To try and gauge the mood of traders, sentiment indicators have been developed. The more common of these have been based on volatility readings and the Put/Call ratio. Futures traders have the added advantage of looking at the composition of market participants.
Volatility Readings: The Demise of Volatility as an indicator ?
"Volatility" is a sentiment indicator rather than an objective measure of the market. It needs to be understood as such. To do this , one needs an understanding of individual and social psychology. The current primary indicators that investors are using, the VIX and VXN .These have an intrinsic composition that places limits on their use. The value of volatility based readings will remain, but has been discounted due to their increasing use and popularity.
The Evolution of Volatility Indicators
The reason for this is based on how these have evolved , being based on option valuation models. There is "historical volatility" that is a statistical derivation of actual prices, and there is "implied volatility". This is derived from equations such as the Black- Scholes relationship, and produces a volatility reading from actual option prices, the actual underlying price & interest rates. Thus this derived figure is "implied" volatility, and becomes a gauge of option buyer and seller expectations.
Option buyers and sellers are not the market, even though their backing institutions may represent a large sector of the market. Even professional and amateur option players are effected by the current "group think", and the market doesn't even seem to know that professionals should be right!
Quantal Theory can help a lot in our understanding of volatility. The mass of emotions in a market make a complex system. Behaviour emerges in quanta...believe it or not! Even the 50% level has shown it's universiality !
Psychological Factors
Both individual and group psychology explain some of the vagaries of the sentiment indicators. We may think that that we can remain independent of these ourselves, but like it or not, we are far less independent than we think.
Individual Psychology
We are designed to survive, and to survive we need to be aware of danger. Danger is signalled by change, and not stagnation. This even has a proven sensory basis (e.g. the Riddoch phenomenon: this is the heightened sensitivity to a moving object in the peripheral visual field- it can be easily measured). To allow us to stay alert to change, we adapt to a constant stimulus by learning to ignore it.
The trading addict eventually develops habituation and fear turns into thrill.
Thus if there are changes that are a cause fear, a continuation of these changes will generally lead to less fear comprehension, although the danger may be the same .Ask the novice versus the habitual bungee jumper about the pre-leap fear.
Social Psychology
"Group think" remains a powerful influence on the individual investor. The group is sometimes right, but whether it is right or wrong, provides a sense of reassurance , belonging, and safety. It’s a happy party when the group is right, and one would be stupid to leave the group. There is great social cohesion amongst those who have suffered a loss and the mutual commiserations become the reward for being part of the group. Anyone who didn’t suffer the loss is an outsider.
Those who hold a contrary opinion are made to feel as outcasts, and unless they find contrarians of their own ilk, remain alone. Those who do join a group of like minded radicals soon become hyper polarized as their cohesiveness depends on their contrary stance. Hence they too are usually wrong when the market turns.
The group fosters a win /lose co dependence.
One special group of co-dependents are newsletter writers and their subscribers. After a loss or a missed move, writers indulge in a period of soul searching, and seek to justify their past advice.
The standard market commentators continue to cheer both losers and winners from the sidelines, encouraging all groups to keep playing the game of speculation.
Rumours , secrets and whispers pay an important role in group cohesion. This is traded upon by may newsletter writers, as they know that this is what their readers are hoping for: secret knowledge leading to wealth.
The following was first published in our August 2002 newsletter:
"The Frightened Investor"
Fear has saved us - from the sabre tooth - but can it help us as traders? How does it effect us? How can we overcome it? Over the next few issues of the "Infognome News", we'll be taking a look at the fear issue.....that is if I don't get scared off.
Firstly a bit about what fear is. It's more than just a feeling that we have when we've forgotten to put the rubbish out. It's a total body and whole brain response. We can adapt to many of its effects so that fear may manifest as stress symptoms, however the effects on our thought processes are the same.
In the future we are going to see more behaviour that is driven by fear. I'll tell you why we should make sure that its not driving our behaviour .We may even avail ourselves of huge profit opportunities if we know what fear does.
Fear can paralyse.
The road-kill that litters our highways as they snake through rural land is evidence of the power of fear to paralyse. And so investors, their portfolios caught out in a market crash, are unable to move, and their stocks are slaughtered. It is good to practise selling stocks that that are weak. With each trade we enter ,we should have exit criteria and stick to them.
Fear Puts on blinkers.
I am of the generation when our milk was delivered by horse and cart. Many rich images remain- the neighbours racing out to retrieve manure for their gardens (blow the milk), and the draught horse's blinkers. The only thing thing that would stop that horse once given the command to move would be something directly in front, such as domestic road kill...."Pussy is just having a sleep" .This was great for the milk, but for an investor, a blinkered approach blocks the warning signs of disaster. Our brains don't like fear, so the blinkers guard us from signals that disturb or cause conflict. This is why we need a dispassionate and objective means of monitoring the markets.
Fear Makes us vulnerable to suggestion
This is a major factor in crowd behaviour - for instance, some one shouting "fire" in a theatre can cause a stampede, even amongst those who are usually implacable. Such is the emotion that takes hold in a crash. Investors rush in to sell stocks at low prices that previously would have been regarded as a bargain.
Fear Makes us irrational.
It is extremely difficult to concentrate and keep a level head when all around you appears to be falling apart. This is particularly the case when overcommitted. The example that is used in the Nifty 50 shows how important money management was during the 1929 crash.