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.

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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
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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
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Extremes in fear mark great buying opportunities.

Sample chart
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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
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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.

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When it comes to maintaining your computer, you’ve probably heard it all before. “Run Defrag!” “Scan Your Disk for Errors!” Although these two activities are important, there’s more you can do to extend the life of your computer beyond today’s predicted two-year span. In fact, by following the simple advice below, you can enjoy the use of your computer to up to five years or more - reserving expenses to simple software upgrades rather then complete and costly hardware upgrades.

One of the easiest and least expensive things you can do to extend the life of your computer is to get rid of unnecessary programs, folders, and files. A disk drive that’s clogged with unnecessary and unused files is disk drive that works harder than it has to. Although Window’s defrag system can ease some of the stress that these files place onto the drive, it doesn’t do much to get rid of the problem in the first place. This is because the defrag program simply organizes the files in a system that makes it easier for the computer to access. (Thus cutting down on the work required to find and load them). But this method merely “relieves” the symptoms that these files induce - it doesn’t attack the cause. These files need to be deleted - not “organized!”

Of course, deleting files can be a scary adventure to most users. Most computer users don’t know which files are safe to delete and which aren’t.

The worst thing anyone could do is snoop around crucial Window directories and haphazardly delete files that don’t look familiar. Doing so could render important programs inoperable, corrupt the Windows operating system, and possibly prevent the computer from even starting. That’s why using special deletion software is so important. Deletion programs will analyze a computer’s operating system and installed programs to determine which files are crucial to computer function versus which files are safe to delete.

You already have such a program on your computer and it’s Windows’ Add/Remove Programs (available from the Control Panel). This software will assist you with deleting programs that you not only no longer want, but additional files that these program use as well (dynamic link libraries, database files, registry references, shortcut icons, etc.).

But sometimes Windows’ Add/Remove Programs isn’t enough. Although this software does a pretty good job of removing unwanted programs, it can leave some files behind even after a complete uninstall - files which become orphan files. And it’s these orphan files that can really clutter up a hard drive and shorten the life of an otherwise, young and robust PC.

Orphans are usually files that contain temporary data created by a program, files created by the user, partial files left over from a computer crash, or any other kind of miscellaneous files created for almost any other reason. The problem is that an uninstall program doesn’t delete the orphan files it leaves behind because they were never part of the program when it was first installed. An uninstall program can remove only the files it placed onto a hard drive during its install routine.

So while Windows’ Add/Remove Programs can remove an entire program, you’ll need to get rid of those pesky little things with a more advance file cleaner like CleanSweep for example. CleanSweep is a unique program that will specifically seek out files that are no longer associated with a program, and then ask if you want to delete them.

The only time that you wouldn’t want to delete an orphan file is if the file were an actual document that you created before deleting a program. If you were to say, uninstall Microsoft Word, all the documents that you created with Word would then turn into orphan files. Or if you were to uninstall a graphics-editing program, all the pictures you made with the program would become orphan files.

The smart thing to do when you don’t want to lose the data that you created with an unwanted program is to:

1. Save or convert your documents to a format that will work with different program first (that is, a program that you intend to keep)
2. Archive them onto a floppy disk, flash drive, or CD-ROM
3. Proceed with a program like CleanSweep.

Using CleanSweep or any other similar type of utility could delete anywhere from less than a megabyte of hard drive space to over five megabytes and up. That may seem like a small amount of “clog material” to you, but to your computer, it’s a lot less to process!

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Benefits from real estate also sometimes take extra steps and responsibilities. If you are thinking of becoming involved in real estate, then you may also be looking at the job title of landlord. While this is a good way to make an investment and a living, you will want to consider several things before designating yourself to this job.

Before beginning the process of becoming a landlord, you will want to make sure that you can profit from it. This means finding the right place for potential tenants and having the ability to market and find the right demographics that you may want in your home. Having the ability to reach out to the right people can help you if you are thinking about renting property to others.

If you decide to become a landlord, you will want to make sure that you are made for it. You will want to ask yourself whether you are fit to deal with different personalities from tenants. Paying rent late, taking advantage of the property, and other problems will often arise. This causes maintenance and upkeep of different rental areas to be part of the job. You will want to make sure that you can handle different situations effectively and make sure that you can find the right way to take care of the different needs for everyone in the area.

Of course, becoming a landlord could be beneficial for you. If you have the right people in the right place, you won’t have to do much work and will only have to collect the rent. Most landlords, if they have a larger amount of property, will have hired help such as property managers in order to handle extra problems that may arise. If you are able to invest and grow enough this way, then you will have the ability to take a year long vacation while the rent is collected.

If you are one that wants to work with renting property and collecting extra profit from it, then becoming a landlord is a good option for you to consider. By finding someone else to live on your property, you will have the ability to collect rent instead of pay it.

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