Options are instruments that allow you to purchase a financial asset or futures contract at a given price for a specific period of time. Their primary advantage is that you cannot lose more than 100% of your money and yet you gain from the tremendous leverage that options offer. The disadvantage is that if the price does not rally by the time the option expires you stand to lose everything. With options it is possible to be dead right on the market and yet lose everything because the price did not meet your objective by the time the option expired.
The other leveraged alternative-the purchase of futuresdoes not suffer from this drawback because the contract can always be "rolled over," or refinanced, when it expires. The problem with futures is that markets rarely move in a straight line. Let's say that Rex has a capital investment of $24,000, and expects the price of gold to advance by $150. Margins vary with volatility in the market, but let's suppose that the current margin or deposit requirement is $2,000 per contract. This means that Rex could buy twelve contracts. Every $1 movement in the gold price changes the value of each contract by $100, so a dollar movement for an account holding 12 contracts would be $1,200. If the price moves up by $150, his account will profit to the tune of $180,000. If he deducts $10,000 for commissions and carrying charges, that's still a very healthy profit on a $24,000 investment.
The problem is that leverage can work both ways. Let's say, for example, that the price of gold does eventually go up by $150, but it goes down $15 first. This means that Rex's account initially loses $18,000. You might think that the $7,000 balance would be sufficient to enable him to ride out the storm. However, his broker will be quite concerned at this point and will issue a margin call. Either he must come up with the $17,000 or he will be forced to liquidate the position. Here is an example where the analysis is absolutely correct but the extreme leveraging of the position, that is, the greed factor, results in disaster. How much more sensible it would have been just to purchase two contracts, ride out the storm, and take profits when the price rallied to $150.
Another way in which people succumb to the greed factor is through pyramiding. Let's say Rex takes our advice and buys 2 gold contracts. He sees the price rise by $25 and has a comfortable feeling when he looks at his account to see that it has now increased from $25,000 to $30,000. Rex is quite happy because the market is telling him that his assessment of the conditions is absolutely right. "What's wrong with adding a couple of contracts?" he asks himself. After all, his account has grown by $5,000 and the addition of 2 more contracts will only increase his margin requirement by $4,000, so his excess equity over margin will still be $1,000 more than when he started. He then suffers a $10 setback in the price, which pushes his total equity position back to $26,000. This troubles him a little, but soon the price takes off again, and it's not long before the price has advanced another $15 above where he bought his second tranche. His equity now stands at $36,000, and his confidence is higher than ever. Having fought one battle successfully and seen his view once again confirmed by the market, he calculates that if he buys another 5 contracts and the market fulfills the last $110 of potential, he will end up with his current $37,000 plus another $110,000. At this point, his original investment has already grown by about 50%, a very good rate of return. Unfortunately, Rex has become the victim of his own success and finds the temptation of the extra $110,000 to be irresistible, so he plunges in with the 5 contracts.
Then the price rallies another $10, but instead of buying more, he decides to stay with his position. The next thing he knows the price suffers a setback to the place where he added the 5 contracts. The mood of most market participants is quite upbeat at this time and many are accounting for the decline as "healthy" profit-taking. Having resisted the opportunity to add at higher prices, Rex is quite proud of himself and looks on the setback as a good place to augment to his position "on weakness," so he buys 3 more contracts for a total of 12. Remember his equity is still at a healthy $37,000. What often happens at this stage is that the price fluctuates within a narrow trading range. After all, it has rallied by $45 without much of a correction. The price erodes a further $5 in a quiet fashion and then experiences a sharp $17 selloff. This means that it has retraced about 50% of the advance since Rex entered the market. Rex still has a profit in his original purchase, but the problem is that he pyramided his position at higher prices and is now under water. The price has dropped by $22, which means the equity in his account has fallen from $37,000 to $10,600 (i.e., twelve contracts X $2,200).
Rex now has three choices: Meet the inevitable margin call by injecting more money in the account, liquidate the position, or sell enough contracts to meet the margin call. All three alternatives are unpleasant but would have been unnecessary if he had stuck to his original plan. If he had, his equity would currently be at $29,400, and he would be $4,400 to the good.
As we know, his original prediction was correct, and the price eventually did reach his price objective. If he had decided at that point to consolidate his position and hold, he would still have come out with a profit. However, he didn't realize his strong position at that point. All he could see is that his account had fallen from a very healthy $37,000 to a very worrying $10,600-a loss of over 50%. The temptation for most people in this type of situation is to run for cover, as fear quickly overtakes greed as the motivating force. Moreover, when prices decline, there is usually a rationale trotted out by experts and the media. This justification may or may not hold water, but it is amazing how its credibility appears to move proportionately with the amount the account has been margined.
