What happens when the market gets emotional?

[TradingAdmin]

And you thought your wife is the only one that gets emotional?  Wait until you see what the market does!

The price that the market charges (or is willing to pay) for an option is determined by risk.  The higher the perceived risk, the more the market will charge (or be willing to pay) for the option.  Risk in turn is determined by three things: (1) how far the strike price of the option is from the actual futures price, (2) how much time is left before the option expires, and (3) and this is the most important, the perceived risk in the mind of the investor.  We measure this risk as a value called the "implied volatility" or IV in short.  When market conditions are calm, investors will be calm, the IV will be low and the options will be cheap.  But if something changes and investors become frightened (emotional, scared, worried), the IV will rise and option prices will likewise increase - the perceived risk will rise..

Let's take an example.  Here is Crude Oil (WTI Crude, August 2015 futures contract):



Crude has reached a plateau, an area where it is going nowhere, it is trading sideways.  In this state it can continue to move sideways for a considerable period of time - we can see it is moving roughly up-and-down and up-and-down between a price of $62/barrel and $58/barrel.  While you cannot trade this with a futures - for fear of being whiplashed up-and-down, we can trade it with an options strategy by simply selling an option both above and below the price range. As follows:



The graph above taken from Options Explorer.  We sell a Call option at $62 and a Put option at $58.  We collect a total of $3,100 in premium from the market for these two options - that is right, the market pays us a non-refundable premium for taking this risk.  On the left side is shown your profitability and on the bottom axis the price of the oil futures.  The red line shows us the profit / loss at options expiry (which is 36 days from today).  The blue line shows us our profit / loss on the day that we enter the trade (that is today).  We setup this trade when crude is trading at close to $62 per barrel - at that point (today, blue line) we see we are at $0 profit.  Should the price drop we'll make a little profit, should the price increase we'll loose.  At the end of the contract (36 days, red line), if Crude is still trading between 58 and 62, we will make $3,100 profit; if between about $55 and $65, we'll still be making a profit (less than $3,100, but a profit nonetheless).  Below $55 or above $65 we'll be making a loss - on expiry date.  It is a nice trade, provided Crude does as expected and continue to move sideways!

Thus, if all goes like planned and crude continues to move sideways, then over the next month we'll be making some really nice profit for.., well, for us doing nothing, we just wait while our money works for us.

That is... unless the market becomes emotional!  Consider the situation 20 days into this trade:

• If the market suddenly becomes emotional, that is if investors become scared for some or other reason, their perceived risk increases, then if we look at the dark blue line (bottom line), we will be looking at a loss, no matter the price where crude trades at
• If on the other hand the market calms down, investors becomes calm, unemotional, relaxed, then the yellow line shows that we will be making a lot of money

It does not matter what price Crude is trading at or how much time is left (it does, but it plays a small role) - the market is controlled by EMOTION!!  If investors become scared and the emotion rises we will be in trouble!  If the market calms down, we will be into serious profit.  Take any price!  Take a price of $60 - right in the middle of the trading range - if the market is scared, we'll be looking at a loss of close to $700!  If on the other hand the market is calm, we'll be looking at a profit close to $3,000!  ALL just based on the emotion of the market!

What does this mean!??

It simply says - ask the question, before you enter into the market..- "What is the emotional state of this market at this point in time!?"
If we know the answer to this question, then we know what to do..!!  For if the market right now is volatile, scared, emotional, then this is a really great strategy!  If prices moves sideways for a couple of days, then the market will calm down and just the fact that the market calms down will make us a lot of profit!!
BUT, if the market is already calm at this point - well then the risk is there that the market will become emotional (it will not calm down, it is already calm), then you have to ask yourself whether it is worth taking this trade or whether you should rather look for a different commodity, a different market!?

Can you see where this is leading to?  There is more into trading than just entering a position - if we had a way to determine the market's emotional state before entering a position, we can ensure that we create ourselves the maximum chance of success - we can put the probability in a trade into our favour!

We'll explore this concept a bit further in a follow-up post..

[TradingAdmin]

Herewith the follow-up post as promised...

Let us look at this Crude Oil trade from a slightly different angle.  I am going to use Options Explorer and draw the same picture as above in a slightly different format (I turn the graph sideways and super-impose it over the price chart for crude oil, but I am only drawing the break-even lines for the position we are setting up)



Again, we are SELLING two options, a $62 strike price CALL option and a $58 strike price PUT option.  The premium we collect is $3,100.  We will be making a profit (up to a maximum of $3,100) if the price of crude oil stay between the two yellow lines!!

Now it is easy to see that IF the price of oil is going to stay level, that is IF crude oil will continue to trade up-and-down between 58 and 62, then this strategy will make us money.  At the bottom of the graph we can see the time left and looking at the graph you can see between which prices crude oil needs to stay each day in order for us to be profitable.  You can also see that on expiry day (in 36 days time) those two prices are $55 and $65 - thus the same information as the graph in the previous post (the expiry day red line).

Of course, us entering into this trade means someone else somewhere in the world is entering into the opposite position.  Whoever is in the opposite position bargains on the price of crude oil moving OUTSIDE of these two yellow lines in order for this party to make a profit.  The question is, "where do YOU want to be?"

• Would you like to position yourself to make a profit with crude prices between those two yellow lines, or
• Would you rather make a profit if Crude Oil trades outside those two yellow lines?

It really depends on your view of the market!  Where do you believe Crude is going to go over the next couple of days !?

THUS, LET US NOW ADD EMOTION INTO THE PICTURE !!

First, what if the market calms down, if the market starts relaxing - what if the IV for Crude Oil decreases?  If the emotions of the traders making up the market calms down over the next 20 days?



The market calming down has a dramatic effect!  Would you still like to be positioned OUTSIDE those two yellow lines, or would you rather take your changes BETWEEN those lines?  Note:  It looks good but you can still loose!  There is no such thing as a guaranteed win!  If the price of crude suddenly overnight shoots up, or melts down you can still make a loss on this trade!  But the probability favours the Traders that has positioned themselves BETWEEN these two lines!

NOW, what if the emotion in the market rises, what if economic or political events causes traders to become scared, frightened, what if Traders' perception of risk increase and the IV for Crude Oil increases over the next 20 days?



Gheez..!!  This is an equally profound change!  Finding yourself BETWEEN those two yellow lines now seriously threatens your profitability on this trade - chances are you are going to loose!  In this case whoever positioned themselves OUTSIDE those two yellow lines have by far the best chance of success with this trade!

SO NOW:

Can you afford to enter into this trade without ANY knowledge of the emotional state of this market?
If you could first, before deciding where you would like to position yourself in this market, get information on the emotional state of the market, will that influence the way in which you trade this market?  In other words where you position yourself?

Options Explorer does exactly that!!  Every day it calculates the emotional state of ALL the markets we are interested in and rank them for us from high to low..  Which allows us to determine (1) the markets we'd like to trade in and (2) how we'd like to position ourselves in that market for the maximum possible chance of success!! 

[thoward]

The best explanation of how volatility impacts the market I have seen!

[Atwater]

Very interesting read indeed. Makes you realize how complex trading really is. There's so much to account for.