We often think of ourselves as being too logical of level-headed to be turned around by some bizarre social reality. We never bought a hoola hoop. We know Elvis is truly dead.
We all are vulnerable to some extent and we all have our Achilles heels. If you understand how these phenomena of heard psychology work, youll be better prepared to deal with them.And, as an options trader, you must be able to see reality for what it is in order to profitably trade reality. Lets start with a few examples to illustrate the point.In London in 1524, the city awaited its doom.
Numerous astrologers and fortune tellers had foretold a massive flood. The great Thames, one of the worlds best behaved rivers, was to jump its bank and engulf the entire city on February 1. Doom and gloom was predicted by just about anybody anyone would listen to. Over 20,000 citizens, nearly the entire population, moved to higher ground.On February 1st nothing happened. But the charlatans had an answer. A minor miscalculation had occurred.
The flood was coming in 1624. Londoners were safe at least for awhile. sound like any economic forecasters you know?If you think these things only happened in the middle ages and that only the poor dumb masses are caught up, think again.
The red bating frenzy of McCarthyism even caught up the ACLU. That is a group who considers themselves above emotionalism. The fact is they too were swept along in the 1050s and refused to defend suspected communists.This type of behavior occurs in options trading regularly. Traders get caught in the power of mass delusion – Prices are going through the ceiling! , Theres no end to this bull move! – that causes them to lose control of their trading.Lets take a quick look at how these fantasies develop. Our personal and collective body of beliefs can be roughly divided into two distinctly different types.
The first is deeply rooted in physical fact. If wee tough something very hot with our bare hand, we get burned. It is extremely difficult for anyone to get us to change our minds regarding these beliefs.When we get into very complicated areas in which we have strong feelings, yet our understanding is somewhat vague, we tend to rely on others that we consider to be authorities.
In the case of religion, it is ministers or priests. In politics it is politicians. In finance, it is bankers, advisors, etc.
Options trading is no different. It certainly can be complex and vague. We look to professional traders, journalists, brokers, newsletter writers, etc.
When they get caught up in the image of what everyone thinks is happening, they whip traders into a wild frenzy. This pulls the average investor in off the street. Everyone thinks the market will never stop.
Novice option traders get burnt!You need the discipline that comes with an understanding of the mass psychology that can overcome even the best traders common sense. Add to this the courage to stand up to anyone trying to bully you or dazzle you into a trade. As we discussed earlier, successful traders control their emotions.Another pitfall traders can encounter is old-fashioned fraud.
This can involve classic Ponzi schemes, falsified research, or a creative presentation of research. For example, a dishonest broker locates 50 or so prospects who will listen to his pitch. He tells them he is backed by an excellent market analyst who has an incredible system for anticipating the direction of the S & P 500 Index.
To demonstrate just how accurate it is, this pitch man offers to share the research with each of the 50 prospects for the next four weeks. With each weekly call, the prospects are told whether the system is calling for higher or lower prices. Half of the group are told higher and the other half lower.Despite what happens is the S & P, at the end of four weeks, there are at least six people who have seen four perfect market projections. These six are convinced and could be taken advantage of. This is only one of the many, many scams perpetrated against would be investors. There tends to be a common thread among these types of sales presentations, and that is an unbalanced presentation between the possibility of loss compared to the easy gains that can be made.
If you are solicited by a stock or futures broker who is using some type of promotion that delivers an unbalanced presentation of the enormous profits to be made from the market with little or no mention of risk, youll know at least two important facts. First, the material is in violation of federal regulations. Secondly, beware of whoever is presenting the materials If their initial overture is to out of tune, the rest of their song will probably be as well. The nest refrain most likely will be a high-pressure sales presentation, consisting of overnight movement of account papers and checks.
Consider yourself forewarned and keep your distance.Advertising, which is balanced and informative, can be very helpful to you both in deciding if you are suited for options trading and if you want to learn more. As you absorb these type of messages, youll learn how much risk youll be accepting and have a more complete picture of profit opportunities.Youll often see a big difference between the ethical broker and one who plays fast and loose. The former will spend time with you, send you information, such as newsletters, and be sincerely interested in learning about your investment needs. The wheeler-dealers objective is to raise the prospects greed level to such a fever pitch that you buy the dream, rather that reality.
This is high-pressure sales. Theres no time for thought and reflection. Youll hear lines like this:An opportunity this good only comes by one in a blue moon!If you dont get $2,000.00 to me by noon tomorrow, youll miss your chance to turn it into $10,000.
00 in the next two weeks!Gold is going sky high – starting tomorrow!From ethical brokers, youll hear description of opportunities won and opportunities lost. The legitimate sales representative will tell you that sooner or later another good, solid trading opportunity will appear. Youll also be provided with a balanced presentation of the risk, something you wont hear from deal-peddlers. Remember the old adage: An option trade that sounds too good to be true, probably is.
In their booklet, Before You Say Yes, The NFA lists 15 questions that can help you distinguish qualified investment sales people from swindlers. The following is a paraphrased version of those questions:1. What is the commission rate? Other costs?2.
What are the risks?3. Can you send me a written explanation o the risk involved?4. Can you send me copies of your sales literature?5. Are you selling an investment sold on a regulated exchange?6. Which governmental or industry regulator supervises your firm?7. Specifically, where would my money be held?8.
When and where can we meet in person?9. How and when can I liquidate my investment if I so desire?10. Will you send me your entire proposal in the mail?11.
If a dispute arises, what are the means available to resolve it?12. Where did you get my name?13. Would you mind explaining your proposal to my lawyer?14.