The odds are therefore very high that our friend Rex will decide to liquidate his entire position. A devastating loss of this nature is a very worrying experience, but most traders will tell you that once the position has been liquidated, most people feel a sense of relief that the ordeal is over. The last thing Rex wants to do at this point is speculate in the futures markets. However, it is only a matter of time before his psychological wounds heal and he ventures back into the market. Like most people, he will vow that he has learned from his mistake, but it is not until those prices go up and his equity grows that he will find out whether or not he has really learned his lesson.
This example shows that success, if not properly controlled, can sow the seeds of failure. Anyone who has encountered a long string of profitable trades or investments without any meaningful setbacks is bound to experience a feeling of well-being and a sense of invincibility. This in turn results in more risk taking and careless decision making. Markets are constantly probing for the vulnerabilities and weaknesses that we all possess, so this reckless activity presents a golden opportunity for them to sow the seeds of destruction. In this respect, remember that no one, however talented, can succeed always. Every trader and investor goes through a cycle that alternates between success and failure. Successful traders and investors are fully aware of their feelings of invincibility and often make a deliberate effort to stay out of the market after they have experienced a profitable campaign. This "vacation" enables them to recharge their emotional batteries and subsequently return to the market in a much more objective state of mind.
Investors who have had a run of success, whether from shortterm trading or long-term investment, have a tendency to relax and lower their guard, because they have not recently been tested by the market. When profits have been earned with very little effort, they are not appreciated as much as when you have to sweat out painful corrections and similar market contortions. Part of this phenomenon arises because a successful campaign reinforces our convictions that we are on the right path. Consequently, we are less likely to question our investment or trading position even when new evidence to the contrary comes to the fore. We need to recognize that confidence moves proportionately with prices.
As our confidence improves, we should take countermeasures to keep our feet on the ground so that we maintain our sense of equilibrium. At the beginning of an investment campaign, this is not as much a requir
ement as it is as the campaign progresses, because fear and caution help rein in our tendency to make rash decisions. As prices move in our favor, the solid anchor of caution gradually disappears. This means that sharp market movements that go against our position hit us by surprise. It is much better to be continually running scared and looking over our shoulder for developments that are likely to reverse the prevailing trend. Such unexpected shocks will be far less frequent because we will have learned to anticipate them. When events can be anticipated, it is much easier to put them in perspective. Otherwise, their true significance may be exaggerated. The idea is to try to maintain a sense of mental balance so that these psychological disruptions can be more easily deflected when they occur.
Think of how a practitioner of karate maintains the poise that enables him to deflect physical blows. The same should be true for the investor or trader. Try to maintain your mental balance by taking steps to be as objective as possible. Succumbing to the emotional extremes of fear and greed will make you far more vulnerable to unexpected outside forces. Unless you can assess their true importance and then take the appropriate action by using your head, you are more likely to respond emotionally to such stimuli, just like everyone else.
Many other emotions lie between the destructive polar extremes of fear and greed. These traps, which also have the potential to divert us from maintaining an objective stance, are discussed in the following sections.
Overtrading, or "Marketitis"
Many traders feel they need to play the market all the time. Reasons vary. Some crave the excitement. Others see it as a crutch to prop up their hopes. If you are out of the market, you cannot look forward to its providing financial gain. When everything else in your life results in disappointment, the trade or investment serves as something on which you can pin your hopes. In such situations, the trader or investor is using the market to compensate for his frustrations. For others, the motivation of constantly being in the market is nothing less than pure greed. In all these cases, the motivations are flawed so it is not surprising that the results are also.
H. J. Wolf, in his 1926 book Studies in Stock Speculation, calls this phenomenon "marketitis." He likens it to the same kind of impulse that makes a man board a train before he knows in which direction it is headed. The disease leads the trader to believe that he is using his judgment when in fact he is only guessing, and it makes him think he is speculating when he is in fact gambling. Wolfe viewed this subject to be of such importance that he made it the "burden" of his ninth cardinal principle of trading, "Avoid Uncertainty." (See Chapter 14.)
He is telling us that everyone should stay out of the market when conditions are so uncertain that it is impossible to judge its future course with accuracy. This conclusion makes a lot of sense when we consider that one of the requirements of obtaining mental balance and staying objective is to have confidence in our position. If we make a decision on which we are not totally convinced, we will easily be knocked off course by the slightest piece of bad news or an unexpected price setback.
Another consequence of overtrading is loss of perspective. Bull markets carry most stocks up just as a rising tide lifts all boats. In a bear market, most stocks fall most of the time. This means that the purchase of a perfectly good stock is likely to go against you when the primary or main trend is down. If you are constantly in the market, your time horizon will be much shorter, so much so that you will unlikely recognize the direction of the prevailing primary trend. Only after a string of painful losses will you come to the conclusion that the tide has turned.
