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Market Conditions and Sentiment

Market shocks can create or destroy fortunes within seconds, so how can traders profit and protect themselves from these waves in the market?

You don’t trade with yourself, so understanding how other market participants think about the market is critical. You need to know what the market sentiment is as well as what current market conditions are.

For example, is the economy expanding or contracting? Is it a bull or a bear market or a trendless market? Market conditions can have an impact on how a market shock affects prices. Bearish news in a bull market tends to be ignored or exerts a smaller impact and has a shorter duration than bearish news in a bear market. Conversely, bullish news in a bear market might be ignored or exerts a smaller impact and has a shorter duration than the same news would have in a bull or neutral market. Knowing that the effects from a shock might be limited affects your trade horizon. It also has an impact on the sizing of the trade because of the risk associated with the shorter nature of the trade.

The level of the volatility index (VIX) gives one measure of market sentiment. VIX is also termed the fear index. VIX is a gauge of investor fear in the market place, in general, and the U.S. stock market in particular. Investors fear negative market shocks. Volatility in the market varies over time. Not surprisingly, it was greater during periods of great market stress and uncertainty such as during the Asian financial crisis of 1997–1998, the global financial crisis of 2007–2009, and the European sovereign debt crisis that followed. This is shown in Figure 1.1, which depicts the behavior of the CBOE Volatility Index over the January 1990 through November 30, 2012 period. Not surprisingly, the level of the S&P 500 stock index often varies inversely with the VIX.

Figure 1.1

Figure 1.1. The CBOE Volatility Index (VIX) depicts a market measure of uncertainty in the U.S. stock market.

(This chart is provided by, and reprinted with permission of, the Chicago Board Options Exchange [CBOE].)

Market shocks can happen anytime. However, you can be ready to profit from them during all periods of market volatility.

What is the value your ideas if they are already priced into the market? What is the value of your ideas if your timing is off? For instance, what value is the knowledge that prices are unsustainable if the bubble continues long enough to cost billions? As analyzed in Chapter 3, “Fads, Fashions, and Bubbles,” according to Ziemba and Ziemba [2008], George Soros’ Quantum Fund managers made precisely this mistake during the Internet bubble. They correctly analyzed that it was a bubble, but anticipated that it would end sooner than it did; the fund lost $5 billion, shorting the bubble too soon.6

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