The Options & Spreads article that follows has been written by an expert who trades successfully for a living. He also offers a course on trading Options & Spreads. For more info on the course click here.
The following article is very educational, informative and well-written.
OPTIONS & SPREADS: The Mental Kitchen & Back Stairs
Investor psychology is currently a hot topic but an embryonic one, not well-developed enough to spin off conflicting theories or doctrines. On Wall Street one does not hear of Freud versus Jung or gestaltist versus behaviorist. What prevails there is more like the pocket psychology of the pilot and the flight instructor who know the hazards of panic or confused judgment.
This can serve a practical purpose, like the barstool philosophy of one soldier telling another, "Don't let close calls shake you. As long as the bullet missed, an inch is as good as a mile." Yet saloons often foment misinformation and psychology may tend toward the intricate and confounding.
I make no claim to being the Sigmund Freud of independent traders, I have received several letters asking what I consider "the personality traits necessary for successful trading." I hereby make a humble effort to look behind the facade of speculators and speculation, to scrutinize the psychological kitchen and back stairs.
My favorite definition of "neurotic" is concise: Self-defeating. My favorite example a brief and humorous one: The psychiatrist asks the man on the couch, "What was it you said?" The patient replies, "I said nobody seems to like me. Now pay attention, you overpaid fat-head!"
Thus a neurotic is someone who routinely plants land mines in his own path or snatches defeat from the jaws of victory. He wants health but keeps drinking too much. He wants to achieve but abandons projects shortly after square one. Or he not only errs but persists in doing so.
Rule One: Do not be self-defeating.
How about a humorous example apropos to investment and profit? During a comedy-skit interview, Bill Dana as Jose Jimenez said that he used to own a ranch. "It was called the Rocking Chair, Circle-V, Twin Mountain, Bar 20, Double Diamond, Half-Moon, Tumbleweed Ranch."
'Was it a big spread?" the interviewer asked.
"Did it have a lot of cattle?"
"No, not many survived the branding."
I used to laugh loudly at the preposterous notion of wranglers destroying a bellowing steer with a giant, red-hot iron, then doing likewise to the whole herd one at a time, with nobody ever saying, "Hey, maybe this ain't a good idea."
Surely nothing resembling this could ever happen in real life, I thought. How wrong I was! Traders in futures and options make the same mistakes not just once or twice, but with monotonous regularity. Bring on the next head of cattle.
Although I had mixed opinions about Bill Gallacher's book Winner Take All, I endorsed his advice, "Never add money to your trading account . . . Writing a second check to a broker is an admission of defeat." Many traders do take repeated beatings and respond by writing repeated checks to replenish their brokerage accounts.
A bad idea, Gallacher says. Good money management, i.e., the limiting of risk, is keystone-essential for successful trading. Adding capital increases risk instead of limiting it. I would go one step further and say that the trader who keeps on writing checks creates a "plan" or a 'program" for financial loss instead of gain!
Here we detour to throw some light. Automatic investment plans have gained popularity in recent years. The original or prototype-model "automatic investment plan" dates back many decades and was an accidental discovery. The managers of a trust received simple instructions: Invest the money half in stocks and half in bonds, then keep the two sides even value-wise.
So when the stocks increased in value, the trust managers sold some of the shares and used the money to purchase bonds, making the two ends of the portfolio equal again. When the stocks fell, some of the bonds were sold and the money used to buy shares. For several years the trust generated income as expected via both interest and dividends.
Then the people made a happy discovery. The total value of the portfolio had increased markedly, even though it had not been designed for growth. How in heaven's name? The trust managers had bought stocks low and sold high, again and again and again. Keep it even was motive, growth the side-effect.
The "automatic investment plans" published in book form in recent years do take-offs on this. (For example, using fluctuating mutual fund shares with fixed-at-a-dollar money-market shares; changing the proportions from half & half). Remember, though, that the original "unplanned plan" developed accidentally and can "spawn a mutant" in the hands of traders which methodically destroys capital.
Let's say a trader has a brokerage account, plus a bank or money-market account, plus employment income. Let us say that the trading account posts repeated losses. Well, at least that does not affect the cattle in his other money corrals. At least he is smart enough to limit the risk.
But wait. First he replenishes the depleted brokerage account with money from employment income. Then from the checking account. Then from both. Some go as far as the pawnshop and a mortgage. Worse than throwing good money after bad, the trader has created an "unplanned plan" structured and circuited to lose capital.
Repositories which preserve or increase money are systematically drained. That which destroys or devours capital is systematically fed, again and again and again. Losses become de facto "signals" to dish in more cash, a cannibalist counterpart to automatic investment plan "signals" for buying or selling stocks or bonds or fund shares. The supreme self-defeat.
