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Investor Psychology and the Need for Structured Plans

We just can’t sell our losers! Some will actually buy more shares to average down the cost basis. Why is that? If sticking your index finger into an outlet resulted in an uncomfortable shock would you then try it with your other fingers?  After you dipped your hand in water?

Market psychology can turn an astute investor into Moe, Larry or Curley. So the question that is so critical is how do we take emotion out of our investment decisions? When we take a position in the stock market we have made a decision; we own it. When it turns south we take an emotional hit; was I wrong? We have a tendency to believe that the choice was the correct one and the price will recover. Most investors also tend to underestimate the financial hit a loser can cause and once that loss becomes substantial there is little to recover.

Can You Sell a Loser?

According to a research report published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, retail investors are 50% more likely to sell a winner than a loser despite the fact that the sold stocks continue to outperform those that were held. This trait is characteristic of many mutual fund managers, real estate investment trusts and some hedge fund managers as well. Perhaps that’s one of the reasons that most actively managed mutual funds underperform the market benchmark. There is actually a new emerging science called neuroeconomics which combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.

So the battle continues: human nature versus maximum investment success. To achieve the latter we must have a structured investment plan in place. The first question we should ask ourselves is “would I buy this stock today given the information available?” If the answer is no why not trade the laggard in for a great-performer? Another way to put it is “Is the cash invested in the laggard better off where it is or in a healthier financial soldier?” These questions, as simple as they appear on the surface, will lead us to better investing and maximizing our returns as we shut the door on emotion. Furthermore, when we unwind a loser we can use the losses to offset up to $3,000 of ordinary income on our tax returns (speak with your financial advisor).

What is a structured plan as it relates to the BCI Methodology?

We have a set of rules and guidelines for both stock and option selection as well as position management. We select only the greatest performing stocks in the greatest performing industries factoring in common sense parameters like earnings reports. We evaluate market conditions and equity technicals to dictate strike selection. After executing our trades, we manage our positions by being PREPARED with a series of exit strategies that will both mitigate losses and maximize gains. Selling a loser is something that I have struggled with (in the past) and most of you as well. Whether you subscribe to the BCI methodology or have another system of investing I hope we can all agree that taking emotion out of our investment approach will benefit us all and help guide us to becoming CEOs of our own money and ultimately financially independent. A structured plan must be in place.

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COUPON DISCOUNT for Alan Ellman’s Encyclopedia for Covered Call Writing ends Monday:

We are offering  a discount of $5 + FREE SHIPPING for Alan’s newest book: Alan Ellman’s Encyclopedia for Covered Call Writing. The total discount will be $8.75  GOOD UNTIL October 31st, 2011. Premium members are ALSO entitled to your everyday premium discount (***enter the Blue Collar store from the premium site). Be sure to enter coupon code “book3″.

Here is the link to the Blue Collar store:

/store.shtml

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Market tone:

This past week’s economic reports were mixed but more positive than negative and took a backseat to encouraging progress on Europe’s sovereign debt crisis:

  • GDP rose at an annual rate of 2.46% during the 3rd quarter calming fears of another recession
  • Consumer confidence fell in October to the lowest level since March of 2009
  • Consumer spending was surprisingly strong in September rising 0.6%
  • Residential homes sales fell 0.9% in September but sales of new homes posted a better than anticipated gain of 5.7%
  • Orders for durable manufactured goods fell by 0.8% in September BUT when we take out orders for aircraft durable goods orders actually rose by 1.7%
  • Wages, salaries and benefits to civilian employees grew by 0.3% in the 3rd quarter

For the week, the S&P 500 rose by 3.8% for a year-to-date return of 3.9% including dividends.

Technically, this has been an encouraging few weeks. Viewing 6-month charts of the S&P 500 we see the market benchmark breaking through resistance and the CBOE Volatility Index (VIX) dropping below 30 for the first time in a while. See the two charts below:

The S&P 500 breaks above resistance

The VIX dips under the 30 level

The favorable economic reports and news on the European debt crisis along with the technical confirmation is exciting and encouraging. There are trillions of dollars on the stock market sidelines waiting to boost this market to greater heights but a large percentage of retail and institutional investors are hesitant to jump in. One of the issues that you may be hearing about in the near future relates to the lack of adequate liquidity for the institutional investors impacting their bid-ask spreads and pricing opportunities. We also must keep an eye on global issues taking a turn for the worse. That seems to be of more concern than our own economy. In my humble opinion, it is still premature to plan the party for a new, explosive bull market but I like what I see of late.

