Saturday, May 2, 2009

Counteracting the Disposition Effect

It is very important for covered calls investors to understand the investing-related term 'disposition effect'. In short, the disposition effect is the tendency of investors to sell winners too quickly and to keep losers too long.

The disposition effect is a topic of academic research in the field of behavioral finance, within the specialty area of cognitive biases. The abstract of an especially well-researched and well-written study on this concept is found here: (link). To read the entire paper: from the SSRN abstract link, first click 'Download', then click on 'SSRN New York,USA'.

From detailed empirical analyses, researchers have been able to demonstrate a tendency of investors to sell winners too quickly and to keep losers too long. The primary reason they identified for this behavior is a greater psychological willingness to accept profitable positions (sell out at a profit if you will); with a corresponding reduced willingness to accept a losing position. People want their investment positions to end as winners, not losers, and will forego their reasoning to make that happen. Said another way, investors have a greater need to repair losing positions and to attempt to return them to profitability before selling them. Researchers have also shown that this tendency has a net negative effect since it reduces return-on-investment performance.

At this point you might be thinking: "Okay, this disposition effect concept seems logical enough; But why does it need to be highlighted on a blog focused on covered calls?" The answer is that covered calls investors are more likely to be adversely impacted by the disposition effect than typical buy-and-hold investors. Why? While the decision to sell an existing underlying stock can of course be made at any time, the overwhelming majority of the keep-or-sell decisions made by covered calls investors are normally made close to the monthly options expiration dates. As expiration Friday approaches, the easiest approach for a covered calls investor keep-or-sell decision is to do nothing. Unfortunately, since it is the easiest approach, it is too often the default. With this approach, the following will automatically occur:
1. Virtually all in-the-money (ITM) positions will be called away (a.k.a. ‘assigned’ or ‘exercised’) and the underlying stock will be sold for the strike price value; and
2. For all out-of-the-money (OTM) positions, the options will expire worthless and the underlying stock will be retained in the portfolio.

This passive approach is absolutely not the technique recommended by this advisor. This strategy results in the investor selling the strongest performers in the portfolio (the winners if you will); and holding the weakest performers (i.e. the losers). Thus, this passive covered calls approach produces a natural result, one that makes covered calls investors inordinately susceptible to the adverse consequences of the disposition effect.

Automatically keeping the securities that expire out-of-the-money is bad enough. But the Covered Calls Advisor has noticed that many covered calls investors compound this disposition effect further by immediately transitioning into a repair strategy, in an attempt to nurse the sick patient (losing stock) back to health (profitability). Unfortunately, this frequently leads to an exceedingly prolonged period of managing a losing position. At this point, the investor is neck-deep in the disposition effect quicksand. With sufficient patience, the investor might eventually manage the position back to minimal profitability. Then, after months (and even years) of frustration, the investor is so relieved to be back to breakeven that the position is quickly sold. If this approach sounds all too familiar, please reconsider your thought process. This is precisely the "keep losers too long" disposition effect that we should avoid.

What can covered calls investors do to counteract the disposition effect? The primary answer lies in the investor's mental perspective. Most investors view their current positions primarily in relation to the purchase price, and make decisions with that price in mind. Unfortunately, this is a biased mindset; one that distorts the clarity of our decision-making perspective as it pertains to the stock as it is, at its current price. Researchers have determined that more successful investors have an ability to largely disregard the purchase price; they have the ability to view the primary reference point of the security at its current price. Using this current price perspective negates the disposition effect. Fortunately, cognitive bias research has also determined that "for individuals who are aware of their reluctance to sell losers, they can more completely evaluate the consequences of their decisions over time, leading to modification of their behavior... and investor groups with potentially better access to information and sophistication about the financial markets have a significantly lower disposition effect than other investors." So the good news is that we can use our awareness of the disposition effect to improve our covered calls decision-making processes through a committed effort to counteract the disposition effect.

To demonstrate how covered calls investors can use an awareness of the disposition effect to improve their covered calls decision-making process, consider the decisions we make to "Keep-or-Sell" or to "Roll-Up or Roll-Down."
Keep-or-Sell Decisions --
There are two methods that aid in counteracting the disposition effect regarding which securities to keep and which to sell:
(1) Because the Covered Calls Advisor favors near-month covered calls positions, relatively frequent keep-or-sell decisions are made. This frequency can have a beneficial effect in countering disposition effect bias in comparison with a more passive long-term buy-and-hold strategy; and
(2) Generally, most keep or sell decision-making is done during the final week prior to expiration. To intentionally counteract the disposition effect at that time, a keep-or-sell decision should be made on each existing covered calls position on its own individual merit, irrespective of the relative moneyness of each position (that is whether a position is in-the-money, at-the-money, or out-of-the-money) at that particular time. Additional comments that present a specific process to aid decision-making on existing positions is contained in this prior article (link) from this Covered Calls Advisor blog.
Roll-Up and Roll-Down Decisions --
A prior article (link), also from this blog (especially the section describing key concept #1) offers an approach to counteract the disposition effect in our rolling decisions by completely disregarding our initial purchase prices and considering only current prices.

This topic is more complex than most prior postings on this blog. If you would like further clarification, please submit your comments and questions. They are always welcomed. Click the 'comments' link below or post them on the justcoveredcalls Yahoo!Group site. If you prefer confidential communications, my email address is listed at the top-right sidebar of this blog site.

Regards and Godspeed to All,

Jeff