Numerous other roads lead to self-defeat. Over-trading, for one. More than 10% of risk-capital per venture is too many cattle under one hazardous branding-iron. I use that for semi-armored spread strategies, less than 10% for anything riskier. Averaging down or averaging a loss: One log on the wrong-direction raft of going against the trend instead of with it. Buck not the trend. Don't be a money-losing fat-head!
Rule Two: Cultivate a sense of detail, including a sense of succinctness regarding material information. Key definitions to follow.
In Germany during the 1920s, young film director Fritz Lang had problems. His first wife caught him in the arms of another woman and subsequently committed suicide. The police suspected Lang of murdering her; grilled him at length. On dingy walls of interrogation rooms, he saw visions of prison gates, chaplain and executioner.
Fritz Lang was released without being charged but the experience left its imprint. He became very alibi-conscious. He kept written records of phone numbers he called, people with whom he had appointments or met unexpectedly, items on a menu where he dined. Taking a stroll, he wrote down the tag number of a parked car, the headline and the news-dealer's gold tooth. Attending a stage play, he made a jotting on the printed program about the actor who limped or the one whose wig was on wrong.
This carried over as the sense of detail for which Lang's films were noted. Also their moral chaos, with innocent people being arrested and guilty ones going free. A successful trader in futures or options or other securities needs a keen sense of detail. Plus an awareness of the markets' moral chaos. The exchanges do not always reward virtue or industriousness, or make a winner of the good guy in the white hat.
Let us clarify as to which details. Financial vocabulary and definition make a distinction between "material information" and "all information," the former defined as "that needed to make an informed investment decision," the latter meaning too much info, mostly superfluous.
A hack novelist spends several pages describing the view from the study; too much data, tedious and unnecessary. Contrarily, gag-writer Robert Orben penned a joke, "When I went to school, I was an honor student. Yes, your honor. No, your honor." This dialogue-detail tells us plenty briefly, sparing us a six-page description of the courtroom. It is succinct.
I never heard that word until my second year of college, and it deserves greater popularity. Related to "cinch"' and "cincture"--packed, enclosed, fastened--succinct" is the words and phrases equivalent of "condensed" or "compacted." While "terse" and "concise" emphasize brevity, "succinct" stresses the high content within that brevity--a lot in a small space.
I go through trading and investment books--and other books--armed with a red pen, underlining key sentences and phrases, bracketing paragraph portions, sometimes asterisking vital paragraphs, rarely blessing a page or passage with a pentacle. Always I seek the sections that tell more than might be expected from their size, the pivotal lines, the see-the-world-in-a-grain-of-sand details. Caravels tightly-packed.
As a trader and student thereof, can you develop a Fritz Lang sense of detail, including an eye for details that are succinctly significant? Now for a test of your ability to observe, evaluate and visualize. Italian Renaissance artist Correggio (1494-1534) was written about in 1877 by John Addington Symonds:
"The unity of his work is derived from the effect of light and atmosphere, the inbreathed soul of tremulous and throbbing life, which bathes and liquefies the whole. It was enough for him to produce a gleeful symphony by the play of light and color, by the animation of his figures, and by the intoxicating beauty of his forms."
"His angels are genie disimprisoned from the chalices of flowers, houris of an erotic Paradise, elemental sprites of nature wantoning in Eden in her prime. They belong to the generation of the fauns . . .
"Correggio's sensibility to light and color--that quality which makes him unique among painters--was on par with his feeling for form. Brightness and darkness are woven together on his figures like an impalpable veil, aerial and transparent, enhancing the palpitations of voluptuous movement which he loved."
"His coloring does not glow or burn; blithesome and delicate, it seems exactly such a beauty-bloom as sense requires for its satiety. That cord of jocund color which may fitly be combined with the smiles of daylight, the clear blues found in laughing eyes, the pinks that tinge the cheeks of early youth, and the warm yet silvery tones of healthy flesh, mingle, as in a pearl-shell, on his pictures."
"Within his own magic circle Correggio reigns supreme; no other artists having blent the witcheries of coloring, chiaroscuro, and wanton loveliness of form, into a harmony so perfect in its sensuous charm."
If you judge the above quotation a masterwork re. sense of detail and succinctness, give yourself 30 points. If you think that the book page containing the above bears a red pentacle from my hand, give yourself another 30 points for understanding the mind of at least one trader--me.
Most importantly, give yourself 40 points if the passage (quoted from Symonds' Renaissance in Italy--The Fine Arts) caused you to do much visualizing: Silver chalices containing orchids and grape hyacinths, Pleiades whose flesh-tints bathe in sunshine, backdrop brocades in ruby or mother-of-pearl.
Then sense-of-detail-wise you are able to hear the grace notes in the arabesque, taste the Loire River breeze in the burgundy, and observe the numbers forming floors of support and ceilings of resistance on the intangible Charles Dow chart or W.D. Gann chart inside your head. You will spot the significant smallness of a spear point penetrating as opposed to the smallness of inconsequential items.
