Option Investor

Covered-Calls 101

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Market Cycles & Investor Sentiment

The recent abrupt decline in share values has many investors wondering if they should "buy the dip" in hopes of a long-term economic recovery or "sell on strength" in anticipation of an extended bearish trend. Indeed, the question of how best to commit one's investment dollars is a hot topic and opinions about this dilemma are prevalent in a number of current commentaries from so-called market gurus. With the outlook for stock prices somewhat unclear, it seems like a good time to review the concept of "contrarian" thinking.

Successful investing requires observation, comprehension, and action. Through education and practice, even a novice trader can learn to evaluate the primary trends, investigate facts to determine the real reasons behind market-moving events, and eventually identify the early stages of a rally or decline. But, it is not enough to merely observe the activity and discern the movements. You must also develop a sense of market emotion and learn to put a range of indicators together in context, thus improving your ability to perceive when a trend is approaching an extreme. Of course, all that aptitude will be worthless if you take no useful action. Acting upon your observations is without doubt the most difficult skill to master and when the market is overwhelmed by rampant selling pressure, the task can be all the more daunting. Unless you are a seasoned player, it is difficult to evaluate the market's unusual behavior for lack of past experience. However, there is one condition that is easy to observe: the opinion of the masses. For example, when the majority of participants are in agreement on the current outlook, there is a high probability that a move in the opposite direction is forthcoming. In simple terms, stocks will rally when every seller has been accommodated. In contrast, when everyone who wants to buy is fully invested, there is little potential for further upside activity. You have all heard the phrase, "In the stock market, the public is right during the trends but wrong at both ends," and that statement was never more correct than in the current environment.

When the market is in a bullish trend, the emotion of the moment generally dictates the activity, causing the majority of typical stock buyers to enter new positions near the top, when most issues are finishing the rally. At that point, everybody who is bullish on the asset already has it and there is no one left to support the price. The professionals are the first to exit, quietly closing out their positions while the public is overwhelmed by glowing earnings reports and bullish forecasts. As the stock struggles to hold its gains, trading volume drifts lower and the primary groups trading the issue; the technicians, the fundamentalists and the general public compete to determine the next trend. When the historical pattern exhibits the first signs of failure, the technical traders begin to sell in earnest. Analysts raise the company's targets to support the inflated share value, but when the issue no longer responds to good news, the outcome is clear. Soon the public becomes nervous and as the correction takes shape, closing orders increase in number. The fundamentalist is the last to go, generally after a full-scale downtrend is in effect. Using this type of psychological analysis, it becomes obvious how human nature determines our actions in the stock market. Hope leads to fear, and then to panic, and the few that remain through it all (the inexperienced) eventually unload their positions for significant losses.

After the market has endured a substantial decline, it's hard to overcome the public's fear and loathing, and the widespread disbelief that any recovery is forthcoming. The general panic propagated by dour doomsayers and the media's sensationalistic coverage of every negative event often creates an apparently insurmountable obstacle. The act of buying into weakness, in opposition of the crowd, will always feel uncomfortable and when the time comes to make the trade, it's unlikely you'll have all the necessary information. With that in mind, it's easy to see why anticipating a change in the direction of the market is more an art than a science. In addition, those who hear your opposing views and witness your contra-intuitive behavior will likely voice their opinions, and they may eventually convince you to abandon your independent line of thinking, at precisely the wrong time. The important issue is to always consider the contrarian viewpoint, even if the perspective leaves you alone in your outlook, without confirmation from the masses. Remember, the stock market moves quickly from one extreme to the next, and success in investing requires that you act as an individual during those times when being part of the crowd simply contributes to the current market behavior.

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