Let’s say you decide to deposit $100,000 into a brokerage account.  You decide you will check your portfolio on a weekly basis.  Now let’s further assume that the first week has passed and you are about to log in to your account.  But before you do, you are told that one of two things has happened in the past week.

[1]  Your portfolio went up $10,000 and then dropped $10,000

[2]  Your portfolio went up 10% and then dropped 10%.

So, the trivia question is:  In case [1], what should you expect your account value to be and is that the same figure as in case [2]?

If you answered $100,000 in case [1], you would be absolutely correct!  If you answered that this is the same as in case [2] you would be absolutely incorrect!  Why?  Well let’s take a look at what happens when the portfolio rises 10% first; it goes from $100,000 to $110,000.  But then we’re told it drops 10%.  10% of $110,000 is $11,000.  So the portfolio drops from $110,000 to $99,000. 

Now how can this help us in our trading decisions?  In its simplest form, this tells us that if we were to simply buy stocks that over the long run had a tendency to rise up substantially and fall down substantially ie starting at 0% and rising up and ultimately falling back to 0%, the volatility is impacting long-term returns.  In statistics, that percentage swing would denote variance, which in turn is often equated with risk.  Another term for risk is beta.  High beta stocks tend to move more than the market and tend to have greater variance.

So, if you are in the market for the long-term, you should certainly pay close attention to the impact of variance.   Over time the impact to the $100,000 portfolio is not just a drop of $1,000 as in the period shown above, but that portfolio erosion continues over time to the detriment of overall wealth.  Unless….

Unless,…

This article is best read after a substantial rise has occurred in the market following a period of sustained bearishness.  Why?  Because it is precisely the time when many will have seen the direction of the portfolios turn.  Some may even have caught the bottom in stocks like Bank of America, up 50% in less than 10 days!  When wealth is attained so rapidly, a tendency towards confidence or more particularly over-confidence is natural.  Short-term results vindicate decision-making at the bottom to ‘bet heavily’ or ‘go all in’.  And they solidify a belief that the next bottom can be called successfully also.  This may indeed occur.  But a danger exists, which I call the Trading Virus.
 
The Trading Virus affects almost every trader.  The victim is affected soon after a successful outcome in the stock market.  The virus manifests as excessive confidence and belief in one’s ability to time the market.  For most the virus is a lifelong condition.  Bulls and bears are equally affected.  As stock markets rise, bulls are infected and ride the glorious waves higher and higher until the inevitable crash cycles around again.  And bears rarely hold out long enough in sustained bull markets to enjoy those crashing sounds. 
 
For both bulls and bears, the virus implants a disease called ‘Results-Focus’.  Each is a keen market observer driven to action or inaction by the latest direction of streaming quotes, media hype, account value or some other short-term mechanism.  And a dependency is soon created; a dependency that demands information in the short-term that produces adrenalin rushes that lead to action that further lead to hopeful and expected results.  This is not to say that, in the short-term, talented traders cannot profit. Of course, they can.  But for mos…

Black Hole:  a region of space in which the gravitational field is so powerful that nothing, not even light, can escape its pull after having fallen past its event horizon. The term "Black Hole" comes from the fact that, at a certain point, even electromagnetic radiation (e.g. visible light) is unable to break away from the attraction of these massive objects. This renders the hole’s interior invisible or, rather, black like the appearance of space itself.

If it ever felt like the market had a black hole, now might be that time!  An inescapable magnetism with vampiric tendencies is exhausting the patience and energy of the most steely and experienced stock market traders.  In the depths of the gloom and amid the contagion of panic, solace and wisdom can often be found in the words of those who have seen it all before, long before any of us had begun to even dabble.  The following quote is from Remiscences of a Stock Operator:

"And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  You always find lots of early bulls in bull markets and early bears in bear markets.  I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit.  And their experience invariably matched mine – that is, they made no re…

But what has this to do with the stock market?  As traders, we are receiving information each day that we must learn to process and indeed we must learn to filter some of it out.  This is an enormously challenging task because our natural inclination is to apply bias to the information we receive.  For example, if we are bullish on a stock and an analyst disseminates a report that aligns with our views, our opinions are more likely to strengthen.  In order to achieve our objective of trading without bias, we must recognize that history is laden with examples of the stock market confounding expectations.