In a past article I mentioned Dow Theory and Gann Theory, Elliott Waves, the Darvas Pyramid of Boxes, Wyckoff Point & Figure and Japanese Candlesticks. All require good sense of detail, whether already possessed or cultivated for the purpose. None are perfect, but all can help sift and assemble the cinched pack of material information from the vastness of total information. Use the Edenic beauty-bloom of your red ball-point.
Rule Three: Get a handle on the convolutions of time, also on the patterns of the past.
Time is a hack writer of formula stories, markedly more prone to repetition than to originality. However, this does not make it incapable of surprises. You will have a fair grasp on the convolutions of time if you regard it as often predictable but not always. A capable trader formulates a sound battle plan calculating what the enemy is likely to do, but to it attaches a worst case scenario.
Psychologically, much depends on people's visions or images of the past, which vary tremendously not just in finance and investments. This makes "getting a handle on" more difficult. After the 1968 assassinations of Reverend Martin Luther King, Jr. and Senator Bobby Kennedy, a sociologist was interviewed on TV.
He said, "Our society has become more violent and this is reflected in our entertainment. The film Bonnie & Clyde is a good example of this. We've fallen in love with a pair of murderers." Really? As compared to what? It sounds like that sociologist was using Lassie movies and Andy Hardy movies as a measuring stick.
Had his knowledge of dramaturgy extended farther back in time, he would have known that the classical Greek dramas and the British Restoration plays did not reflect any increase in murder, incest or other not-niceties.
Do movies, TV, books or magazines cause violence, immorality, or anti-social behavior? A person's answer depends largely on his or her image of the past. Those who say yes are usually the right-wing reactionaries and fundamentalists-people who call themselves "traditionalists" when their knowledge of tradition goes as far back as Shirley Temple.
They yearn for the "good old days" when movies and radio banned the words "bathroom," "pregnant" and "diaper"; when several film studios prohibited infant nudity and topless seven year-olds. Shakespeare devotees know that littering the stage with corpses did not boost the homicide rate in Elizabethan England.
Opera buffs realize that stagings of Verdi's Aida did not cause any young lovers to be buried alive. Art lovers are aware that the Delacroix nudes--conquered, chained, enslaved-did not compel impressionable children to go around hanging chains on undressed women.
Admittedly, I have an ethnic battle-ax to grind. As a proud Italian, I have a short fuse for so-called 'traditionalists" who think that Bernini and Botticelli were hit-men for the Capone mob. For mentality and personality traits, this ilk should trade on the financial firing-line when Rush Limbaugh and Rev. Pat Robertson start discussing Florentine art and grand opera. Or Fritz Lang and cinema with sub-titles.
Cultivating a sense of detail. Getting a handle on the convolutions of time. Having an image of the past that possesses complexity and kinship to reality. A rabbinical scholar dissecting the intricacies of Talmud can do it. As can an archaeology buff scrutinizing a Greek Linear B manuscript or a Brindisi bronze. Or an analyzer of Dutch and Flemish brush strokes. Or a musicologist knowing something more than Tin Pan Alley moon & June. Great for labyrinthine chart/calendar swirls.
But the person who "bought it" when Lawrence Welk palmed off ragtime as clean, decent music from golden yesteryear? (It was the "whore house piano" of the gaslight era, condemned from many an 1890s pulpit.) Or the person who applauds when Ann Landers denounces women's underwear commercials and feminine product commercials in the name of "old-time bedrock goodness"? Buy plenty of old-fashioned savings bonds or expect the worst.
Rule Four: Keep on learning and developing. These are life-long processes.
R&D (research & development) one hears mainly as a corporate departmental phrase. It applies crucially to the individual as well. The eminent physician sits up late reading medical journal articles, to develop himself and keep up in his field. He may complain that only half those articles contribute anything of value to medical science, but sift he must.
World-class opera singers still undergo training sessions with voice coaches. Scholars of all disciplines from computer science to literature to Egyptology take graduate courses and read prodigiously. With finance, however, the league record is spotty at best, especially under independent trader insignia.
Every broker and financial advisor can tell horror stories of people who spend years working and saving money, but do not spend five minutes researching how to invest it wisely. Reading and learning, Research & Development are even more important for the active trader than for the easy-does-it long-term investor.
While on in years, the late magician/author Burling Hull wrote in a how-to piece for conjurers, "Please understand that when I say 'teach' or 'learn,' I say it with no superior attitude. I am learning about magic every day."
Busy and productive in his mental kitchen and backstairs. In his R&D department, no stagnation and no self-defeat. Like a Correggio palette recording and telling much via "the-witcheries of coloring."
Recommended Reading: Lawrence G. McMillan's book Options as a Strategic Investment for its several fine chapters on spread strategy.