Market News

November 28, 2013  Thu 5:45 AM CT

I regularly receive emails about how I must be crazy or stupid to be writing about specific (usually bearish) option activity. These missives come from people who are long the stock and don't want to hear anything negative about it. And while I have come to expect such emails from time to time, please don't be that guy--for your sake, even more than mine.

It is human nature to look for confirmation of what we already believe. That's why salespeople are trained to compliment you on your selection when you're making a purchase.

This is a well researched phenomenon known as "confirmation bias," a topic studied widely in behavioral economics. It is also a major obstacle to sound trading.

The best traders resist this behavioral trap. They actively look for reasons that they are wrong, not confirmation that they are right. Investing legend George Soros is well known for such discipline, and Ray Dalio--founder of Bridgewater Associates, the largest hedge fund--has created an entire culture around it.

Constantly analyzing how you might be wrong can do many good things for your trading. First, it helps refine your thesis, forcing you to reevaluate positions. More important, it can help you become less attached to your holdings.

This leads us to another well known phenomenon dubbed "ownership bias" or the "endowment effect." The premise is simple: We place a greater value on things when we own them, so there are obvious consequences for trading. Once we buy a stock, we value it more highly and are often unwilling to part with it.

Traders sometimes refer to this as "marrying" a position. No matter you call it, it's detrimental to the bottom line.

This is one of the reasons that I am such a strong advocate of trading rules. You should trade from a thesis. You should test that thesis. And when the thesis is no longer valid, you get out.

You also get out when certain things happen. If an option position gets cut in half, you sell it. If it doubles and then pulls back to even, you get out. These rules should be hard and fast, so the tricks our brains and emotions play on us are kept in check. It is even better if you can automate such things, which is not hard to do using a platform such as tradeMONSTER.

Nevertheless, some of the emails I receive truly baffle me. Below is one that came in yesterday, regarding an article about put buying in U.S. Airways.
"Why do you insist on emphasizing one individual that purchased 7,000 options against LCC. This guy has, what, less than 20K invested in this. Big Deal. How do you know its not a hedge, maybe he is long 100K shares as well."
I don't mean to pick on this writer, and we had a cordial follow-up (which is rare in this type of interaction). It is true that we often cannot be certain whether puts are bought as a straightforward bearish bet or as a hedge against long stock in position that is bullish overall.

However, the same could be said of any call purchase, which could be a hedge on a short position and therefore ultimately bearish.  

In any case, I think the writer would be better served seeking out the case against his position, rather than focusing on an article such as the one I wrote. For example, in the case of LCC, the first question to ask is: Why is some large institutional trader opening a bearish trade in the name? What is he or she seeing that I am not?  

In writing my optionMONSTER posts, I analyze trading activity that I see among institutional investors. And while it is often hard to tell exactly what they are doing because of the myriad strategies that can be employed with options, it is worth watching for directional clues if not outright tells.

Those big players may not be right, but their thinking comes from firms that are well funded, full of Ph.Ds, and staffed by savvy traders who spend countless hours and money on the markets. So behooves us at least to pay attention.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter of Nov. 5.)
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