Trading on greed and fear

SPECIAL REPORT

Greed and fear, though not directly quantifiable, can be translated into measures of volatility. And this can be a useful trading tool.

In the financial markets, volatility plays a key role in determining the value of an asset. This is a neutral proposition cutting across every asset class. Unfortunately, there seem to be as many measures of volatility as there are participants.

As a result, focusing on a single true measure of volatility is a futile task. We shall instead concentrate on how this volatility (irrespective of the measure) could be used as a determinant and representation of underlying sentiments in the market.

Of late, all markets, from stocks and currencies to gold, have been whacked with enormous volatility.

In a recent report published by the World Gold Council, between March and June 2006, the spot gold prices soared by 14.5% from $638 to $731 an ounce, tumbled almost all the way back again and was trading around $637 in June 2006.

Around the same time the S&P CNXNifty (benchmark Indian stock Index) rose 20% from 3,123 in early March to a high of 3,754 and tumbled back to 3,128 towards close of June 2006.

This splurge of volatility is not difficult to understand. While long-term equity prices are driven almost exclusively by some fundamentals such as earnings and valuation, short-term prices are subject to the capricious whims of investor psychology.

Greed and fear definitely seem to have a lot more influence on short-term market action than the strategic fundamentals. Long-term investors usually loathe extreme short term volatility, while speculators seek and crave it. These are good times for speculators who are right and nasty for those who are wrong.

Given the volatile nature of markets, the big question before us is "“ Can one BUY and SELL greed and fear? Greed and fear, while not directly measurable, can be translated into measures of volatility.

In essence, can you buy and sell volatility? Can volatility be commoditised? And is it possible to replicate a volatility barometer that would provide a good signal to speculators and traders to play in such market conditions?

The key to defining benefits from a vibrant and volatile market lies in understanding this volatility measure. This could turn into an impressive record of accurately marking turning points in trading. SEBI and the Indian stock markets would definitely do well to introduce a benchmark market volatility index to assist investors in tracking such volatility. 
 

GRADING VOLATILITY
Volatility Level	Interpretation
5-15	Low anxiety to moderate complacency
15-25	Moderate anxiety to low complacency
25-35	Moderate to high anxiety
35-45	High anxiety
45-55	Very high anxiety to moderate panic
55-65	Very high panic
65+	Extreme panic

Index volatility "“ What the numbers say?
A peek through the movements of index volatility and corresponding underlying prices unravel the relevance of such an indicator as a perfect proxy for investor fear and greed"“an altar for short-term speculative investors.

It is interesting to note that high values of volatility have coincided with extreme investor fear signaling the short-term market bottom and a forerunner to a selloff.

Likewise a period of low volatility has been a harbinger of market peak. Such negative correlation can also be corroborated from the plots between index closing prices and underlying market returns.

Investors who buy or sell options inevitably have a directional view on the market and end up being long or short on volatility. But surprisingly, investors do not tend to treat such investments as specifically buying or selling volatility; in short, volatility has so far not been treated as an asset class of its own.

The Nifty time series analysis reveals that volatility values greater than 30 are generally associated with high volatility and correspond to investor fear or uncertainty. While values below 20 generally correspond to less stressful, even complacent, times in the market. The table given here provides an interesting summary to volatility levels corresponding to Nifty.

Applicability of volatility index
A peek through the movements of a volatility index provides a good indication when market complacency and panic are at their height.

A simple analogy can be drawn to a forecast on the drought and weather conditions for a farmer. When everything in the country looks wonderful with no droughts expected and good monsoon on the cards none would want to buy an insurance against possible damage to crops.

In stock market parlance, this signifies a calm market and in such situation buying calls (a bet that market will move up) outnumber put buying (a bet that market will go down). Such a market echoes lack of fear and signifies complacency in investor sentiment.

On the contrary, if the forecast was plagued by an unusually severe period of drought and cyclones, insurers would be left with little choice but raise the premiums that local farmers are required to pay for insurance against possible damage to their crops. In such conditions, traders tend to buy puts, which in turn pushes the price of these options higher.

Volatility trading
Volatility traders essentially bank on two fundamental parameters to assist them in decision-making "” historical and implied volatility.

Historical volatility (or statistical volatility) measures how erratic or volatile the asset has been in the past while implied volatility measures the market s perception of how erratic or volatile it could be in future.

Ceteris Paribus, an option on a stock or index that is more volatile is priced higher than the option on a stock or index that is less volatile.

When stocks or indices are stagnant, volatility decreases which, in turn, brings down option premiums. A fall in option premium in turn brings down the implied volatility levels. A fall in implied volatility generally goes hand-in-hand with bullish markets. Intuitively, this means (which is also a common belief) that bullish markets are less risky.

If the implied volatility of an option is lower than the statistical volatility then it is an indication that the option is cheap and traders could probably benefit from buying the option. In such conditions, traders would prefer to buy calls (a bet that market will move higher) than buy puts (a bet that markets will go down).

This is akin to a world where everything looks nice and calm. When a stock or index is fluctuating wildly, it is deemed volatile. When volatility increases, so do option prices.

For instance, if the implied volatility of an option is high while at the same time the statistical volatility has not budged much, it is an indication that the option is overpriced.

Therefore, selling the asset is warranted and hence traders could prefer buying puts (a bet that market will go down) than buying calls (a bet that markets will go up). When it looks like the sky is falling, it is natural for everyone to go for insurance and hence volatility spirals up!

Thumb rule: go long on panic and fear and short on complacency.

The success in creating a volatility index and allowing volatility trading as an asset class rests on the premise that current and future market trends can be captured by the current level of implied volatility in the options market.

Proponents opine that products on volatility as an asset class is attractive to first-time investors because the returns from both up and down movements help create a comfort level for them.

In parts of Asian sub-continent, particularly Hong Kong, South Korea and Singapore, investors are familiar with the concept of trading volatility through structured products.

Typically, investors buy and sell volatility "“ whether knowingly or not "“ through their investments in structures such as daily range accruals or equity-linked notes. Incidentally, a new breed of structured products has started to expose Asian investors directly to volatility as an asset class.

As Indian mindsets change and more investors view volatility as an asset class, markets would be encouraged to roll out these innovative products to meet this demand.

Most trading desks dedicated to volatility trading work closely with structured products to deliver pricing and hedging of risk on these issued products. This continues to be a growing area of focus for these desks. As the demand and competition for these structures in the retail market increases, so does the need for greater differentiation.

Warren Buffett once said, "Markets in the short term are nothing but voting machines". To paraphrase Buffett, markets are 'voted' based on greed and fear. When most market players are greedy, markets tend to rally. When most market players are scared, markets tend to plunge.

The key to speculation is recognising these swings in naked greed and dark fear and time entry and exit points appropriately. Successful speculators sell on extreme greed and buy on intense fear. They are contrarians who act opposite to natural human emotional instinct.

(The authors are consultants with the Financial Securities Group at Infosys Technologies. They engage in consulting global investment banks and asset managers in areas associated with trading and risk management. The views expressed in this article are personal)