A famous work of finance literature is a book entitled “Popular Delusions and the Madness of Crowds”. The most famous story from that book involves tulip bulbs, which were at one time traded as a commodity in Holland. People paid outrageous prices for them on what is called the “greater fool” principle. Although no one denied being a fool for buying a tulip bulb that cost as much as a house, they would rationalize the decision to do so by arguing that an even greater fool would purchase it at an ever more exorbitant price. The purchase of such tulip bulb had nothing to do with gardening, although initially the bulbs were valuable since they could be propagated and sold as a “crop”. The trading had become the proverbial dog-wagging tail, and no one really cared what tulip bulbs were, they just bought them to sell.
In the stock market, the same thing happens with certain stocks and options. A price swing will cause investors to panic, purchasing options as a hedge or speculation. Next, the swing traders swoop in, hoping to purchase the already over inflated options in the hope of selling them to a “greater fool”.
The problem with the “greater fool” principle is that the chain has to end somewhere. Someone will end up being the greatest fool and end up holding nothing but a tulip bulb, or a worthless stock option. At least you could plant the tulip bulb.
An underlying of mine found its way into my portfolio because my scan software picked it as having potentially overpriced options. I sold some, then sold some more when the price continued to increase. Both the puts and the calls have consistently increased in value, so at the moment, I look like a (literal) loser. However, the options are out of the money and have not gotten any closer to the money since I sold them. Come expiry, I believe I will be the one pocketing a profit, while those who bought the options will either have made a small profit selling them or worse, be stuck with them as they expire.
My dad agreed that this underlying was offering an opportunity, and did the same trade. He wondered out loud why on earth anyone would want to buy a call for so much when they could just buy the stock. I told him, “It’s not an option to them. It’s just a thing to trade, and has nothing to do with stock, or assignment, or leverage. It’s like a tulip bulb.”
That was yesterday, and this morning I informed my husband that I was going to sell some more “tulip bulbs”. I had to explain the reference, but he agreed the analogy is apt. From men haggling over tulips to me sitting on my couch with my laptop selling overpriced options, human nature has remained the same. People will always get caught up in trends and want to “get in on the action”. Those of us who refuse to succumb to the madness of crowds may look foolish in the short term, but will walk away with a profit when the insanity subsides. It is truly amazing just how little technology has changed the fundamental nature of trading. The strategy is the same, but the execution is easier and more accessible, making the market more of a meritocracy and less of a “member’s only” club. Anyone can have a chance to play the game of “who’s the greater fool.” Care to join me?