When business conditions deteriorate, manufacturers cut back on production because there is less chance of making a sale. Traders and investors should regard their market operations in a similar businesslike approach by curtailing activity when the market environment is not conducive to making profits.
The Curse of the Quote Machine, or "Tickeritis"
A constant resort to price quotations clouds judgment. Uncontrolled tape watching or quote gathering is a sure way of losing perspective. Just after I began trading futures in 1980, I remember renting a very expensive quote machine that also plotted real-time charts. At the beginning of the trading day, the screen was blank. As the day wore on, it gradually filled up as each tick or trade was plotted on the screen. This seemed to be a good idea at the time, because my approach to speculation had a technical, or chart-watching, bent. What better way to trade than to have the most up-to-date information.
Unfortunately, the task of actually following these charts and trading from them was emotionally draining. At the end of the day, it seemed as though I had endured several complete bull and bear cycles. As a result, my perspective changed from a long-term to an extremely short-term outlook. To make matters worse, the market had usually moved a great deal by the time my orders reached the floor of the exchange. Consequently, the executions were not what I had expected.
This point is not meant to reflect badly on the brokers concerned but merely to indicate that the time lags involved in such transactions were not conducive to trading successfully on such a short-term horizon. I am not suggesting that one should never trade on an intraday basis. Very few people, however, have the aptitude and quick access to the floor of the exchange to make such an approach profitable. You really need to be a professional, devoting a full-time effort into such a project to have even a small chance of success.
In 1926, Henry Howard Harper wrote an excellent book called The Psychology of Speculation. He describes this constant need to watch the market as "tickeritis." A sufferer of tickeritis, he reasoned, "is no more capable of reasonable and self-composed action than one who is in the delirium of typhoid fever." He justified this comment by explaining that the volatile action of prices on a ticker tape produces a sort of mental intoxication that "foreshortens the vision by involuntary submissiveness to momentary influences." Just as an object seems distorted when looked at too closely through the camera's lens, so does close, constant study of the ticker tape or quote machine distort your view of market conditions and values.
If you are in the quiet of your own home, it is possible to conduct a careful and reasoned analysis of what investment or trading decisions you would make the next day or next week based on certain predetermined triggering points. In the quickly shifting sands of rumor, manipulation, and unexpected news, however, it becomes very easy to lose your reasoning powers. Occasionally, you will find yourself subject to the hysteria of the crowd, frequently doing the exact opposite of what you may have been planned in the quiet solitude of the living room last night. This does not mean that everyone who turns off the TV or quote machine will be successful, merely that such a person will have greater perspective and a more open mind than one who submits to the lure of ticker or quote.
Some traders and investors have an ability to sense important reversals in price trends based on their experience, observation, and interpretation of price quotes or ticker action. In this case, they are using the price action solely as a basis for making decisions. But this ability takes a great deal of expertise. Successful practitioners of this method live and breathe markets and are extremely self-controlled. The main difference between these individuals and the vast majority of us is that they become buyers after prices have reacted adversely to bad news and sellers when prices respond upward to good news. They do not react to news in a knee-jerk fashion but use their experience to move in the opposite direction of the crowd.
Hope, the Most Subtle of Mind Traps
After prices have experienced a significant advance and then undergo a selling frenzy, the activity often leaves the unwary investor with a substantial loss. It is natural to hope that prices will return to their former levels, thereby presenting him with the opportunity to "get out." This redeeming concept of hope is one of the greatest obstacles to clear thinking and maintenance of objectivity.
Hope often becomes the primary influence in determining a future investment stance. Unfortunately, it can only w
arp or obscure sound judgment and will undoubtedly contribute to greater losses. In a sense, the victim of hope is mentally trying to make the market do something that he desires rather than make an objective projection based on a solid appraisal of conditions.
Hope is defined as the "expectation of something desired." Sound investment and trading approaches are based, not on desire, but on a rational assessment of how future conditions will affect prices. Whenever your position is under water, you should step back and ask yourself whether the reason for the original purchase is still valid or not. Ask these questions: If all my money were in cash right now, would this investment or trade still make sense? Are the original reasons for making the purchase still valid? If the answers are positive, then stay with the position; if not, then the only justification is one based on hope.
Whenever you can identify hope as the primary justification for holding a position, close it out immediately. This action will achieve two things. First, it will protect you from a potentially serious loss. If your exposure is being rationalized on hope alone, you will be ignorant of any lurking dangers and will be that much more vulnerable to further price declines. Second, it is vital for you to regain some objectivity and free yourself from as many biases as possible. This can be achieved only by selling your position and making an attempt at a balanced assessment of your situation.
Investment Psychology Explained Page 4