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Strong stock market rallies, like the one we saw last week, have usually occured after periods of excessive fear. An overly fearful investor is an irrational investor, and some of the things that he or she might do is, for example, sell a stock below its intrinsic value, over-pay for market insurance in the form of a put option with high implied volatility, or even buy the put option when it is entirely not needed.

The put/call ratio is a reasonably good proxy for the level of fear and a very large number of traders follow it to measure irrationality-driven market chaos, which ultimately results in very good buying opportunities. Over the past three years, traders have become accustomed to buying the market when the put/call ratio has made a higher high and reaping huge profits.

But, something unusual happened last week. If a trader had faithfully been following the put/call ratio and waiting for a higher peak, they would have missed the big bounce. So, why did the trusty indicator fail to signal this entry point? Here is one hypothesis, but first look at the chart below.

Bad News is Only Shocking Once

The latest decline was not accompanied by bad news that we didn’t know about before – the same energy and subprime issues. Investors have become immune to these uncertainties. It would take either a very severe deterioration in the subprime situation or an entirely new negative event to shock investors into excessive buying of put options and pushing the put/call ratio to a new high.

Investors, being human, are highly adaptable once they know where they stand. It takes something new to produce in them the same level of high emotions as before.

Comments (6)

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1. scott said:
Monday, 3rd Dec 2007 at 8:47 pm

Another correlated explanation, related to the “Institutionalized” trading you mentioned above was highlighted on a recent trading blog. The writer uses a historically searched for the word $Vix across all websites and used high incidence of hits as a predictor of market bottoms. He showed graphically a very high correlation to market corrections and the use of the word $Vix in the media/internet/blogs. The peak usage on every occasion sited correlated to market bottoms.

He noted that during this current correction that there was very limited use of the word $Vix in the media. Instead he noted a high degree of correlation between the words sub-prime, and rising oil prices and the correction.

Apparently, the use of the word $vix is not as strong of a market mover as sub-prime is today.

In a recent Wall Street Journal article, Citadel chief Ken Griffin was quoted as saying, “that the time to be buying distressed securities was at the moment newspaper headlines were all saying at the same thing at the same time about sub-prime…”

Mr. Ken Griffin understands the media effects and market psychology very well.

2. Mo Shaarani said:
Tuesday, 4th Dec 2007 at 4:12 am


You shed light on some interesting points in your earlier comments.

It is fascinating how shifts in mass psychology affect or are affected by all sorts of events around us and I can imagine there is room for some big debates regarding causality here.

Also, I would be grateful if you could post a link to the post you refer to above. It would be interesting to learn more about the methodology used.

3. scott said:
Tuesday, 4th Dec 2007 at 9:29 am

I would of posted a link but cant remember where i saw the article, i monitor to many sites. I will check my history tonight, maybe i can find it again.

Like i said in a previous post, this issue has really got my attention. Figuring it out could be very rewarding financially, imho.

I love the charts here. There are some extremely powerful indicators here.

4. scott said:
Tuesday, 4th Dec 2007 at 10:15 pm

the article is dated tue nov 27, Not a Lot of Fear or Volatility Lately

5. scott said:
Tuesday, 4th Dec 2007 at 10:18 pm

this is the chart tool link. They give you access to changing the parameters. Also they provide a link to add to a web site.

6. Mo Shaarani said:
Wednesday, 5th Dec 2007 at 1:39 am

Thanks for the links Scott.

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