In the 1970s, few envisioned that commodity prices would elevate to the degree they did or that bond yields would rise up to 15% by 1981 or that bond yields would decline to around 3% in 2003 or that a protracted equity bull market would ensue.  Few expected that almost two deacdes after the Japanese market reached its peak, it would still be down 60% from its highs.  Few recognized in 2000 that commodity prices were at historic lows while China and India were emerging rapidly.

Recognizing that the opinions you hear from others originate from a place of vested interest means critically analyzing comments becomes imperative.  For example, just a couple of months ago, Lehman’s CEO announced that "the worst is behind us".  It is evident from the chart below that the worst had certainly not been priced into the stock yet! 

…

Maybe we can blame it all on the Beatles invasion of America.  The bustling 60s with its expressions of freedom was the time when the transition seemed to sweep the nation.  Instead of purchasing what we wished AFTER we had earned the capital to do so, as in generations past, we learned to purchase BEFORE we had earned sufficient capital to match our desires.  The availability of credit has forced grown-ups to take a grown-up version of The Marshmallow Test.  

Recall the MarshMallow Test was a test given to youngsters to determine the correlation between patience, self-discipline and success in life.  A marshmallow would be placed in front of a child, who was told if the marshmallow had not been consumed by the time the adult returned to the room, the child would recieve a second marshmallow.  The end result being children who passed the Marshmallow Test did better financially in life!

Most of the population are tempted by the proverbial marshmallow every day under the guise of credit offerings.  These days credit card offerings are expected daily in the mail and homes have been turned into ATM machines.  And those homes were in turn purchased through borrowing.  The excesses are compounded by the fact that some studies have reported that over 9 out of 10 borrowers mis-represent their net worth during applications.  Not only is most of the public failing the Marshmallow Test, but the government is too.  A balanced budget, once demanded as part of fiscal responsibility, is now all but a distant memory.

The pervasive excesses of borrowing inevitably lead to greater gains during upswings and greater losses during corrective phases.  During the declines, few stock market participants have a containment strategy.  Account value fluctuat…

Firstly, the snapshot of the major indexes…

DJIA:  11,842.36  down 0.33 points

S&P 500:  1,318.00  up 0.07 points

Nasdaq:  2,385.74 down 20.35 points

In spite of today’s action doing absolutely nothing to inspire confidence in banking sector - you need only look at the action in the XLF today - we decided to go hunting, believing that certainly, somewhere out there, a solid bank existed (even if its stock had been taken out for a beating of late).

Well the search took us across the Atlantic to Ireland.  Oh sure, Ireland has its share of problems right now, but Bank of Ireland reported a 5% increase in underlying profits for the year to March 31st - IN SPITE OF doubling its bad debt charge due to the slowdown in the Irish property market.

In spite of its relative outperformance in its peer group, its 12.5% dividend yield and the fact that it’s trading well below 50% of its average 10-year book value, the stock keeps going lower! 

One of the big questions is whether the dividend is safe.  According to Ireland’s leading full-service broker (you could say the Goldman Sachs of Ireland), Davy, the dividend is rock solid and should not be in any jeopardy.  Indeed management is …

Just a couple of decades ago it would have been almost unfathomable for the retail investor to consider generating consistent returns above 20% per year.  Indeed, those who competed in arguably the most competitive financial market place, the stock market, were considered gurus when they beat the S&P 500 year in and year out. 

Others, such as Jerome Kohlberg, Henry Kravis and George Roberts made a name for themselves in private equity as did Peter Peterson and Stephen Schwarzman with the Blackstone Group.  Gains in the stock market for Joe Public were subjected to a limiting factor - the inability to leverage substantially.  Joe Public was also limited in participating in private equity investments; they were the domain of the rich - the insiders.  These days, private equity still remains the domain of the rich, but leveraging is possible through the purchase of equity derivatives.  And the sale of those same equity derivatives can be highly profitable too.

Whereas it would have been unthinkable years ago to consider making big profits year in and year out on a stock that doesn’t move much - because the only source of income, dividends, tended to be in the low single digits in percentage terms - these days options afford us the opportunity to sit tight and profit while holding stock positions.  This can easily be achieved through the sale of short call options against stock holdings, otherwise known as the Covered Call strategy.  While the Covered Call strategy may appear straightforward when first encountered, many applications may be employed.  In this article, we will consider the application that Stock and Option Trades labels: 7 Steps to 40% per year!

St…