It’s only a stock market bubble when it bursts.
Until then, the market is perhaps best thought of as a powerful locomotive that seems destined to advance for as long as companies and investors believe that artificial intelligence is a powerful revolutionary force that will override concerns about inflation, rising interest rates, and valuation metrics.
Investors thus need to consider developing a plan to do something that is rarely discussed, at least publicly, on Wall Street: when and how to secure profits on long positions in stocks and options.
AI may well prove to be more transformative than Bitcoin, but investors would do well to remember that Bitcoin and the blockchain were also expected to change the world. Bitcoin’s price subsequently rose to a record high of about $68,000—before falling as low as $16,000.
Everyone has a different risk tolerance, and there should be little agreement on the best way to sell or take profits—but let the Bitcoin experience influence how you think about managing risk. Anyone who buys stocks or bullish call options at these elevated levels should have predetermined sale prices in mind when they place buy orders.
A reasonable discipline involves locking in profits when prices have quickly advanced 10% to 20%. The historical annual return of the
S&P 500 index
is about 9%, which is a good reference for contextualizing gains. It might seem that stocks only rise, but history shows that isn’t always true. Many investors who buy a stock that tumbles reflexively sell when prices have fallen 10%.
We have previously offered some ideas about using calls, or call spreads, to participate in the rally while being mindful of its risks and rewards. Since then, demand for calls has reached a crescendo, and the options market is telegraphing that investors think the greatest risk that they face is missing out on future stock rallies. This is so unusual that it potentially distorts and threatens the normal equilibrium in the markets.
The options market has historically been defined by fear. Investors tend to buy put options to hedge their stocks, focused on the fear of stock losses, rather than the fear of missing out, or FOMO, on gains.
The greed that now defines the options market reflects a widespread belief that AI is so powerful that it can redefine earnings outlooks and other market risks. The dogma is reminiscent of how Bitcoin was once held in such high esteem that companies were eager to show they were involved in the next cool thing. The same is happening all over again.
In recent weeks, for example, Oppenheimer told clients that
Marvell Technology
(ticker: MRVL) stands to thrive from its exposure to AI.
Intuit
(ticker: INTU) said it was partnering with OpenAI to develop financial tools. Earlier, the company announced plans to develop “AI experiences” across business units.
Booking Holdings
(BKNG), an online travel company, recently announced trip-planning software powered by AI. The mere mention of a company’s association with AI is usually enough to make the stock surge and outperform the S&P 500.
The more AI helps to drive stocks higher, the more likely FOMO will become a virus that could morph into a pandemic of greed. The only antidote for such situations is knowing when and how to sell. If it proves wrong to have focused on risk over reward, so be it. You will have enjoyed some gains and you will have shown that you are disciplined, which is an important skill for successful investing.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.
Email: [email protected]
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