Have you ever noticed that whenever and wherever a fire erupts most people head in the other direction while firefighters rush toward the fire (God bless ’em)? They know that whatever fear they may have inside themselves must be cast aside in order to save lives. Well, in a similar manner, the same can be said for your portfolio and for making money in the stock market (think dollar cost averaging). The point here is not to, identically, compare the brave heroics of firefighters with the, sometimes, very volatile, blazing gyrations of the stock market; rather, the point I wish to make is that, before looking to jump out the nearest window as quickly as possible when the stock market bursts into flames, one should take some time to truly evaluate the situation before making any (often rash) decisions. The truth is that even the bravest firefighters take a moment to assess a situation before jumping into harms way. Investors need to be able to do the same — especially when your house of investments is burning down all around you.
Fear is a very powerful emotion — much more powerful than greed — and the sophisticated traders on Wall Street know this. Many of them are schooled in human psychology and in those situations that affect human emotions most. This is why individual traders and investors need to be acutely aware of their emotions whenever stressful market conditions arise. To do so, it may help to remember this fact: For every trade/investment position exited in fear, there is someone on the other side of that trade who is purchasing that position with the very real expectation that they will be able to turn a profit on it. This is why it is so important to take into consideration exact situations that are affecting a given stock price at any given moment in time. Wall Street’s fear mongers are constantly looking for ways to scare you out of your positions so that they can make money on your losses — don’t let them get away with it!
One of the most important realizations that individual investors must grasp is the fact that there are limits to almost everything in this world. Infinite and infinity are words that need to be stricken from one’s investment lexicon. This is because, even when it comes to potential gains (or losses), there are forces at work that impose limits. Think of it for a moment: If a person loses “everything,” then what else is left to take from them? And, though Wall Street often seems to operate within a vacuum, unless someone finds a way to make it work outside of Earth’s atmosphere then it will forever be restrained to the limits imposed by the ephemeral world in which it operates. Said differently: “What goes up must come down” (at least temporarily).
People get up and go to work to try and earn a living for themselves and their families and, if they are lucky enough, they have some money left over at the end of the month that can be used to invest for their futures; but those investment dollars are limited. With those limited investment dollars, investors look to find the best place to put them in order to build wealth. They ask family and friends for their opinions and advice, they may consult with a financial advisor, and they may perform Internet searches and read articles to try and gain perspective on current market conditions, and/or to gain knowledge on where best to invest so that they can achieve their future financial goals. Once they find that “place” to park those investment dollars, they take their stake(s) and then sit back and hope that they will be able to watch their investment(s) grow.
Since each investor is different, however, no two investments are the same. Some will want to be broadly diversified, while others will want to be narrowly focused. Some will want to invest in tech stocks, while others will wish to invest in those old stalwarts like Johnson & Johnson (JNJ) or Proctor & Gamble (PG). Still, others, will want to find the next latest, greatest and hottest stock in which to invest so that they can “get rich quickly” and live happily forever after. Nonetheless, with each investor and every investment style there are still limits. Given that no investor has his or her own money printing press (at least not legally) no one investment can be supported in perpetuity: Said differently, no stock price can (or will) climb indefinitely; and, with that in mind, this is where the “short sellers” come into play. Short sellers are keenly aware that all stocks have upside price limits. Once the majority of investors have made their purchases there is nothing more that they can do but sit back and watch the price action. They do not have an endless supply of money that they can use to continuously “buy on dips” whenever their cherished investment takes a nosedive, so there is a always a threshold to buying activity — and short sellers know this plain and simple truth! Short sellers also realize that fear (especially with regard to individual investors) is their greatest weapon in their arsenal. This is the very reason that so many short sellers lobbied to have the Uptick Rule abolished, which they accomplished in 2007, right before the housing market collapsed. How ironic — no?
They knew full well that if they could get the SEC to eliminate the Uptick Rule that they would be able to exact an even greater toll on investors’ psyche. Essentially, by eliminating the Uptick Rule, short sellers are able to drive down stock prices much more quickly and dramatically than they would have been able to do with the rule in-place; and this has had a much greater effect when it comes to scaring investors out of their positions (think of the rout that occurred following the housing market collapse). If short sellers are able to drive a stock’s price down dramatically in a shorter period of time, investors are much more likely to jump ship. This type of trading strategy also dramatically affects those with stop loss orders. Without the limits imposed by the Uptick Rule, short sellers can drive down stock prices even further in shorter periods of time, effectively driving people out of their positions. Even if a stock’s price rebounds after the initial slaughter, the damage has already been done. This type of strategy is most effective during times of low market participation (e.g. during the summer doldrums when large money managers (i.e. those who would normally buy a large number of shares on the dip) are away on vacation). This is why there is, often, greater volatility in the stock market during the summer. Couple that strategy with Wall Street’s negative propaganda machine and you have a perfect recipe for significant price declines, with short sellers laughing all the way to the bank. Why should short sellers worry about summer vacation when they can celebrate their winter holidays in the Bahamas.
