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Covered-Calls 101

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Understanding Market Psychology & Sentiment

There are a number of ingredients that must be present in any successful investment portfolio. The inventory of resources that one needs to stay ahead of the market can be daunting to new traders. Most novice participants become overwhelmed with the vast amount of information and ideas that must be absorbed before consistent profits can occur. The best way to begin is to focus on those strategies and techniques that have a proven history of generating a prosperous outcome. Today we will discuss the effects of public sentiment in the stock market.

The first thing new investors must learn when they enter the market is the importance of human psychology in the buying and selling of stocks. This emotional component has absolutely nothing to do with the fundamentals of the company, but it does have an overwhelming affect on the share value. Of course, the idea that emotion determines stock prices may contradict the opinions of many valuation investors but when you understand the changes produced by public sentiment, it becomes much easier to discern the broader, more technical movements in the market.

The primary unwritten rule is that rumors are one of the prime movers of stock prices. It's amazing how quickly speculation of upcoming events can change the character of the current trend. The market anticipates the movement of the economy and shows us in advance what we can expect with regard to corporate health, unemployment, interest rates and other financial trends. When investors and analysts begin to discuss bearish trends, the market generally reacts negatively because the public believes it is destined for a downturn. In contrast, when an upcoming financial report is rumored as favorable, the market erupts far in advance of the actual announcement. Understanding the many subtleties of the media's affect on the stock prices is one of the basic prerequisites for long-term success.

As strange as it may seem, the common trait among professional traders is they rarely go along with the crowd. That is the primary reason institutional investors are so successful when stock values are ruled by emotion. History suggests the first indication of a potential bull-market correction is a period of euphoria. That occurs when risk is no longer discussed and previous losses are forgotten. As the bullish trend becomes prominent and well-defined, the investing public grows more comfortable with higher price-earnings ratios and historically low yields. The idea that "this time it will be different" becomes an accepted theme. Monetary greed drives undisciplined buyers to purchase stocks near the market top and when the inevitable correction finally occurs, they are unable to accept the truth. Fear eventually pushes the same investors to sell near the market bottom, at the worst possible time. The key is to avoid the impulse to buy near the height of the rally just because the market is up and everyone is talking about their successes. You must fight the fear that would draw you into the stampede.

Unfortunately, resisting the impulse to sell amid panic is only half the battle; the even tougher challenge is to buy during this hysteria, when it appears the market is at its worst. Of course, that is indeed the case, and it is the one reason you should be buying while everyone else is selling. When large numbers of traders act the same way at once, a classic climax ensues, bringing opportunities for those who are adept enough to recognize the activity. The central basis for this type of thinking is the requirement to approach the stock market from a contrarian viewpoint; one that opposes the views of the collective majority. Only in this manner can you avoid the tendency to react emotionally in the heat of the moment rather than using a sound and sensible investment method based on proven strategies.

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