We know that greed and fear rule the markets. But did you know that
when investors gets too greedy, markets usually fall, and when
investors are overcome with fear, markets usually rise. So how can when
we monitor investors emotions and take advantage of investors emotional
extremes?
Welcome to the world of investor sentiment analysis.
Investor psychology has been analysed for at least 250 years. Charles
MacKay wrote his book, ‘Extraordinary Popular Delusions And The Madness
Of Crowds’, in 1841, describing, among other manias, the herd mentality
that caused the South Sea Bubble. Since then, many academics have
published financial theories based on the concept that individuals act
rationally and consider all available information in the
decision-making process. But real life frequently demonstrates that the
behavior of equity markets is irrational and unpredictable. A field
known as “behavioural finance” has evolved over the years attempting to
explain how emotions influence investors and their decision-making
process. Studying human psychology helps predict the general direction
of financial markets as well as many stock market bubbles and crashes.
At the height of a period of optimism, greed moves stocks higher,
ignoring business fundamentals and therefore creating an overpriced
market. At the other extreme, fear moves prices lower, ignoring obvious
opportunities and creates an undervalued market.
One important study, (“Aspects of Investor Psychology,” The Journal of
Portfolio Management, Summer 1998) found that investors are much more
distressed by prospective losses than they are made happy by equivalent
gains. Some researchers theorize that investors “follow the crowd” and
conventional wisdom to avoid any regret in the event their decisions
prove to be incorrect.
QUANTIFYING INVESTOR EMOTIONS OR INVESTOR SENTIMENT
When a stock or market index rises, we know that it means investors are
more eager to buy than to sell. But how can we accurately gauge just
how investors feel?
Most often, investors are somewhere between mildly positive and mildly
negative, and only occasionally do they demonstrate the extremes of
greed or fear. It is easier to detect emotion when it is close to
either irrational exuberance or outright fear. When markets act this
way, it becomes "news" and moves from the business section, to being
featured at the start of the evening news, and on the front page of the
daily newspaper.
The success of charting as a tool, depends on investors repeating their
behaviour patterns. There is always a comfort factor in doing the same
as others and generally an aversion to behaving differently. Investors
display herding instincts in their behaviour and this has become
particularly noticeable among institutional investors. In the early
stages of a rising trend in a market, positive sentiment can act as a
positive driving force as everyone rushes in to join the party.
However, there comes a time after the trend has been in place, when
this positive sentiment acts as a warning that the trend is nearing its
climax. That’s when smart investors will start switching to alternative
investments.
The most sophisticated and active players in the market use derivative
products to effect their transactions. These players tend to display
earlier changes in emotion than most investors and normally their
emotions run to greater extremes. So, derivative markets are a good
source of data on investor sentiment. There are various options
available on stocks, ETF's and indexes. By using an option pricing
formula, we can extract a measure of how much investors are prepared to
pay for the possibility of making a profit, or hedging against a loss.
This is known as implied volatility, and it provides a mathematical
valuation of investor emotion. Implied volatility tends to be high (the
scale is inverted) when the market has had a sharp fall and this is
associated with investor fear. At the other extreme, low implied
volatility often occurs after a rise in the market and when investors
are becoming complacent.
Implied volatility image
http://www.theuptrend.com/ebook/ImpliedvolatilityAA.gif
WHAT IS THE VIX?
VIX is the symbol for the Chicago Board Options Exchange's volatility
index for the S&P 500 (SPX). It is a measure of the level of
implied volatility and not historical or statistical volatility. A
numerical value for the VIX has been published by the CBOE since 1993.
The method of calculating VIX was changed in early 2003. Instead of
using the S&P 100 (OEX) Index options, it is now calculated using
the options on the S&P 500 (SPX). Also note that the VXN is the
symbol for the implied volatility index of the NASDAQ 100 index.
The implied volatilities are weighted to give the VIX a value that in
effect acts as the implied volatility of an at-the-money SPX option at
22-trading days to expiration. The VIX represents the implied
volatility of a hypothetical at-the-money SPX option. If implied
volatility is high, the premium on options will be high and vice versa.
Generally speaking, rising option premiums reflect rising expectation
of future volatility of the underlying stock index, which represents
higher implied volatility levels. The higher the VIX, the more panic in
the markets and the greater the chance that investors have given up
hope, taken their money, and gone home.
Comparing the movement of the VIX with that of the market can quite
often provide clues as to the future direction the market might move.
The more the VIX increases in value, the more "panic" is an issue in
the market place. On the flip side, the more the VIX decreases in
value, the more complacency there is amongst investors. The
psychological impact measured by a relatively high VIX is a clear
indicator that tells traders markets are oversold. A historic example
was displayed on July 23rd 2002 when the VIX shot over 55. That big
move coincided with a significant low in the Dow Jones Industrial
Average that was followed by a 1,034-point, six-day rally. That rally
didn't stick and the market again re-tested its July low in October of
2002. But throughout this double bottom in 2002 the VIX accurately
identified a major directional shift in the market. At its core, the
VIX is a statistical measure of emotions, and emotions are a major
factor signalling capitulation in the market.
