, if wheat closed one cent per bushel above the call price, he would be called for 100,000 bushels on his privileges, making him short that amount of wheat. This he bought in at once and pocketed a loss of $1,000 less the $200 received. Although he accepted some severe losses now and then, his account showed over $30,000 profit on a year’s business.

Another account was operated on a different principle by the seller of privileges and resulted in even larger profits. This individual would sell ten “puts” and ten “calls” on wheat each day. In the event of his being called, i.e., short of the wheat, he would, on the next day sell no “calls,” but 20 “puts.” In the event of a decline below the “put” price, he had enough short wheat to protect ten of his “puts” and in reality automatically close out his ten thousand short, frequently at a profit. As has been stated, his profits were greater than in the first instance quoted. There was, of course, a more highly speculative element in his form of operating than in the other method, but the operator was never either long or short more than 10,000 bushels, and received about $6,000 a year or 60 cents per bushel from his privileges, in addition to the accruing of profit or the curtailing of loss by his mechanical method.

In the accounts examined the persistent purchasers of privileges all finally lost money, except in a few cases where lines acquired on “puts or calls” were carried to a successful conclusion in the course of time. That is, a purchaser of “calls,” finding a profit in his privilege, would call the wheat and _keep_ it. This, however, resolved the matter into pure speculation, as the maximum benefits derived from this form of trading can only be correctly measured by the profit shown at the expiration of the “put” or “call.” That is to say, the seller need suffer no greater loss than that shown when the contract he has given matures, and consequently the profit to the buyer cannot be greater except through speculation.

It would appear from these facts, that the purchasing of privileges is a poor business proposition, while the selling of privileges is a money making affair. This is true. We need only compare the kind of men who _buy_ “puts and calls” and those who sell them to have this truth made apparent. The late Russell Sage was a persistent writer of these instruments and made a great deal of money by the process. The late Edward Partridge also made a good deal of money in this manner in the Chicago Wheat Market. He also used privileges to aid his manipulative campaigns. On several occasions, he sold “calls” heavily through the day, then suddenly bid wheat up just at the close of the market, effecting a closing just above the call price. The scattered purchasers would call the wheat and put Mr. Partridge short several millions at a high price, which was just what he wanted. He could not have sold as much wheat in the open market without breaking the price several cents. On the same principle, he used sometimes to sell a great many “puts” when he wished to cover a line of short wheat and rush the price downward at the close, thus enabling him to purchase a great line without disturbing the market by bidding for it. The process only worked a few times, however. As soon as it was discovered it failed, as the call price, when reached, met with such a wave of selling that it was impossible to break through it, and the manipulator was “hoist with his own petard.”

There is another drawback to the habit of buying privileges--a mental one. They are frequently made the basis of positive trading with disastrous results. The man who believes in an advance in certain shares or commodities, frequently purchases privileges instead of following out his own convictions by actual trading. Thus the man who had good reasons for expecting an advance in wheat at the time of the 20 cent advance mentioned above, and who used either “puts” or “calls” or both, as a means of operating on his opinions, would have reaped less than two cents a bushel during an advance of twenty cents. He might, of course, have called the wheat on the first day of the advance and remained long, but in that case he would merely have been speculating with equal chance of loss or profit in ensuing transactions. Aside from the initial two cent gain, he would have been in no different position than if he had purchased and held the cereal on margin.

It is the writer’s opinion, founded on the experience set forth above, that it is much better to effect transactions in the ordinary manner, than to depend on privileges. If “puts and calls” are dealt in at all, they should be sold, not purchased. The insurance companies make more money than is paid out in losses; so do the sellers of privileges. It may be well to add, however, that the man who runs an insurance company is in danger if he does not understand his business and his risks, or if he enters the field without sufficient capital to provide for possible initial losses. All this applies to the seller of privileges.

VII

The Question of Dividends

It is a certainty that the short seller of dividend-paying stocks suffers a drawback from dividends, except in the rare cases where interest is allowed on short stocks. If we sell short a 6% stock at par and at the end of a year find the stock still selling at par, we have lost 6% without adverse market action. This onus cannot be escaped by short-time commitments; it is merely a matter of degree. The chronic short seller is swimming constantly against the current.