As with anything investment-related, see my disclaimers. This post deserves an additional disclaimer. Investing involves risk. Trading stock options is extremely risky and you can lose 100% of your investment. My story is provided solely for entertainment purposes and in no way do I recommend doing what I did. Or anything else, for that matter.
I’m not 100% rational. Few (any?) people are rational all of the time. And even though I am aware of psychological traps and my own irrationality, I still find myself occasionally trapped.
I worked at Dumpster Fire Inc between 2013 and 2017. During my time at DFI, they went public at $40/share and within six months, climbed to a zenith of nearly $100, before falling to the $10 to $20 range for the next five years. I still watch DFI’s price frequently, and my familiarity with the company and its trading patterns lead to a familiarity bias, thinking I knew more about how it operated than I actually did.
During the time that I worked at DFI, I received shares periodically in the form of restricted stock grants (RSUs) and also through an employee stock purchase plan (ESPP). Usually, I immediately sold any shares I received, especially the ESPP shares.
That is, until my last year at DFI, when I started to hold on to RSU shares.
Why? I had mentally anchored the stock price to the halcyon days of $60+. And with the stock below $20, it was just a matter of time until it popped back up. Right?
Yep, anchoring bias.
And as the stock continued to drop, my anchor dropped, but always staying higher than the going price of <$20. A trailing anchor, if you will.
It couldn’t go lower, could it?
Yes, it could.
The stock continued to trade in a depressed range for the next four years, not caring much about my anchor of where it had been.
The Endowment Effect
At DFI, I was restricted to when I could buy or sell shares, usually only during a window of a few weeks each quarter. We still couldn’t trade on insider information during that window, but frankly I don’t think I had access to anything that you could call inside information. So much for my “familiarity”. I was also prohibited from shorting the stock, which includes synthetic shorting through selling covered calls.
Once I left DFI, I no longer had such restrictions. During the summer of 2019, I began selling covered calls to juice my return on shares that didn’t seem to go anywhere. I didn’t write calls against my total position, usually only about 30 to 50% of my total shares, still waiting for the event that would take the stock to the stratosphere.
Would I have bought DFI at the price I was expecting? No. Sounds like maybe the endowment effect had me in its clutches, causing me to give more value to something simply because it was in my possession.
Excluding my covered calls, my internal rate of return on my DFI shares during that period was 2.66% up to mid-December. If I had sold the shares and put the money into VTI, I would have a return of nearly 14% for the same period.
Things have been pretty static for the past five years. Of course there’s been indirect COVID-related pressure on DFI, causing me to buy shares both in March and July, only to sell them just a few months later for a short-term gain. Throughout the past eighteen months I’ve been selling covered calls regularly, increasing my returns to 10.3%. It’s been better than doing nothing, but not quite as good as exiting the ride earlier in DFI’s history.
Things looked like they’d continue indefinitely. Until mid-December. Then, bad news struck, dropping the stock 13% in one day. This was actually bitter sweet. I happy because my options would expire worthless, allowing me to repeat the process of selling more covered calls, but sad because my shares were again down in value.
Within a week, the bad news became good news, and the stock jumped 33.7% in one day. Three more days of 5-10% increases left the price 44% higher than when “disaster” struck.
I had fallen into the recency bias trap, thinking the range would continue indefinitely.
The Unknown Bias
I frankly don’t know when the recent roller coaster will end. My calls expired in the money mid-January, calling away 85% of my position in DFI. I’ve already set aside the tax money and started dollar cost averaging the proceeds into my 529 contributions for the year.
However, recently DFI’s stock price has retraced back to $20, making it tempting to buy back in. A group of the calls that expired in January had a $20 strike price, leading me to justify that I was simply buying them back at the price I’d sold them, enabling me to sell more covered calls and get a stepped up cost basis. It would be as if I’d never sold those shares.
I’m sure there’s a bias hiding there. Is it mental accounting, somehow treating the money that I’d tied up in DFI as something special? Loss aversion? More familiarity bias?
If I do buy back in, I’m certainly ignoring my goal to option my way out of the shares in the first place. Sigh.
Those are a few of the bias traps that I observed in myself through my experience with DFI. I’m sure there are more. Like everyone else, investors (or maybe what I’m doing is more speculating?) are plagued with psychology traps that influence behavior, often to their own detriment. Being aware of them is a step towards fixing them.
What kinds of psychological traps do you see in your personal finances or others? What are you doing about them? I’d love to hear about it in the comments.
Note: I’m sure my casual return number crunching is riddled with errors.