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Myths and Realities

MythReality
“The stock can’t go any lower.”A stock can go down to zero—if it does so and you’re long in the stock, you could face a 100% loss unless you use a Stop Loss.
“The stock can’t go any higher.”This statement is just as farcical as the one above. Furthermore, it doesn’t actually mean anything. In theory, a stock can continue to go up forever, although nothing lasts forever, as we all know. Stocks can continue to appreciate year in year out, during good times and bad. The markets, being somewhat irrational, do go overboard, and many securities do get over or under valued at some point in time. If they didn’t, there would never be any opportunities for us to invest or trade in the first place. These excesses, which are caused by mass greed, fear, and hype in the marketplace, give us our opportunities on a daily basis.
“The stock has doubled every year for the last five years, so it’ll double again this year.”We all know that stocks have personalities, but this is taking personalities too far. I’ve witnessed so-called gurus express this type of simplification in their seminars, and it’s highly misleading. Whatever has happened in the past is no guarantee of what will happen in the future.
 The past may well give us some clues as to how a security may behave, but a stock doubling every year is an over generalization. Please stay away from over-simplified solutions and glib comments. They’re great for making the exponents rich and wasting the customers’ time. If it sounds too good to be true, then it generally is. Trading and investing is a serious business and should be treated with respect. Sure you can do it—that’s what this book is all about—but you’ll definitely have to devote time to it and make it your passion.
 During the great Bull run of the 1990s, this sort of ridiculous comment was rife. Do avoid making and listening to sweeping statements and predictions. Start to look at price movements as opportunities and be prepared to admit defeat sooner rather than later if the price violates a Stop Loss or some other predefined parameter you have set.
“Shorting stocks is too risky...”Shorting a stock is no more risky than buying a stock, provided that you use sound rules about Stop Losses and money management. In fact, most of the time stocks will fall far faster than they rise, so by definition, shorting can’t be as risky. (Please do not confuse shorting a stock with selling an option naked. Selling an option naked is highly risky, and I don’t advocate it to anyone other than advanced traders.) Where people get worked up about shorting stocks is in three areas. First, the mechanics of the trade. Shorting involves selling something you don’t actually own. For this to be accomplished, you effectively have to borrow the stock from your broker and then sell it. To close the position, you’ll have to buy the stock back, hopefully at a lower price (so that you’ll have made a profit!). Second, the “Uptick Rule” states that you can only short a stock on an uptick. For Direct Access daytraders who rattle through hundreds of tickets per day, this can be a valid point given that every tick is meaningful, but for other traders and investors it’s not a major factor when weighed against the benefits. The third complaint with shorting is that you’ll have to effectively pay the dividend to the actual owner of the stock. So just make sure you’re not shorting dividend paying stocks at the appropriate record date.
 As a trader, you won’t actually see the mechanics, and, frankly, aside from the dividend payment, what difference does it make anyway? Secondly, there is the technical risk of unlimited loss. But this is only true if the stock literally goes ballistic (upward) in a flash. As we’ve discussed, it’s far more likely for a stock to halve in value overnight than double in value overnight. To add in a tier of safety, some of you may want to avoid shorting immediately prior to major announcements like earnings. For that matter, you may want to avoid any kind of trade (except Straddles) immediately prior to a major announcement. Picking your direction for a stock is an entire process in itself, but, for me, it’s far more risky to see securities as instruments that can only go up. This is a blinkered view that naturally biases a predominantly Bullish outlook. Far better to see both upward and downward price movement as opportunities, and then you’ll not end up looking for signs that simply aren’t there.
 From a psychological point of view, accepting that you can make money from a stock falling changes the entire trading and investment mindset. For a start it becomes more of a business decision-making process. Rather than looking for stocks that are going up only, you’re now looking for profitable opportunities in either direction. This is a far more healthy approach since you start from a position of neutral bias, not purely Bullish.
“The cheaper an option is, the better, even if it means it’s closer to expiration. I can’t lose much if it’s only a dollar.”WRONG! WRONG! WRONG! I’ve seen people consistently do this and literally lose 100% of their trade (not to mention their accounts) in a matter of days. When you buy an option, give yourself enough time to be right. Don’t be cheap. 100% is 100% even if you only paid 1 cent per option. If you really want high leverage and insist on a short-term option, then you’ll need to hedge against Time Decay, and that means buying Deep in the Money options. These will be more expensive in terms of cost, but far better value because you won’t be losing as much Time Value as the expiration date looms.
 Remember, a cheap short-term option can end up being extremely expensive.



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