Never Let Hope or Emotion Influence Your Options Decisions

May 16th, 2007

16 May, 2007 -

Case in point. With my GM puts, although they were up at one point 35% (my target was a 50% gain), I ended up selling out at a 40% loss when I got stopped out (normally I’ll set my stop-losses on options anywhere from 25% to 40%). Had in not been for private equity firm Cerberus acquiring DaimlerChrysler, I believe I would have hit my 50% gain as news of that acquisition caused an about-face in the price behavior of GM shares. Now while I still believe GM is a terrible company run by incapable management, the people that influence the sheep-herd do not, and that is all that counts in the short-term game that is the option game. Again, knowing something and having the share price of a company act accordingly on a short-term basis does not always happen due to the irrational thinking that permeates the investment industry. No doubt what helped turn around GM shares is the fact that it was upgraded by several analysts after the DaimlerChrysler deal.

Most analysts are among the most incompetent of all industry professionals yet the sheep-herd follows their advice as if they were oracles. Every week you will see a company get upgraded by an analyst after their earnings quadruple or downgraded by an analyst when their earnings tank. Well that’s something a six-year old can do but still millions of the sheep herd follow analysts like robots. Upgraded? I’ll buy, downgraded? I’ll sell is the typical sheep herd thought process. Occasionally, analysts will upgrade a company or downgrade a company in the face of all logic and contrary to all evidence. And still, the sheep herd will follow. Upon the Chrysler news, Lehman Brothers upgraded GM because of “an increased possibility of GM taking a tougher stance in upcoming union negotiations.” Lehman Brothers further “noted that GM’s disappointing quarterly results may lead to a tougher negotiating stance.”

When I read that, my response was ??? So the fact that a company’s awful situation is now a little less awful is a reason to upgrade the company? I guess these highly-paid analysts took a different logic class than I did. In any event, some of you may ask, “If you really think GM is such a terrible company, why not hold on to your puts and hope that the bump in price was temporary and that the downward trend will resume shortly?” I didn’t because that would violate the number one rule when it comes to investing in options, and that is, don’t let hope ever influence decisions. Because so much irrational behavior influences stocks in the short term (and consequently option prices), you should always adhere to pre-determined price points for exiting gains as well as losses. Occasionally, as in the case of my BIDU options, doing so will cause you to leave further gains on the table, but when an option has turned and has started to run away from you, more often than not, doing so will also prevent a loss from becoming an even greater loss.

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J.S. Kim is the Founder and Managing Director of SmartKnowledgeU™, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.

Entry Filed under: Option Investing