Summary:

IBD: Market in a confirmed uptrend.

BCI: Cautiously bullish but starting to integrate a small percentage of out-of-the-money strikes into my covered call portfolio.

My very best to our wonderful BCI community,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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25 Responses to “Investor Psychology and the Need for Structured Plans”

  1. Barry B October 29, 2011 1:31 pm #

    Alan,

    Great article! You should run this piece every few months because the concept is so critical to long term trading/investing success.

    Barry

  2. Kevin October 29, 2011 2:30 pm #

    Alan,

    Congratulations on your latest book. Packed with relevant information and the color charts and graphs make the learning process easy to follow. A job well done.

    Kevin

  3. Barry B October 29, 2011 4:18 pm #

    Premium Members,

    The Weekly Report for the week ending 10/28/11 has been uploaded to the Premium user website.

    Best,

    Barry and The BCI Team

  4. Fred October 29, 2011 6:03 pm #

    Alan and Barry,

    I love this weeks stock list. Plenty of excellent choices despite several with earnings coming up.

    Fred

  5. Barry B October 29, 2011 6:44 pm #

    Fred (#4),

    Thank you for your comments. It takes 8-9 hours to assemble the report. This week , with all of the choices (industries, prices, betas, div. yields, etc.) you have a great opportunity to add a lot of diversification to your personal watch list.

    Best,

    Barry and The BCI Team

  6. Barbara October 30, 2011 5:24 am #

    Alan,

    What type of return would you be looking for with 3 weeks left on the November options selling in the money strike prices?

    Thank you.

    Barbara

  7. admin October 30, 2011 11:51 am #

    Kevin (#2),

    Thanks for those kind words and to all our members who have sent direct emails regarding my new book. Your generous remarks mean a lot to me.

    Alan

  8. admin October 30, 2011 12:13 pm #

    Barbara (#6),

    With one week of time value eroded from premium values, we would lower our goal of 2%-4%, 1-month returns in normal market conditions. Using in-the-money strikes also slightly lowers our expectations because we are trading in the highest returns for very good returns with additional downside protection. Therefore I would expect to generate returns towards the lower end of the 2% – 4% range. With a healthy watch list like we have this week this should be an easy task. I have randomly selected a stock to calculate: QCOR. As of market close on Friday October 28th here are the option chain stats:

    Stock price: $41.75
    November $40 call: $2.85
    Expiration Friday: November 18, 2011

    These figures are entered into the Ellman Calculator and the results are as follows:

    ROO = 2.8%, 3-week return (time value only)

    Downside protection OF THE PREMIUM PROFIT = 4.2%

    This means that our 2.8%, 3-week profit is guaranteed as long as the share price does not decline by more than 4.2% during the next 3 weeks. Below is a screenshot of the Ellman Calculator with these stats highlighted in green. Click on the image to enlarge and use the back arrow to return to this blog:

    Alan

  9. FrankK October 30, 2011 10:22 pm #

    Got your new book last week and have had time to skim it. Seems to have most of what was in your other books with some additional useful comments. I love that it’s all in one place. great job.

  10. Fred October 31, 2011 3:20 pm #

    Just checked my portfolio and was surprised to see I’m actually up for the day thanks to hans, nus, tif, bbby and pii. I was expecting a bloodbath!

    Fred

  11. Mark November 1, 2011 8:09 am #

    Alan,

    Does your 20-10 rule apply to in the money strike prices as well as out of the money and at the money? Thanks.

    Mark

  12. owen November 1, 2011 10:31 am #

    Mark,

    The 20-10 guideline (not rule) is there suggest that there might be a better use of the funds in that trade. If you have three weeks left in the position you should seriously consider closing it and letting the funds make you some additional profits in the current month. If you only have three days left in the position you should consider leaving it until expiration, or consider a position for the follwing month. Personally, I have a deep mental block about paying the broker $17 to close an $8 trade, but I am seeing a doctor about it.

