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Covered-Calls 101

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The Psychology of Volatility

Volatility in equity prices is a familiar phenomenon to all traders but one has to wonder what causes the extreme changes in the market value of stocks on a daily basis.

Over the past two weeks, there has been a surge in the volatility of share values and even to the investing novice, it's obvious that there are extremely wide day-to-day changes in the prices quoted on the major stock exchanges. Experts have tried to explain and justify the unexpected change in the market's character but the exact reasons for the pronounced increase in volatility remain unknown. Surprisingly, analysts cannot agree on whether it is economic or psychological components that are the primary catalysts for price fluctuations in the stock market. This is an important question in the financial world because the entire basis for fundamental and technical analysis, concepts on which millions of dollars are spent each year, hinges on the answer. If investors were to learn there are no underlying economic reasons for fluctuations in share value, the two most common forms of analysis would be relatively useless.

One of the leading authorities in the study of market volatility is Yale Professor Robert J. Shiller. Shiller is an advocate of the Popular Model explanation of market volatility, which proposes that the public's reactions, due to psychological or sociological beliefs, exert a greater influence on stocks than economic issues. Based on this principle, he suggests that traditional standards of measuring value in common equities no longer apply. That is not to say that Shiller totally disregards the opinions of economists who base their theories on the Efficient Market Hypothesis. On the contrary, he admits that the EMH can be supported by statistical data but he also believes that investor attitudes are crucial in determining share prices.

For those who are new to the concept of Efficient Market Hypothesis, it basically states that all information, both publicly and privately known, is incorporated into a stock's current price. The problem is, recent data suggests that excess volatility exists in the stock market; volatility that cannot be explained by the EMH. Some experts say the excess volatility can be attributed to psychological attitudes such as the public's collective thoughts and beliefs concerning recent and future events. Other authorities note that not all investors are equally informed and even when that is the case in a specific situation, many investors simply react improperly to the data they receive. These observations seem to suggest that all freely available information is not necessarily factored into a stock's current price, thus there is certainly more to share value than the fundamentals of a company and its economic environment.

Most studies on this subject are based on the idea that the public normally acts rationally on the known information. In contrast, Shiller suggests that irrational "herd" behavior has a greater effect on stock prices and that investors are often subject to "attention cascades" triggered by small events. Although there is certainly some truth to this opinion, investing does not have to be rational to produce favorable results. A great example of this concept occurred in the late 1990s during the era of "irrational exuberance." That period produced a deluge of capital investments that led to technology advances that would have been impossible in a less enthusiastic environment. Despite the incredible economic expansion of that timeframe, some analysts believe that unfounded growth in stock value is never good for a company because of the resultant "inflated" capitalization and the potential downfall of future shareholders. In reviewing the conflicting attitudes, one expert noted correctly that, "Irrational exuberance can be bad for the exuberant but good for the economy."

That brings us to a much more important question: Do the recent excessive reactions by investors, which have generated extreme volatility in stocks, mark a critical change in market character? Many analysts believe they do and they cite reasons such as the spike in the CBOE's volatility index (VIX), representing an apparent panic by the public during the recent market declines, and the fact that equity put-call ratios, another indicator of investor sentiment, have surged to a level where some of the previous market transitions have occurred. Unfortunately, the study of historical data, while often a good indicator of future trends, does not guarantee a specific outcome so it remains to be seen whether the recent sharp sell-off in stocks will soon end with a resumption of the current bull market. With this fact in mind, the best course of action is to select covered-writes that will generate an acceptable level of profit while protecting (as much as possible) against the potential for downside losses. In addition, any positions that become unfavorable due to changes in the fundamental or technical characteristics of the underlying issue should be removed from the portfolio before they can generate large deficits.

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