Decisions, Decisions.
Well, so far September has been a real dud. Dismal. And it’s only got this week to redeem itself. We’re at an interesting place, sitting right on support – is it going to break down? I have had quite a few emails about limiting losses – understandable after the last couple of weeks. People feel their losses much more than they feel a gain of the same size. Illogical, yes, but many experiments show that.
Prospect Theory
To illustrate this, suppose you are presented with two decisions about profits and losses:
- Decision 1: You have a 100% chance to make a profit of $450 OR a 50% chance to make a profit of $1,000.
- Decision 2: You have a 100% chance to make a loss of $500 OR a 50% chance to make a loss of $1,100.
What decision would you make? You might think that it depended on the person, and that risk averse people would choose the first option and people with a high tolerance for risk would go for the second option. However, that’s not what actually happens.
When deciding between a certain profit of $450 or a 50% chance of a profit of $1,000 people were risk averse. They chose a certain profit of $450 over the 50% chance of $1,000.
But here is where it gets interesting.
Where hey either made a certain loss of $500 or had a 50% chance of $1,100 loss they became risk-seeking and chose the 50% chance of a loss of $1,100.
What would you have decided?
When I first read about the study I went along with the herd, although I hesitated more about the second decision. I was risk averse in profits (who doesn’t want a guaranteed $450?), and then I was risk-seeking in losses (I might not make any loss at all, whereas if I choose the $500 loss then I’m locking in a definite loss.)
Does this have an effect on how people trade? Absolutely.
Investors settle for less risky stocks with smaller profit knowing that they are a ‘sure thing’, hence the emphasis on ‘blue chip’ or ‘quality’ or ‘dividend’ stocks. They don’t want to invest in little startups that, while they may have a chance of becoming the next Apple or Google and make an enormous profit, also have a significant chance of crashing and burning.
However, when they come to selling their investments, it is a different story. When things are heading south there is a reluctance to sell and ‘crystallize’ their losses. Investors hope that the losses will only be temporary, and that it may yet turn into a profitable trade. So, they hang on to their losing investments.
People make irrational decisions, especially in the heat of the moment. When you are under pressure in a losing position, your emotions often control you. That’s why outcomes are better when you make your decisions with a clear head. And that means deciding in advance what will cause you to sell and get out of the market.
If you have a backtested strategy, and know that it will get you out before you make large losses but not whip you in and out unnecessarily, then trust the strategy.
SPY Chart
We have dropped right through support at $445, and are resting on support at $430. If it drops through this, we should be getting ready to exit the market. Currently, there is a gap of around $24 between the 10 and 200 SMAs which needs to be closed if we are going to get a death cross, our OUT signal. We started the year at $380, we are now at $430 which is a 12% increase, nice but not wonderful. In July we reached the peak of $458, and an increase of 20%, which was much nicer.
We are not yet in correction territory, which is 10% below the most recent high. SPY has to reach $412 for that. We are 6% below the recent high, but it is still painful.
You always berate yourself with the ‘why didn’t I sell at the top?’ routine and then beat yourself up. Well, I do anyway, even though I know better. But it’s pointless. We are all brilliant traders in hindsight. I will leave the last word on that to Sir John Templeton:
SPYG Chart
SPYG is also sitting on support, at a level it first reached in early June, which means that we have been going sideways for almost 4 months. Unlike SPY, in September SPYG reached resistance at it previous high of $63 which it reached in July. Since the start of July we have been in consolidation ($59.50 – $63) and as for SPY we will be looking closely this week to see if we bounce off support or drop through it.
QQQ Chart
QQQ looks similar. It has been consolidating since early June, and is sitting on support at $358. Of you are into chart patterns, then you can see a head-and-shoulders pattern, with the right shoulder higher than the left which is often considered a bullish sign. However, I think the thing to keep our eye on is whether support at $358 holds or the price breaks down. This week should be interesting.🙀
VIX Chart
The VIX has turned up, but is still under 20, so technically we are in a low volatility market. It is now at the same level as it was in early August, when the lovely uptrend finished.
Daytrading Experiment
I am getting extremely fed up with this – not only am I losing money, but it is boring! I started with $5k.