  13. owen November 1, 2011 10:42 am #

    This week’s entry from Alan brings back my previous posts about setting a downside percentage limit. Your exit strategies should include a simple rule that if a trade has lost a certain percentage (closer to 8% than 70%, by the way) that you will close it and move on.

    It’s a simple rule of math. If you lose 50% of your investment you must now generate a 100% return JUST TO BREAK EVEN! If you set a loss rule of, say, 6%, you will still have a reasonable amount of capital left from the trade to move on.

    Losses are inevitable. The only person who was right 100% of the time was Ivan Boesky, and he got 2 years in jail, and a hundred million dollar fine, when the government figured out how he did it. If you take a small hit, and move on, you will survive. If you take a large hit, you may not have enough left to continue investing.

  14. Mark November 1, 2011 1:18 pm #

    Thanks Owen. I always find your comments insightful and entertaining. Keep em coming.

    Mark

  15. Les November 2, 2011 6:43 am #

    How deep in the money should we be selling our options given the unstable situation in Greece?

    Thanks.

    Les

  16. admin November 2, 2011 11:46 am #

    Les,

    Here is how I approach these situations:

    1- Go to an options chain for the equity you are interested in.
    2- Jot down the premiums for 1,2 or up to 3 strike prices below the current market value.
    3- Enter the stats into the “single” or “multiple” tabs of the Ellman Calculator.
    4- Evaluate the ROO (initial time value return) and downside protection (of that initial profit).
    5- Decide on the best strike based on your market assessment and personal risk tolerance.

    Note that the deeper in-the-money the strike is, the lower the ROO as time value approaches zero as the strike goes deeper in-the-money.

    Alan

  17. brian ketover November 2, 2011 5:04 pm #

    Just got through your 3rd book—Congratulations Alan-another great read- another home run–outstanding!!–Brian Ketover

  18. Ted November 2, 2011 7:10 pm #

    Alan,

    I want to echo Brian’s comments about your new book. I especially liked chapter 6 on calculations. I was never much for math but after reading (and re-reading) that chapter I feel that I have a deep understanding of the numbers.

    Kudos!

    Ted

  19. Jeff November 3, 2011 8:13 am #

    Alan,

    How can I get a copy of the calculator you mentioned in comment 16?

    Thank you.

    Jeff

  20. admin November 3, 2011 1:03 pm #

    Jeff,

    If you are a premium member, the Elite version of the Ellman Calculator is found in the “resources/downloads” section of the premium site. There is also a user guide in that same area. If you are a general member, send me an email (alan@thebluecollarinvestor.com) and I’ll send you a copy of the Basic Ellman Calculator along with its associated user guide.

    Alan

  21. Fran November 3, 2011 3:51 pm #

    Alan,

    How close to expiration friday do you consider rolling your options? Tomorrow too early? Thanks a lot.

    Fran

  22. admin November 3, 2011 5:37 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    Not a premium member? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  23. admin November 3, 2011 7:08 pm #

    Fran (#21),

    Generally I consider rolling strategies as close to expiration Friday as possible. The main reason relates to the risk involved in owning the underlying stock. Why not keep it to just 1 month? If the strike is in-the-money we have protection of our initial option premium so why not ride it to expiration Friday and then evaluate whether you want that equity in next month’s portfolio? An exception to this is when the strike is so far in-the-money that the time value approaches zero. In that case you may want to close your entire position and use the cash to execute a different cc position and set up a second income stream in the same month with the same cash.

    Alan

  24. Barbara November 4, 2011 6:49 am #

    Alan,

    On page 264 of your newest book you discuss the mid contract unwind exit strategy. How late into the contract can this strategy be used?

    Thanks for all your help.

    Barbara

  25. admin November 4, 2011 10:27 am #

    Barbara,

    I absolutely love when I implement this strategy. It really can be employed at any time during the contract cycle as long as the cash generated from your new position is greater than the time value of the closed short option position. For example, if the time value of the original short option is $0.20, you would want to generate a greater time value with the new position. Practically though, it would be difficult to generate a great time value the last week of the contract as erosion of time value declines precipitously the last 2 weeks of the cycle as shown in the graphic below.

    Alan

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