Why Opportunity Cost Can Get Expensive

Risk is something that I think about constantly. It's what I lose sleep over. There are many different types of risk, but today I want to focus on one that I think gets left out of the equation way too much. I'm referring to Opportunity Cost. Long-time readers of the blog and people who follow me on the Stocktwits and Twitters of the world or see me on TV & Radio often hear me refer to this type of risk on a consistent bases. Sometimes I choose to call something, "Dead Money", but as my buddy Jonathan recently pointed out, I sound smarter if I call it "Opportunity Cost" instead. I don't really care about sounding smarter, but he says it helps people understand this concept much better than if I just call something "dead money". I think he has a point there.

When calculating risk some of the figures I like to consider are 1) Price - at what price to I throw in the towel and admit that I am wrong, 2) Time - how long is this going to take to work out and what kind of margin interest or option premium am I going to pay to wait for this to play out, 3) Overnight/Over-weekend Risk - What might happen over night or over a weekend that can force a gap down (up) through my stop that can increase my risk (like an earnings release for example), 4) Correlation Risk - How is adding this new position going to increase my portfolio's exposure to a given asset class or particular market, etc.

Most of these risk factors I just mentioned are in most people's formulas for calculating risk. I don't think I'm reinventing the wheel with any of these types of risks. There are more of these as well but I would consider these to be some of the more obvious ones. Opportunity cost, however, is one that I rarely see or hear mentioned by market participants, but is a risk factor that I actually think is one of the most important and can arguably be one of the most expensive. By this I mean: what else could I be doing with this money that I am allocating to this particular trade or investment that can make me more money in the meantime. What is the opportunity that I am missing out on by using this money to own XYZ?

One of the ways that I try and avoid opportunity cost is by not owning or shorting securities that are trading anywhere near a flat 200 day moving average. This to me is generally the sheer definition of a lack of trend. Who wants to own something that is not going anywhere? You'd be surprised how many people do. I prefer using a 200 day moving average because it basically gives you the average price over the past 3/4 of a year but when looking longer-term, a 200-week moving average works well also. Staying away from securities with a lack of trend is one of my favorite ways to avoid this type of risk. Breakouts to the upside tend to fail and breakdown also tend to fail. Securities trading near flat 200 period moving averages cause a ton of headaches in my experience. Who needs that?

Here is a good example. This is a the Telecom sector ETF $IYZ over the past year. I highlighted some of the failed breakouts and breakdowns that have quickly mean reverted as this lack of trend continues. This has been a difficult sector to be involved with since last year:

Securities in a sideways range also create expensive opportunity cost. Like in the example with flat 200 period moving averages, when something is in a sideways range, it also has a lack of trend. Why not wait for the range to resolve before getting involved? A good example of this has been Apple since February. As soon as Apple hit our $130 target, there has been no reason to be involved as it continues to trade in this 11-12 point sideways range. Both longs and shorts have been frustrated for most of the year:

There are other ways to avoid opportunity cost, but I wanted to bring up the conversation today because I don't think it gets talked about enough. Whenever we are putting on a trade, we want to consider, "Is this the best thing I could do with my money right now? Or is this just a waste of time/money that can be better allocated elsewhere in something that is actually trending?"

There is no right or wrong answer. No one said this was easy. In fact, making money consistently in the market is one of the most difficult tasks where even some of the smartest participants in the world consistently fail. Including opportunity cost as part of the risk equation I think gives us a leg up over other participants. Let's try to consider this going forward before putting on new positions. I really believe it's a huge advantage to keep this in mind.

Members of AllStarCharts.com that receive our research see constantly that we want to stay away from most things that lack a trend, except when they reach extremes and we are potentially looking for that mean reversion. To start to receive our weekly research reports, Click Here to find the package that is best for you.

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Tags: $AAPL $IYZ $STUDY