I can’t help but wonder if my following someone makes them suddenly lose their edge? It always seems to happen. I remember in his book, Best Loser Wins, he said that he had not had a losing day for 15 months (or thereabouts), but look at his results from last week:
Profit: GBP 64,300
Loss: GBP 83,200
Net Loss: GBP 18,900
I will keep going to the end of the month and see how his monthly stats are (his weekly snapshot is below), but I am enjoying it so little I just want to stop right now!
ITMeter
The Future
This will be an interesting week – whether good or bad is yet to be seen. All eyes will be on support to see if it holds. At time of writing (11 hrs to market open) the futures are up a bit, so lets hope we are in for a good week. Goodness knows, after last week we deserve it!!
Heather
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15 Responses
Heather, I enjoyed reading your Bullish ITM Book. Thank You for it. When I looked this morning at the SPY chain I found that with SPY about 427.25, the Sep 50% 215-strike had an EV of 11.23 about 2.6% and cannot meet your requirements, even though the VIX is at 18.5. had to drop the strike to 35% or the 150 Call to get an EV of 4.12 or your 1% TV requirement. My question is simply if market timing was good to go ( I know it isn’t), which strike should I use? Regards, Ira
Hi – that’s a problem for all of us right now, options are expensive because of the high interest rates, which affect the time value. When they come down option prices will come down also. It was discussed in a previous blog post, and in the comments – here’s the link: https://heathercullen.com/why-are-options-expensive/
The strike that you choose just depends on your tolerance for risk. A strike of 215 gives a leverage of 100% (If SPY goes up 5% the option will go up 10% – + or – the time value). A strike of 150 gives you leverage of 75%, so you win less, but you will also lose less if the trade goes against you.
Technically, we are on a low-risk environment which means that now sudden moves are expected and you will have time to react and sell if your OUT signal is reached.
Sorry if this is rambling – I have a frightful cold and my head is spinning so it may not make much sense but I wanted to answer within the day – but please feel free to get back to me if it doesn’t make sense.
h
Thank you for your quick reply to my question.
Hope your feel better very soon.
Ira
Intriguing. But curious about the back test. You used a 1% time value but today if appears to be a little less that 3%. How does that change the back test results?
Hi – yes, the interest rates going up have affected the options prices so it is not as easy to get options within the 1% stated. I addressed that in the blog a few weeks ago, and we had a lot of comments with some good information – here’s the link: https://heathercullen.com/why-are-options-expensive/
I will try to address it in next week’s blog also.
Re the backtesting – it doesn’t affect the backtesting results as that was accurate when it was done – it does, however, point to it being less profitable in the future unless interest rates come down again.
I am aware of it, and I am starting a new backtest system so that I can backtest more strategies more quickly – you know, automate or die!
h
Message: Heather, I immediately bought your last book on timing the market, which details what does not work.
When might you be releasing your book on what does work, and will it be more than a restatement or slight refinement of your bull and bear market books, both of which I rate 20/20. I was hoping to see an extension of your two base books in this latest one but did not find one.
While awaiting your response, I will read it a second time to see if I find suggestions on how best to time the market rather as opposed to what not to do.
Finally, I could not agree more with your thoughts on the dangers of averaging down in quantity and in playing a game that fire risk without understanding your personal heat tolerance. For me, not losing big-time is a key element to winning reasonably, which conviction prompted my recent questions about entering GTC exit strategies at date of purchase.
Hi! Goodness, your post had me scurrying to find my Timing the Market book to see if I had, indeed, left out the method of timing. (Although I was sure if I had I would have had a lot of people telling me by now!)
Whew! It was there. The timing I used in it was very basic, its on Chapter 3 page 59:
– when we enter a bear market we sell
– when we exit a bear market we buy back in.
It was deliberately very simple, as I was just proving that even the most basic timing strategy could beat a buy and hold strategy. The ITM strategy beats the ‘avoiding bears’ hands down, but the book was aimed at run of the mill investors who believe the financial ‘experts’ rather than options traders.
Hope this helps
h
Your as-always excellent blog comment prompt several questions for the risk-averse reader:
1. When is it too late to prudently take a new position? Please place this in the context of early August and then in that of last week’s activity, or today’s Monday activity after market open. I felt that if I missed the early days following a golden cross, it was too late. Today, I feel like “waitin’ and seein”.