Sample charts
http://www.theuptrend.com/ebook/Impliedvolatility1.gif
http://www.theuptrend.com/ebook/Impliedvolatility2.gif
INVERSE RELATIONSHIP
Extremely high readings of VIX indicate market bottoms, while low readings indicate market tops.
The VIX actually has an inverse relationship to the stock market. This
is one of the first things you'll notice when viewing the VIX on a bar
chart. When the VIX goes down the stock market moves higher. When the
VIX advances, the stock market is headed lower. Generally speaking, a
rising stock market is considered less risky by investors. On the other
hand, a declining stock market is considered more risky. Therefore, the
higher the perceived risk by investors the higher the implied
volatility. This will make options, especially put options, more
expensive.
When the phrase "implied volatility" is mentioned, keep in mind that it
is not about the size of price swings. Rather it's the implied risk
that is associated with taking a position in the stock market. When the
stock market declines, the demand for put options usually increases.
Increased demand means higher put option prices.
USING VIX to TIME the MARKET
One early study identified a VIX value of 25 as normal, and a value
above 35 as high. Between October 1997 and May 2001 the VIX indicator
went above 35 eleven times. In this study, the S&P 500 index as
represented by SPY ETF. was purchased each time and held until the VIX
retreated below 25. There were 9 profitable trades for an average gain
of 3.1% and an average holding period of about one month. By using this
VIX timing scheme you could capture 80% of total gains in the market,
but your money is only at risk one third of the time.
Sample chart
http://www.theuptrend.com/ebook/Impliedvolatility3.gif
Extremes in fear mark great buying opportunities.
Sample chart
http://www.theuptrend.com/ebook/Impliedvolatility4.gif
THE CONTRARIAN VIEW POINT OF THE VIX
An extended and/or extremely low VIX suggests a high degree of
complacency and is commonly considered bearish. From the contrarian
view point ,many traders are of the opinion that if the VIX becomes
low, they'll begin looking for a reason to begin selling stock. On the
flip-side of the coin, a very high VIX can indicate a high degree of
anxiety which often leads to panic among options traders. This action
is often considered bullish by the contrarian, and they'll look for
reasons to begin buying stock. High VIX readings usually occur after an
extended or sharp market decline with investor sentiment still very
bearish. Some contrarians view readings above 35 as bullish. Hence,
they'll begin looking for a major market turn to the upside.
The VIX should be used in conjunction with "regular" analysis of price
action on price charts. The wise trader will never make a purchase or
sale based solely on the price level of the VIX. The wise trader will
use the VIX (and its support and resistance levels) in conjunction with
the price action of charts of the S&P 500, the Dow, and the NASDAQ.
Using the VIX with charts of these indices will help you get a good
grasp of the current market psychology. Since market movements are
based entirely on human emotions, it is important for traders to
understand psychological indicators. When the VIX is used correctly it
helps you stay on the right side of the market and make profitable
trades.
SUMMARY
Understanding Investor Sentiment (or Investor Psychology) is by far the
most powerful tool an investor can use to understand exactly where the
stock market is, and where it is going. But it is often hard to digest,
as it is counter intuitive to our human nature.
Here is a recent example that will help illustrate this point.
In September 2005, the TSX was making multi year highs. While the VIX
Indexes was down near multi year lows. Standing back and looking at
these two pieces of information, you might question the wisdom of
adding long-term money to this market at this time.
You might, but human nature would not.
From GARY NORRIS
Canadian Press
Mon Oct 17, 3:58 PM ET
Canadians are shovelling money into mutual funds almost like it's 2001
again, with September purchases of $1.8 billion - up from net
redemptions of $545 million a year ago.
The Investment Funds Institute of Canada said Monday that investments
in long-term funds - equity, bond and other funds excluding short-term
money market funds - topped half a trillion dollars for the first time.
"This underlines the fact that investors are making long-term
commitments to funds, and not simply parking their investments
temporarily in money market funds," commented Tom Hockin, president of
the fund industry association.
Sales in the first nine months of the year, net of redemptions and
excluding reinvested distributions, totaled $18.4 billion, "the highest
net sales figure since the same period in 2001," Hockin observed.
Yes, you read that correctly, Canadian have not been this enthusiastic since the last time the market was peaking.
TSX Sample Chart
http://www.theuptrend.com/ebook/ImpliedvolatilityB.gif
Now we don't have enough data yet, but since Canadian Mutual Fund
investors did their "extreme" mutual fund shopping last month, the
market has already dropped 800 points.
Now ask yourself, if you were going to put money into this market, was
September the best, low risk time to do so in the past 5 years? Were
these investors thinking analytically, or did the emotion of greed
cloud their judgments?
My guess is that this is what I like to call "Panic Buying", of
Canadian Mutual Funds last month, will signal the very top of this
market, and be the catalyst for a major sell off.
Only time will tell if I am right.
