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Why mispricing is crucial to trading

Chris McKhann (chris.mckhann@optionmonster.com)

You should trade those things that you think are mispriced. We have discussed this in the past, but a recent post at Farnam Street reminded me just how important this idea is.

The blog piece is headlined, "How Good Gamblers Think." Most traders don't like to be called gamblers, but of course "good" gambling is based on probability and odds, just like good trading . And the article makes that point, bringing Warren Buffett and Charlie Munger of Berkshire Hathaway fame into the conversation.

Too many traders take action based on the latest news or simply because they feel the need to do something. CNBC this morning discussed the idea that too many people had bought Apple just because the stock was going up. There is an argument for momentum trading, but that is not what most people based their decisions on.

The blog quotes a 1987 investor letter written by Buffett about "Mr. Market" and his bipolar behavior. Mr. Market can fluctuate between euphoria and depression, he says, and every day he comes to buy or sell you shares. But you don't have to do anything other than decide if you think that Mr. Market is mispricing something--and if you aren't sure, you can simply wait.

Buffett also makes a good point that can be applied to Apple: "Mr. Market is there to serve you, not guide you. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence."

Munger is also quoted, and his remarks focus on betting when the odds are in your favor. What separates the winning betters? According to Munger, they don't bet all the time.

"The wise ones bet heavily when the world offers them that opportunity," he says. "They bet big when they have the odds. And the rest of the time, they don't."

In his book " The Signal and the Noise ," Nate Silver says of successful gamblers: "When their estimates of these probabilities diverge by a sufficient margin from the odds on offer, they may place a bet."

This perspective can provide many advantages in options as well.

First of all, I believe that it is easier to find mispriced options than to find mispriced stocks. That can be through following the institutional trades, as we do with optionMONSTER's real-time tracking systems every day, or through the pricing of the options through volatility data or sentiment.

Second, options allow you to stay in positions. Often those stocks that are mispriced can stay that way for a while before they correct. But options allow us to make trades without abandoning our longer-term strategies.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Jan. 16.)

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