2. Calmly adapted, predetermined strategies: I satisfactorily use a 15% trailing stop/
30% profit exit combo for stocks. I have not yet found a satisfactory gtc exit strategy for options, notably thinly traded ones, whether on SPY, GSPY, or other securities. Help, please.
all the best,
L.F.
Thank you for your kind words – always appreciated! Let me take the questions separately.
1 – when is it too late to enter? This is, of course, the $64 thousand dollar questions. When backtesting, you enter the trade on the ‘buy’ signal (golden cross) and exit on the ‘sell’ signal (death cross). There is no way that I can figure on how to back test an entry on every single day for the last 30 years – but if you have any ideas please let me know. That’s why I do the weekly blog with the chart analysis so that you can get a feeling what the market is likely to do (based on previous chart patterns & trader actions) Right at the moent ‘waitin & seeing’ is probably a good idea. Watching for a drop through support which would mean not a good time to enter. If it bounced off probably a good time to enter.
2.1 15% trailing stop If that lets you sleep at night then its a good idea! I ‘walk the talk’ and don’t get out until a death cross. Which may well be sooner than the trainling stop? Would have to check.IN an abrupt fall like covid it would be a good idea, but if it was a long gradual decline it might not work quite as well.
2.2 The profit exit – again, as for the trailing stop. Good to have clearly defined entry & exit, it takes the emotion out of the situation. But they need to be backtested to see if they perform satisfactorily.
I need to mention ‘thinly traded options’ – the market makers MUST provide a bid/ask for every options, and the prices must be within clearly defined paramters for the spreads so there is never a case when you can’t sell you SPY or SPYG option at a good price as the spread is mandated to be very low, from memory less than 1%. I’d have to check that but I am close.
So even if there is no Vol and no OI, it doesn’t matter on SPY, SPYG and QQQ as they are the most heavily traded ETFs and hence have the tightest spreads.
Maybe I should do a section on this in the next blog.
Hope this helps.
h
I want to start this strategy once SMA 10 crosses ABOVE 200 SMA. Do you have any proof you did sell those DITM options even in 0 volume condition before expiring? Market makers will buy after expiration. But how to sell and roll before expires?
Hi – the 10 SMA crossed above the 200 SMA in January this year, and apart from momentarily converging in March it has been above it since then. Re proof that you can sell DITM options in 0 volume conditions – as explaned in the comment above, the volume has no effect on being able to buy or sell – it simply means that no-one has bought that particular option on that particular day. With SPY there is ALWAYS a bid / ask for every strike and every expiry – the market makers are mandated to do that, so you wil ALWAYS be able to sell your option.
I am not sure what you mean by market makers buying after expiration – do you mean your option gets exercised at expiration? It does, but it is your broker who does that, and it depends on the price of the underlying at expiry, as there is no time value left. You can buy and sell any SPY options at any time before expiry.
I hope this helps. I feel I am missing something here! Please feel free to get back to me if this isn’t clear.
h
After I read your book, I kept thinking about selling the DITM option in the option chain. There was no volume though there were some Open Interests. Even if I am profitable, how can I sell that DITM OPTION? (Kyaw)
Hi Kyaw
being able to sell your option does not depend on the open interest – if there is a bid / ask then you can be sure of selling it. With SPY, you always will be able to as market makers are mandated to provide bid / ask for all options, and also mandated as to the spreads. So – just because an option has had no volume that day does not mean that you wouldn’t be able to sell it.
There are very few stock options that don’t have a bid / ask (i.e. both are zero) but in the bull book I show how to deal with that in the section ‘Teasing the Market Makers’.
However, with SPY you don’t have to worry about open interest or volume – there will always be a bid / ask so you can be sure of selling your options.
at the moment the bear has a longer claw than the bison’s horn (Rodney)
Hey Rodney – at first I thought you were commenting on my photoshopping skills (not great, I know) but then I realised you were speaking metaphorically. Yes, a lot of people are pessimistic, and they may well be right. I am still bullish, but tentatively. I haven’t yet seen anything that makes be turn bearish, but I’m watching.
In short – I don’t know – but then, nobody does!