Without a doubt, Wall street’s wolves are a very cunning bunch. They are a skilled group of hunters who patiently wait to pounce on their prey like a ravenous pack of wolves (not to insult wolves). They sit back and wait to single out their prey and then they attack in groups (think Bear Raids) and overwhelm their prey with sheer numbers and brute force. Their attacks can be just as vicious as real wolf attacks, creating a truly bloody mess that individual investors watch on their computer screens as their, once hopefully profitable, positions turn blood red with losses. And just like an innocent herd of deer, individual investors first reaction is to run. Fear takes over and the investors left standing have an overwhelming desire to get away from the danger as quickly as possible (it’s part of the human fight-or-flight response mechanism designed to protect us during times of danger).
This is where individual investors need to be smarter than the cannibals on Wall Street. Summertime is perfect hunting ground for short sellers. Many (if not most) of the big money managers head to the Hamptons for vacation, and most pension fund managers wait until the end of summer to make new investments. Volume, the fuel which drives stock prices, dries up and there is nothing left to propel stock prices higher. This is, generally, the time when Wall Street’s negative news engine kicks in. It is a time when even good news can become bad news (think Ben Bernanke’s recent public address on improving economic conditions), and this is a time when short sellers are eventually able to seize the day (carpe diem!).
Don’t let them get away with it by scaring you out of your positions! Do what you can — what you must — to protect your investments. If necessary, “Sell in May and go away.” Otherwise, look into using hedging strategies to protect your positions. Whatever the case, don’t willingly give your money away to “the shorts!”
For a brief time I did some freelance writing for a rather well known financial news site and, during that time, I was instructed not to write articles on Options trading unless they were a part of a much larger discussion on stock trading/investment ideas. Apparently (according to the company), individual investors prefer to own stocks and are not interested in investing in Options. This way of thinking, however, is flawed. To me, it is similar to trying to sell a family a home in a flood zone and not advising them to purchase flood insurance. Yes, Options can be employed in other trading and investing strategies, but for individual investors who wish to protect their investments, Options act as an insurance policy against losses.
One of the more common Options strategies used to protect one’s portfolio during volatile market conditions employ the use of VIX Call and Put Options.
As can be seen in the above set of graphics, the VIX saw increased activity recently (following Mr. Bernanke’s recent comments on the improving economy and the Fed’s intentions to end its bond buying program). Fearful that the economy is still too weak to support itself, investors became nervous when they heard that the Fed was looking to end its “easy money” policy (that is, at least, how the news was presented to us). But, shouldn’t the idea of an improving economy be seen as good news? Apparently not. Even though the patient is up and walking around, and taking in nourishment, it does not mean that we should remove the life support systems that have been keeping him alive all this time (I just snarfed my tea).
Okay, I’ve regained my composure.
Regardless of most people’s ability to receive information and process it in a reasonable and rational manner, the most recent good news (Uhh, Hmm — I mean bad news) was enough to give the shorts the fodder they needed to create a feeding frenzy. Hopefully, those reading this defied their unscrupulous attempts to drive you to the poor house; and, hopefully, you will be able to use this opportunity to pick-up some of your favorite stocks at bargain prices.
Yes, we are living during some troubling times, but we have been living with these troubling times for some time now; and though concern and caution may be warranted (as they are always warranted), the world did not come to an end on December 21st 2012, and the sky is not falling. Don’t be overly concerned with recent market volatility, and don’t allow Wall Street’s Wall Of Worry propaganda machine to scare you out of your wits and out of your stocks. Though I would never advise you to run into a burning, I would certainly suggest that you view the recent fires in the stock market as potential opportunities, upon which the bravest among us can capitalize.
Finally, don’t be afraid to use Options strategies to protect your portfolio. Institutional investors use them, so why shouldn’t you. For an interesting article on how to use VIX Call and Put Options to hedge your portfolio, click here.
Note: Information for this article was obtained from the CBOE, The Options Guide and Wikipedia.com. Charting data provided courtesy of optionsXpress.com.
Disclosure: I own shares of JNJ and PG, indirectly, through Vanguard’s (VTI) ETF.
