What is the temperament of an options investor? To most, the word “conservative” would not fit the bill. What about these words – “Sanguine”, “Melancholic”, “Choleric” or “Phlegmatic”? These are now common terms used to describe certain personality types of people. These four personality traits trace their roots back to some two thousand years ago, to a Greek physician named Hippocrates, who studied human temperaments.
The temperament theory, which is based on human behavior, moods and emotions has since been further developed and various aspects added by other researchers and psychologists. Based on their work, we now have the opportunity and benefit of understanding ourselves better as an investor – especially as an options investor.
Did you manage to fit yourself into one or two of those traits? Some of you may have been disappointed, like me. I thought I have a schizophrenic personality as I just couldn’t pin myself down on one or two and find that I am not only evolving but am in different traits at different times. Is this normal? I think I read somewhere that’s all right.
I find that to be a successful options trader or investor, one actually needs to assume different traits at different times.
We need to be Sanguine, to be creative like an artisan, to come up with creative trading ideas, especially in the current market, which trades in a tight range (the S&P/ASX200 ended 2010 with a minus 2 after a busy year). For the options investor, this trend is compounded by a very low volatility on most stocks. The XVI (which is the S&P/ASX 200 VIX index), which gauges the volatility of the market is currently at the mid-teens near to its all-time low of 12. When volatility is low, options premium tend to be low. This tends to favour buyers of options. However, buyers of options suffer from time erosion. In order to make money, buyers of options need the underlying share to perform (up for a buyer of calls and down for a buyer of puts) quickly, to profit from it. This request may be a big ask in a side trending market.
A couple of cautions of the impatient Sanguine options investor would be the risk of over-trading for returns in a side-trending market and being impulsive in coming up with trading ideas.
A Melancholic is a sensible options investor and is very risk aware, often not only considering the reward but also its risks. The guardian in him would rarely find him being caught in naked trades such as selling of naked put without the resources to fulfil the buying obligations or selling of naked calls without the holding of the underlying shares. A Melancholic options investor is more likely to be found in trades such as put spreads, where the downside of a trade is limited and known at the upfront. His sturdy and sensible manner often takes over and hedging strategies is often top of mind.
There is a trap a Melancholic options investor needs to be aware of though, one that he will constantly face, stemming from the tendency to hoard. This is the aversion trap, which is the mental trap of regarding “losses (paying of cash) twice as painful as a similar amount of gain”. A Melancholic options investor may find himself less inclined to pay cash to close off and lock in profits in a short (or selling of options to open) position. This can be in a covered call position or a short (selling of) put positions, both the calls and puts which were first sold (to open) can now be bought back at a tiny sum to close off and lock in the profits. A Melancholic options investor will struggle with this decision, but is best to overcome his weakness and enforce the profit taking strategy. As often, short calls and puts though may be covered, but left unclosed turn the other way at expiry and render an initially profitable trade to be a loss.
The Choleric options investor is hopeful and is intuitive in his investment style. His optimistic nature may be what’s needed in a side-trending market to try new strategies and experience new shares.
The Phlegmatic options investor is a rationalist, one who needs to work through the scenario analysis of both gains and losses. The logical mind of a Phlegmatic would benefit from the use of options, as often, both the up and downsides of a trade can be known at the upfront, even before the execution of a trade. Knowing the maximum potential loss of a trade is comforting to a rational Phlegmatic, especially when shares or strategies go wrong, where the calmness of a Phlegmatic will then take over.
To be a successful options investor, we need to be creative like a Sanguine in a side trending market, Melancholic when market turns volatile, Choleric in a dull and slow- moving market and retain the rationale of a Phlegmatic in all markets.
These are some of the descriptions of the four personality types (the last being the weakness of that trait):
||Lion (bold), artisan
||Ox (sturdy), guardian, sensible
||Man (humane), enthusiastic, intuitive
||Eagle (far-seeing), rationale, thinking, calm