Wednesday, April 22, 2009

Fear vs Greed

There was some discussion of fear vs. greed the other day in the comments section of the blog. The discussion revolved around whether they were mirror images of each other. My contention was that they aren’t and I pointed to the study regarding Worden Bros. overbought indicator from Monday as evidence of that.

There are many ways to look at fear vs. greed. Today I’ll touch on the topic a bit more. For today’s study I first applied a zig-zag indicator to an S&P 500 chart to identify all places where the market rose or dropped at least 10% before swinging 10% in the opposite direction. Below is a copy of that chart.



While a reversal after a 10% move is an overly-simple and perhaps not terribly accurate definition of a “top” or “bottom”, it does well enough to make today’s point. For instance, I doubt many traders would refer to 10/13/08 as a “top”, but it qualified, so I used it.

I then took the dates of the last 12 tops and the last 12 bottoms going back to 1999 and ran a few simple tests.

The first simply looked at VIX levels. The VIX is often referred to as the “fear index”. It’s really more a measure of expected volatility based on options premiums, but when traders are fearful it tends to spike. I then took an average of the VIX for the tops and the bottoms. At the tops the average VIX reading was 27.41. At the bottoms the average VIX reading was 47.70.

This confirms the obvious point that traders are more fearful at bottoms than tops. It also suggests that expected volatility is much higher at bottoms. This volatility can present opportunity. But while the expected volatility is much higher, what about the actual volatility after the top or bottom has been made?

Below are 1-5 day returns for the 12 tops identified. (Based on $100,000 / trade)



Now look at the 1-5 day returns of the 12 bottoms.



People are too greedy at tops and too fearful at bottoms. Fear is a much stronger emotion, though. It therefore results in much stronger market moves. When trading overbought/oversold methods, traders should take this into account.

4 comments:

Anonymous said...

Illustrating as always! Appreciate it.

What do you think about the last weeks noise on the blogs (and elsewhere) that more and more quant and l/s funds are getting squeezed? Hard.

And that their deleveraging during this sudden rally is decreasing the liquidity, which eventually will render in lots of dried up markets - can you say crash?

I've also seen that SPY has been really hard to borrow lately. Might this be the reason we're having the repeated pattern of being into the red during market opening, but then always a quick and fast rally before closening as all are covering their market hedge?

R.

Daniel said...

I stand by my original comment. There is of course truth to what you say, Rob, but I think it's as much a matter of diffusion of attention as anything else. Topping is simply a different phenomenon than bottoming, for all the commonsense reasons... AND.. it is still all Fear.

At least for me. When I SELL it's bcs I fear no higher price will come along (for a meaningful while). Conversely, I BUY only bcs I fear I won't see a lower datapoint printed. If I rotate from A to B, it's bcs I fear that B will show greater future relative strength than A. Always fear.

Greed is a derivative of FEAR.. but, there IS also a secondary set of emotional and psychological factors with greed, such as ego, pride, competitiveness, etc., so there isnt an exact equivalence.

Great investors like George Soros are good at monitoring their own fear and discomfort levels. They cultivate the experience of the meta-emotion of "becoming afraid of their own growing lack of fear"... which sounds odd, but is actually a sound practice.

Daniel

Anonymous said...

the reason bottoms are different than tops is simply because MOST market participants are long side traders/investors

now, with so many mom and pop traders, even college and highschool kids, wanting to quit their job and school and trade for a living using technical analyssi and willing to go both long AND short, this dynamic will change

going long has always been the primary choice by market participants which makes them panic when a bottom is made

with retail traders willing to short the market, the tops will induce panic

i love the philosophical explanation by some people (sarcasm)

Anonymous said...

to anon1, the market refuses to drop because EVERYONE on earth is dying to go short the market

i have went short on April 6th

the market SHOULD have fell on that day according to technical analysis

but it didnst

my guess is that technical analysis is losing its edge as all sorts of people are flooding into the market after watching cnbc's fast money and picking up couple books off amazon and decide to trade for a living

although the market dropped for a day or two since i went short, i never took the profit since i thought it was go down more

i was stopped out the same week with a small loss



no matter what you read from a book or a blog or anywhere who say charts tell the direction, they are either lying, or just plain dumb

price moves because of people's position in the markets and their reaction to the previous tick

when everyone believes in technical analysis, it gets priced in and the follwoing action on the chart is "expected" thus creating no "reaction"


technical analysis will die completely in about a year or so, in my honest opinion

the culprit is of course the agents of this information age

the tv, the internet

where everyone searches for information and it becomes useless