Would you give me the names of you principals and officers?15. Can you provide references?Experience has shown that the dishonest sales people usually resist or are not prepared for this type of interrogation. Their marks are impulsive buyers who make entirely emotional decisions. The answers you get are vague and evasive. For example,Question: How much are commissions?Response: Theyre never a problem.
Question: If I have a complaint, what can I do?Response: Dont even worry about that, Ill take care of you personally.By gathering a lot of information and taking some time making your decision, you can protect yourself from the majority of swindlers – but not all. The very best mimic legitimate sale operations, but must can be uncovered if you do your homework and control your emotions.
Another simple procedure you can do to avoid scam artists is call the NASD or the NFA Information Centers and ask these questions:1. Give the name of the person youve talked with and ask if he/she is registered.2. With which firm?3. How long has he/she been registered?4. Has the NASD or NFA taken any public disciplinary action against him/her?5.
Has he/she been registered with any firm that has been cited for compliance problems?6. Is there anything else you can tell me about him/her, since Im considering investing with him/her?Once you decide who you think the right broker is, you make your selection by completing the account papers. Your broker should ask you to read them carefully and fill them out in your own handwriting. The reason for you to do it in your own had is so the broker is assured that you saw them and had the opportunity to read them. The broker will ask you if you understand them and have any questions. The account papers describe the risks you are assuming.
You have no one t blame but yourself if you ignore them or sign them with out reading them carefully.If the broker offers to fill them out for you (Ill just get them typed up for you), consider this a warning signal. The easier the broker makes it for you to fill out the account paper, the less likely you are to study them. They are worth the time and effort it takes to understand what you are signing because they define the risk you face in great detail.Poor communications is another miscue that often occurs between clients and their brokers.
Its important that you and your broker set up some guidelines. Here are some to use to sidestep this problem. Be sure to cover them all before trading begins.1. Time of day you are most easily accessible.2.
Whether you are to call in or whether you broker will call you.3. What steps will be taken if you cant be contacted, i.e., should you broker put stops in the market, close out positions after 4, 8, 12, or 24 hours of not being in contact, etc.4. What steps will be taken if the account goes into debit? do you Plan to wire money into the account? Transfer from another account? Over-night a check?5.
How trading emergencies will be handled.6. What hours you are available and who to contact when you are not available.7. Normal office hours, plus any evening hours your broker is available.8. You may need to provide your broker with your home or office phone number, if thats the only way for him to stay in touch with you.
9. Your broker needs to know who to contact if you are not always near a phone. This person should be able to reach you quickly. For example, farm wives are often in radio contact with their husbands during planting and harvesting.
Many business people carry cellular phones when out of their offices.10. You need to make provisions for unusual situations, such as when you are traveling r taking a vacation.
The point is simply this: It is easy to avoid the mistake of losing contact with hour broker. If a situation arises where you are going to be out of touch, either put stops in the market, close out the positions or even your account. Do not risk trading when you cannot be reached quickly, if the market situation warrants it. If your broker doesnt mention this, be sure you do.
Another common misfire made by new option traders is jumping the gun. Many traders come to the conclusion there is no reason to hesitate since the risk of buying a put or call can be predetermined. They reason: The option only costs $900, or $1,000 including fees and commissions. I can afford that.
Go ahead and buy it.First, if the option expires worthless, you lose 100% of your investment. Think of it in those terms, rather than a dollar amount you can stand to lose.When you think of it as 100%, you start trying to figure how to salvage some of it. What about cutting the loss to 50%? or 20%? Its this kind of thinking that leads to the use of placing trailing stops behind your positions.
The opposite – waiting to long to trade – can be debilitating. Some people wait until they learn everything there is to know about options trading before they place their first trade. Of course, this never happens.On the other hand, if you have the gut feeling that options may not be for you, dont fight it. You dont have to trade. Trading stock and futures options is highly speculative, not suited for every investor.
Never let a broker or friend bully of dare you into trading. Hang up on any broker who challenges like this:if you dont have the guts for this trade,you better get a testosterone check!If you have to ask your husband for permissionto trade, youre not a 1990s woman!Your motivation for placing an options trade should be profit based on a sound, unemotional evaluation of the strategy, the market, and the trades risk-to-reward ratio.A Variation of these last scenarios is the purchasing of an option at the wrong strike price of month because you dont have enough money n your account to buy the right one.
For example, lets say you are considering buying a December crude oil call. The futures price is $20.54 per barrel and youre looking at the at $20.00 strike price. Its at $0.
74 or $740.00 (1000 bbl x $0.74). Since you only have $500.00 in trading equity, you settle on a $21.00 per barrel strike price. Its at $0.
16 or $160.00 plus commission and fees.This is a big change, from approximately 50 cents in-the-money to 50 cents out. The in-the-money call had $500.
00 of intrinsic value and the rest was for time to expiration. Since the out-of-the-money option has less time value than the key error is comprising your strategy to accommodate your wallet. Also, you must resist the suggestion of your broker to down trade in these circumstances. Brokers normally work on commissions and are continuously looking for ways to sell a trade.Youre usually better off searching for a new trade that meets all your criteria and also is affordable – or standing aside the market. Standing aside is a totally acceptable stance.
Inexperienced trader often make the mistake of overtrading, feeling they should always have something going in order to be successful. The pros often sit on the bench when the game is not going their way or they are not sure which way it is headed. This leads to the next subject, which is the proper way to get into the markets in the first place.