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VIX and the Psychology of Markets
VIX and the Psychology of Markets
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.
About the author:
Stephen Whiteside has been trading since 1974 and has been CEO
of the stock trend analysis site, www.TheUpTrend.com for the
last 5 years. Enter "Smart
Money Alerts" into any search engine, and you will see his
work is currently ranked #1 around the world. What to learn
more, please sign up for your free 30 trial.
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