<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (June 9, 1998) -- At least a dozen readers asked me to respond to a column in yesterday's CBS MarketWatch by Brenon Daly outlining a strategy combining the Beating the Dow stocks with long-term options (LEAPS). It's an approach advocated by Laura Holder, head of the A.G. Edwards options department.

Her strategy is one where the investor buys call options on the five Beating the Dow stocks. Options give the holder the right to buy the underlying stock at a certain price up to a certain date. (One buys a call option if one expects the stock to rise. Put options are used when investors believe the stock price will fall.)

The theory is that if these stocks are good candidates to rise over the next year, using options allows one to enjoy the benefits of that gain without investing the same amount of money. (The price one pays for the option to buy 100 shares is significantly lower then the price to buy the same 100 shares of stock outright.)

Let me explain, however, why I don't like options even though they can be very powerful tools when the options investor is correct.

With options, one has to be correct about three different factors to make a profit. One has to be right about the direction a stock's price will move, the size of that move, and the date by which it will make that move. If the options investor is wrong about any one of those three things, the option will expire worthless and the entire investment is lost.

When one buys a common stock, one only has to be right about a single factor -- whether the stock will go up or down. If I buy Exxon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: XON)") else Response.Write("(NYSE: XON)") end if %> for example, it's a successful investment if it rises more than the market does. If it doesn't rise as much as I expected by a certain date, however, I haven't lost anything. I can and probably should continue to hold the underlying stock for a longer period until it does rise to the value I expected or hoped for. If the stock does everything right, but falls short of a price target by a dollar or two, I still enjoy all that gain whereas the option investor would lose his entire investment.

Now I should point out that Ms. Holder's strategy is to buy "deep in the money" calls. That is, she buys call options that are below the current market price for the stock, which eliminates the risk that the stock will fail to get to its strike price by a few bucks per share and cause the entire option to be worthless.

Overall, though, options are a leverage tool. And like any leverage tool, they take on more risk than simply buying the underlying equity does. You can achieve greater gains with options than with common stocks on occasion, but the odds of doing so are much longer and the risk of losing one's entire investment is much higher. So I won't recommend that you consider options with the Dow strategy, even though I recognize that option investors would be attracted to such a mechanical approach that has proven very consistent. For me, though, I'd rather own the stocks and only have to be right about one element, rather than three, to make a regular profit.

Current Dow Order | 1998 Dow Returns

[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   -   3/8   49.50 
 IP   -  13/16  46.94 
 MO   +   3/4   40.25 
 EK   +1  1/2   71.81 
  
 
 
                    Day   Month    Year 
         FOOL-4   +0.32%   1.93%   8.58% 
         DJIA     -0.22%   1.69%  14.44% 
         S&P 500  +0.24%   2.53%  15.25% 
         NASDAQ   +0.73%   1.23%  14.67% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  206 Eastman Ko    60.56     71.81    18.58% 
  12/31/97  291 Union Carb    42.94     49.50    15.28% 
  12/31/97  289 Int'l Pape    43.13     46.94     8.84% 
  12/31/97  276 Philip Mor    45.25     40.25   -11.05% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  206 Eastman Ko 12475.88  14793.38  $2317.50 
  12/31/97  291 Union Carb 12494.81  14404.50  $1909.69 
  12/31/97  289 Int'l Pape 12463.13  13564.94  $1101.81 
  12/31/97  276 Philip Mor 12489.00  11109.00 -$1380.00 
  
  
                              CASH    $415.96 
                             TOTAL  $54287.77