Don't Cross Your Pain Threshold
 |
Jon Najarian OptionMonster .com |
|
Given the heroic move made by the market since the March 6 lows, it is not surprising to hear stories from investors bemoaning the fact that they missed the move. Trust me, folks, this is a broken record, and you will hear it time and again for two main reasons: fear and greed.
We like to say these are the fundamental catalysts for trading, and the theory was reinforced again in the fear that drove investors out of the markets and the greed that is driving them back in now. It's like dating someone you know is going to break your heart even though you know they've got a history of doing just that.
There are myriad reasons people elected to exit the market at or near the March lows. The main one was that they were trading outside their pain threshold, and when you do that you can't see anything but the losses piling up in your account. One of the primary reasons for this is that the investor is simply in too deep.
They may have doubled down, buying shares at $50 and adding to the position at $30, thus entering at an average price of $40. Their initial investment at $50 was probably at their threshold, which most of us trade at all the time.
They may have started with 1,000 shares, then another 1,000 shares at $30, and as the price fell to $22 every dime along the way triggered a gag reflex and further eroded their judgment.
There are several ways to avoid trading outside your pain threshold. One is to decide that you are indeed going to scale into a position. If that's your decision, then halve your initial buy or sell. The 1,000-share investor should therefore buy or sell 500 and hold off on the balance, never committing more than his or her full limit.
Another solution is not to trade stock at all but instead use options, buying calls or call spreads. If you do this, you don't commit the same capital that 1,000 shares would control. In the case of that $50 stock, 1,000 shares is a $50,000 investment.
That investor shouldn't buy more than a 10-lot of calls or call spreads. Sure, with the leverage of options you could easily buy 50 calls and still invest considerably less but, remember, options are wasting assets--they can and will expire. If your timing is off, you could lose a lot of money frighteningly fast.
Jon "DRJ" Najarian is a professional investor, noted media analyst and speaker, and co-founder of optionMONSTER®. Following a brief stint as a Chicago Bears linebacker, Jon launched his financial career at the Chicago Board Options Exchange (CBOE) in 1981, trading in the pits for some 25 years. In 1989 he founded Mercury Trading, running the company for 15 years until 2004, when he sold his floor-trading operations to Citadel, one of the world's largest hedge funds. More recently, Jon--often known after his CBOE floor call letters "DRJ"--has developed and patented trading applications used to identify unusual activity in stock, options, and futures markets. Most notable is the Heat Seeker® program, which uncovers extraordinary buying patterns from among the millions of quotes per second that stream from America's stock, options, and futures exchanges. Jon is a regular contributor on CNBC.