Option Investor

Covered-Calls 101

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Stock Buying Basics: Understanding the "Herd" Mentality

Profitable trading requires observation, comprehension, and action. A successful trader must be able to monitor a wide range of technical indicators, know how to distinguish the early stages of a rally or decline, and be able to recognize the turning point in a primary trend. But, it is not enough to be aware of commonplace activity and discern only the broader movements. A trader must also develop the ability to sense the public's emotional condition and learn to put a variety of sentiment indicators together in context in order to perceive when prices are approaching an extreme in the near-term. Of course, all that aptitude will be worthless if he takes no useful action. Acting upon one's observations is without doubt the most difficult skill to master and when share values become overwhelmed by rampant selling pressure or investors start to exhibit 'irrational exuberance,' the task can be all the more daunting. Unless the trader is a seasoned player, evaluating unusual market behavior may be very difficult, simply due to lack of past experience.

Although it can be very challenging for the average trader to analyze the glut of market signals on a daily basis, there is one condition that is easy to discern and quantify; 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. Indeed, history suggests that stocks will rally once the majority of sellers have been accommodated. On the contrary, there is generally little potential for further upside activity when everyone who wants to buy is fully invested. This condition is typically more apparent during periods of high transaction volume and certainly lends credence to the phrase, "In the stock market, the public is right during the trends but wrong at both ends."

The Bullish-to-Bearish Cycle

Consider the sequence of events that occurs during a bullish-to-bearish cycle. First, the buying phase begins, which eventually generates an increase in share value. If the upward movement continues until the activity becomes well-known, the increased accumulation generally results in additional demand for the asset. At that point, the emotion of the moment can start to affect investor mentality, causing many retail players to initiate new positions near the top, just as the stock is finishing its rally. By then, nearly everybody who is bullish on the issue already owns it and there are few buyers left to support the inflated price.

The professionals (mostly scalpers and momentum traders) are 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, daily volume drifts lower and the primary groups with long-term interests; the institutions and the general public, compete to determine the next trend. When the historical pattern exhibits the first signs of failure, the technicians begin to sell in earnest. Analysts often raise the company's targets to try to bolster the share value but once the issue no longer responds to 'good' news, the outcome is all too clear. Finally, the public becomes nervous and as the correction takes shape, closing orders multiply. Sadly, the fundamentalist is often the last to go, generally after a full-scale downtrend is in effect.

The Investor's Rationale

From a purely psychological viewpoint, it's obvious how human nature determines a person's actions in the stock market. Hope leads to fear, and then to acute financial anxiety, and the few desperate people that remain through it all (the true amateurs) eventually unload their positions for significant losses. In fact, you can almost feel the angst and hysteria of investors during the heart-pounding selling climax when it occurs in one conjunction with one of these bull-bear cycles.

After an issue has endured a substantial decline, it's tough to overcome the public's fear and loathing, as well as the prevailing disbelief that any recovery is forthcoming. The widespread 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 the current news and research will be unbiased.

The Solution

With these facts 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, being an optimist when almost everyone seems to be selling (or vice-versa) is very difficult even though history suggests that period is often the best time to oppose the crowd. 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. That's why it is so important to always consider the contrarian viewpoint, especially when 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 the long run requires that you act as an individual during those times when being part of the majority simply contributes to the current herd mentality.

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