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Avoid Regret With Options
Education | 08 October 2010
By: jason.liew
Articles (66) Profile

By Wai-Yee Chen

Two years on since the global financial crisis which brought even the biggest names in the financial world to their knees; its adverse rippling effects is still being felt not just by investors but their families and those normally oblivious to the happenings of the financial world.

Families postponed home renovations and overseas holidays, older workers deferred retirements and others lost businesses and jobs. For investors, many have lost faith in the financial systems, some have vowed never to return to investing in shares and yet others are sitting on cash awaiting a “clearer” picture.

If you share any of these experiences, you are not alone. The feeling of lost of control, of “there is nothing I can do to change this situation”, is a common reaction by most people, who are faced with adverse situations (like the lost of large sums of money), especially in a situation they feel they cannot control (like the stock market) and their efforts in trying to overcome them seem futile. They lose heart and stop trying. This feeling of “helplessness” can be a learned behavior which psychologists call learned helplessness.

Psychologists first found this mental attitude in animals. In an experiment they conducted, animals which were conditioned (for a week) to think they can’t run away (by tying down one of their legs), were found not to attempt to run away despite being freed after the conditioning. They later discovered humans are no different! They found students who have been failing consecutively in a particular subject, for example Math regard themselves as “hopeless at Math”, even though they may be outstanding students at other subjects.

Is this common feeling of helplessness changeable? Dr Martin Seligman the psychologist who discovered this common mental trap which he called learned helplessness seems to think so. According to Seligman, we can turn those default negative attitudes or reactions to positive ones by changing the way we explain the bad situation to ourselves. Instead of these above-average students resigning to the fate of being “ hopeless at Math”, by attributing the failure to other external possibilities like the Math teacher setting unreasonably high bars for their level, they could turn that hopelessness to a constructive positive reaction of lifting their Math skills to meet the elevated standard required by the particular teacher. This is learned optimism, a conscious mental effort in reversing the more common behavior of learned helplessness.

What about investors? We have all suffered, either financial losses or the very least emotional stresses which are either direct or indirectly caused by the GFC, but as investors, how we move forward from here depends on how we explain that adverse experience to ourselves. Will we resign to fate or learn to take control?

If you belong to the latter group of wanting to take control, then options will be the tool you want to know about. You would want to know how you can protect your capital, how to have the confidence of investing without the risk losing a large chunk of your capital and how you can ensure your losses are limited to what you are willing to bare.

Options have two very powerful strengths (amongst others); one is by creating a maximum tolerable level of loss and two, is by allowing investors to test the water by capping the amount of capital at risk.

Both of these strengths of options help investors avoid regret; by not losing more than willing and by not losing out.

Strategy 1: Creating a maximum tolerable loss

This strategy helps owners of shares create a floor for their share investment by guaranteeing them an exit price.

Diagram 1 depicts the typical exposure of the owner of shares, who enjoys all upside but suffers all losses up to zero value of the share.

A shareholder’s long exposure to a share
Diagram 1: A shareholder’s long exposure to a share

Diagram 2 shows the characteristic of a put option, which rises in value when the underlying share price falls.

Put rises as share falls
Diagram 2: Put rises as share falls

Diagram 3 shows the new exposure of the share owner who has combined a share exposure with the buying of a put option.

Buying put options for shares owned
Diagram 3: Buying put options for shares owned

The share owner has created a guaranteed exit price for his share at the strike price of the put and hence constructed a floor for his exposure; whilst still being able to enjoy all upside from the ownership of the share.

Puts put you to sleep.

Strategy 2: Capping capital at risk

Options allow investors a similar exposure to a share as if they were owners of the share, only without privileges of dividends and other shareholder rights.

Buying call options over a share instead of buying the shares outright gives the investor time to consider if he should plow more into a particular investment, by putting at risk just a fraction of the cost of the share. If the underlying share proves to be a winner as suspected, then the call option investor has the right to exercise the call to buy the share at the strike price. If the investor were wrong in his judgment, then he simply walks away with a small loss. See diagram 4.

Buying call options limit losses
Diagram 4: Buying call options limit losses

Calls let you try before you buy.

Options help investors avoid regret. We regret if we lose money and we regret if we didn’t buy a winner. Buying of put options helps protect what we own and buying of call options helps us buy what we don’t already own. Used wisely, options give investors control and peace of mind. No regrets.

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