We have been hearing a lot about how “derivatives” have increased market volatility. A derivative is a financial instrument or security that can be traded, where the value is “derived” from another security. One of the oldest forms of derivatives is the stock option.
The “basic” stock option is a “right, but not an obligation to buy or sell a stock at a fixed price”. They can be used as a form of insurance, but in most cases they are used by gamblers to increase potential gains as well as potential losses.
One fundamental aspect of most common options is that they “expire” on a given date. In other words, they can become completely valueless on a given day. From the website www.cboe.com (Chicago Board Options Exchange) “The expiration date for equity options is the Saturday following the third Friday of the month. If the third Friday of the month is an Exchange holiday, the last trading day is the Thursday immediately preceding the holiday. After the option's expiration date, the equity option will cease to exist.”
During periods of relative market stability, options expiration does not appear to cause large changes in stock prices. But during periods of extreme fear or greed, it appears that markets sometimes move by large amounts during the week preceding the options expiration date for equity options in the USA. For example, in January and February of 2009, during a period of extreme fear, the S&P500 fell around 10% in the 7 day period preceding options expiration.
On May 12, 2010, the S&P500 closed at 1171. A 10% move down from there would result in an S&P500 level of 1053 or about the same as the 2010 low on February 8. An S&P500 level of 1053 would be a 13.5% “correction” from the 2010 high of 1217. Although such moves down are worrisome, they are not necessarily abnormal nor do they necessarily predict continued decline.
Markets move up because of greed and hope. Markets move down because of fear. In my last blog, I indicated that “As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other.” It is clear that the gamblers or traders have been overcome by fear related to uncertainty. This uncertainty is related to Europe and potential changing of rules in Washington DC.
Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate, but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
There is no way to predict when this current downdraft will reverse. But, you can already hear some of the gamblers beginning to speak about the markets reaching levels where they are comfortable “getting back in”.
Keep in mind that a falling Euro will benefit companies that produce in Europe. It will also cause products made in Europe to be cheaper for American consumers. Keep in mind that falling oil prices tend to stimulate the US economy. Not more than 2 months ago, the headlines were all about the belief that a falling US Dollar was bad. Now, with a stronger US Dollar, there is fear that economic activity will decline. When the headlines seem irrational—they and markets are usually driven by fear and fear in markets tend to create opportunities for buyers—not sellers.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last two weeks has produced a renewed list of opportunities that seem to become more attractive each day.
The days leading up to options expiration can be so much dominated by options induced volatility, it is seldom a good time to make decisions regarding a change of strategy or a decision to reallocate a larger amount of the portfolio to cash/fixed income. Investors should base their decisions on fundamental principles, not a fear of volatility. Volatility is a normal part of market action, particularly during periods of economic recovery.
Markets sometimes tend to act like a herd of cattle. Sometimes the herd moves toward its expected destination rationally—sometimes it just stampedes off in one direction or another and only stops when the members of the herd get tired.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
If you are an investor, it is probably wise to stay the course until we can see more clearly if the economic environment is truly changing.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
The “basic” stock option is a “right, but not an obligation to buy or sell a stock at a fixed price”. They can be used as a form of insurance, but in most cases they are used by gamblers to increase potential gains as well as potential losses.
One fundamental aspect of most common options is that they “expire” on a given date. In other words, they can become completely valueless on a given day. From the website www.cboe.com (Chicago Board Options Exchange) “The expiration date for equity options is the Saturday following the third Friday of the month. If the third Friday of the month is an Exchange holiday, the last trading day is the Thursday immediately preceding the holiday. After the option's expiration date, the equity option will cease to exist.”
During periods of relative market stability, options expiration does not appear to cause large changes in stock prices. But during periods of extreme fear or greed, it appears that markets sometimes move by large amounts during the week preceding the options expiration date for equity options in the USA. For example, in January and February of 2009, during a period of extreme fear, the S&P500 fell around 10% in the 7 day period preceding options expiration.
On May 12, 2010, the S&P500 closed at 1171. A 10% move down from there would result in an S&P500 level of 1053 or about the same as the 2010 low on February 8. An S&P500 level of 1053 would be a 13.5% “correction” from the 2010 high of 1217. Although such moves down are worrisome, they are not necessarily abnormal nor do they necessarily predict continued decline.
Markets move up because of greed and hope. Markets move down because of fear. In my last blog, I indicated that “As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other.” It is clear that the gamblers or traders have been overcome by fear related to uncertainty. This uncertainty is related to Europe and potential changing of rules in Washington DC.
Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate, but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
There is no way to predict when this current downdraft will reverse. But, you can already hear some of the gamblers beginning to speak about the markets reaching levels where they are comfortable “getting back in”.
Keep in mind that a falling Euro will benefit companies that produce in Europe. It will also cause products made in Europe to be cheaper for American consumers. Keep in mind that falling oil prices tend to stimulate the US economy. Not more than 2 months ago, the headlines were all about the belief that a falling US Dollar was bad. Now, with a stronger US Dollar, there is fear that economic activity will decline. When the headlines seem irrational—they and markets are usually driven by fear and fear in markets tend to create opportunities for buyers—not sellers.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last two weeks has produced a renewed list of opportunities that seem to become more attractive each day.
The days leading up to options expiration can be so much dominated by options induced volatility, it is seldom a good time to make decisions regarding a change of strategy or a decision to reallocate a larger amount of the portfolio to cash/fixed income. Investors should base their decisions on fundamental principles, not a fear of volatility. Volatility is a normal part of market action, particularly during periods of economic recovery.
Markets sometimes tend to act like a herd of cattle. Sometimes the herd moves toward its expected destination rationally—sometimes it just stampedes off in one direction or another and only stops when the members of the herd get tired.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
If you are an investor, it is probably wise to stay the course until we can see more clearly if the economic environment is truly changing.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
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