Accept it

chameleon_5

It’s blue, no, it’s green … it’s red! That’s the amazing chameleon. It has the ability to change colours in 20 seconds; as its mood changes, to attract light or just to camouflage. Why is the chameleon the way it is? That’s how it is, accept it.
Why is investing in the stock market so unpredictable, why does it change its mood all so often and why does it go up and down so suddenly? That’s how it is, accept it.
Psychologists say when living objects are faced with unknowns and potentially highly risky and stressful situations, these animals or humans tend to react one of two ways – fight or flight. Some have chosen to flight: as the stock market got more volatile, harder to predict, with more unknown variables, they have kept themselves on the sideline watching the chameleon change colour every day (being what it’s made to be). On the other hand, there are those who stayed on to fight with hopeful optimism – but without arming themselves – not noticing the change in the colour of the landscape, oblivious of the chameleon and its true colours.
Whether one has chosen to flight or stay to fight, the fact is the colour of the chameleon has changed and is going to continue to change. Unless we accept it and adapt with it, regardless of whether we are going to flight or fight we may just not get very far.
If we need to adapt to the chameleon, then we need a palette of colours too that allows us to change like the chameleon does. With options, we are given a brush with a free hand to mix colours according to our expectations and hope, mitigating our fears and making the best from our judgments. Options let us change like the chameleon. It opens up various strategies to allow us to hedge, to protect, to earn income and to reduce capital put at risk. The four variables of the buying or selling of calls or puts, with their varying strikes prices and expiry terms, make the mix colourful and versatile to us as investors.
Let’s just look at two. The buy-write strategy is commonly used. One might say “the market is so volatile, I will stay out”, or another might say “the market is so volatile, why don’t I use the buy-write strategy to reduce the cost of share purchase while earning some extra income”.
NAB was a perfect share for the buy-write strategy in late May this year. NAB was around $26 with a couple more weeks to an ex-dividend payment of 84 cents per share with franking credits. The price of $26 was about the mid-range for the stock in the past three months. Stocks that carry a hefty dividend with franking credits such as NAB tend to be sluggish and fall slightly after it goes ex-dividend. Investor A wants to be able to own NAB, earn the dividend income and yet be somewhat protected to the downside. Investor A achieved that by selling call options for extra income in addition to buying shares to be entitled to the 84 cents dividend. In fact, Investor A’s judgement had been accurate; NAB has indeed languished after it went ex- dividend. Investor A has successfully used options to buy shares cheaper than the market price and earned some dividends with the tax benefit of franking credits.
Consider RIO at around $65 in late May 2010, having fallen from the $81 level because of the announcement of the Mining Resource Rent Tax. Investor B considers this almost 20% fall in value as an opportunity to buy a quality Australian resource stock; though the thought of the share possibly falling more hasn’t escaped him. He wants exposure to it and yet wants to lose as little as possible. The buying of call strategy would have worked perfectly in this situation. Buying of call options gives Investor B the opportunity to buy the shares at a later date (if he/she chooses to spend the money) or alternatively just benefit from more profitable calls if shares should recover from this low $60’s level; yet at the same time limiting initial capital spend and maximum loss. If RIO did not recover from the $60’s and went to $50’s instead, Investor B “wasted” a few thousand dollars of options premium instead of sitting on paper losses after spending $65,000 buying 1000 shares
Two different shares with two different patterns of trading, yet options has helped these two investors manage their fears to stay in the game. Psychologists say when we experience these “fight or flight” emotions, if we do something to mitigate those stresses we will feel less stressful.
Options help us feel less stressful about the ever-changing chameleon stock market. As we feel less stressed, we are more empowered to adapt and are ready to accept the chameleon.

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