Markets and "The Science Of Availability"

Only field that matters to markets is Psychology....Perception of Reality is the only Reality..

O Ashuji...

In markets, we often use the term recency bias to describe how we often tend to paint current understanding of events based on recent history or pricing of stocks based on recent events. The same concept has been beautifully explained in the book "Thinking Fast and Slow" - Daniel Kahenman (Chapter 12 - The Science of Availability). Ability of market participants to extrapolate recent events into the future is very natural because it gives sense of control over events. Assets gets priced accordingly, while future is invariably very different and hence asset prices in future is very different. I will quote part of text from the chapter "The Science of Availability" and then understand how same can be applied to option pricing. 

Markets and "The Science Of Availability"

"We defined the availability heuristic as the process of judging frequency by the - ease with which instances come to mind." -  "Thinking Fast and Slow" - Daniel Kahenman (Chapter 12 - The Science of Availability)

Similarly in markets recent price performance will be extrapolated and in most cases results will be very different. Few examples from the book "Thinking Fast and Slow" on "The Science of Availability"

1) A salient event that attracts your attention will be easily retrieved from memory. Divorces among Hollywood celebrities and sex scandals among politicians attract much more attention, and instances will come easily to mind. You are therefore likely to exaggerate the frequency of both Hollywood divorces and political sex scandals. 

2) A dramatic event temporarily increases the availability of its category. A plane crash that attracts media coverage will temporarily alter you feelings about the safety of flying. Accidents are on your mind, for a while, after you see a car burning at the side of the road, and the world is for a while a more dangerous place. 

3) Personal experiences, pictures, and vivid examples are more available than incidents that happened to others, ore mere words, or statistics. A judicial error that affects you will undermine your faith in the justice system more than a similar incident you read about in a newspaper. 

Similar examples one can be applied to markets and same gets priced into options accordingly. 

Options Value (primarily through higher implied volatility) will tend to rise going into major economic/monetary events. Market participants tend to exaggerate expected market movement. Actual market movement post event in most cases is very muted compared to implied by option prices. Apply this to Obama re-election event, Fed Meetings, RBI Meetings, Infosys Results, etc. Most of the time option prices will exaggerate expected price movement. Implied volatility plays very crucial role in option pricing. 

In past, I have written extensively about compression of prices and how the same affects option pricing. 

1) Why Options are best way to play "Central Banks" dominated markets.....(29 May 2013)

Link - http://speculationanart.blogspot.in/2013/05/why-options-are-best-way-to-play.html

2) August 2013....Setting up for BIG MOVE in Equity Markets...!!  (23 July 2013)

Link - http://speculationanart.blogspot.in/2013/07/august-2013setting-up-for-big-move-in.html

3) Market Compression Reaches Extreme !!! (26 December 2012)

Link - http://speculationanart.blogspot.in/2012/12/market-compression-reaches-extreme.html

4) Is Nifty's Implied Volatility Under Pricing Actual Volatility.....? (4 July 2013) 

Link - http://speculationanart.blogspot.in/2013/07/is-niftys-implied-volatility-under.html

Options can become very cheap due to...

1) trending markets

2) perceived risk is smaller than actual risk (when major events are out of way)

3) market moves are very subdued (small ranges, lower volatility etc) 

Very Favorable Entry Point in Buying Straddle or Puts for January 2014 for Nifty...

Indian Market (Nifty) Internals still fails to point healthy market (will try to discuss in some other blog)..Though entry point is not as good as in late July 2013 (Pls refer to blog dated 23 July 2013), but still very favorable. 

Subdued December (and major event out of way - RBI and Fed Taper) is getting priced into option markets through sharp fall in IVs. Actual risk is higher when perceived risk falls. 

Large number of trading days and lower IVs for Jan 2014 provides very favorable entry point for option buyers (more so put buyers)

Being Right Is Not Enough In Markets....

Large part of effort is spent on getting direction of market right...little is spent on how to play that direction right....

O Ashuji...

Most in financial markets (I refer to traders not brokers...brokers are as their name implies BROKERS) spend most of their time getting the direction right on markets. It may based on studying macros, price movement, inter market relationship, volatility, cycles, etc. But most of the time results are very different even though one may be right on the direction of markets. This is due to SIZING OF TRADES. In this blog, I will not get into how to size but why sizing of trades is important. 

Being Right Is Not Enough In Markets....(Why Sizing of Trades Matter)

Stock Price Moves are Compressed

Stock market returns are compressed (Price Moves are compressed, Large part of moves occur in very brief period of time). Since moves are compressed, wrong sizing of trades and frequent trades can drain you out before large moves set in. Trading is boring and Investing is even more boring because moves are compressed. If trading becomes exciting then its largely broker who is enjoying. Leverage should differ across times. If its kept constant then basic principle of price move (compression of price) is not respected and results will be very poor. One has to be active only during 20% of time (because 80% of price move occurs in 20% of time) and its only during this time sizing of trade matters. If sizing is poor during this time then at worst of the time sizing will be increased to compensate for the missed move. 

Extent of Volatility is Difficult to Know

Call on market direction may be right but extent of volatility could be very different which can drain out mental capital in the market. "I got the general direction of the market right, but I did not allow for volatility. As a consequence, I took on positions that were too big to withstand the swings caused by volatility, and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done better if I had taken smaller positions and stuck with them." - George Soros (Book - The Soros Lecture). Basically with reduced size of trade volatility can be played much better. 

Mental Capital is More Important Than Economic Capital

Wrong sizing of trade kills not only economic capital but also mental capital. Mental capital is far more important than economic capital. Being right on trend/trade and not making money or making very little money is very painful. One might not lose economic capital here but mental capital will be exhausted to capture future opportunities. 

Most of the biggest traders made largest part of their fortune in the smallest amount of time in their career. Trading is very different (compared to other businesses) and should be treated differently. Its not annuity game, its a barbell game. 

Bubble Talks (All Around)....

Asset Bubbles are formed when "This Time is Different"....

O Ashuji...

Asset Bubbles have been widely discussed topic. Many have devoted large amount of research to the same. I will not get into definition aspect of the same. One of the most important requirement of bubble is lack of discussion on bubbles. Bubbles are born and flourishes when "This Time is Different". 

Bubble Talks....All Around..

S&P 500 rally has been one of the most hated one because it has take most by surprise and continues to do so. Rally has been relentless on top deteriorating economic data. Most traditional "valuation" tools used by experts are flashing red flags (Unless belief is such high profitability and margins are sustainable). But Price action is supreme than opinions. Opinions are cheap and meaningless if they don't catch up with price action. S&P's price action continues to be strong among growing bubble talks which indicates - we could be in early part of big bubble formation. Market Frothiness can correct with time and price but when bubble is so widely discussed sustainable fall in asset prices is unlikely. I have never come across bubble discussion so much with market touching new highs. Most Discussions are centered around how Fed is fueling asset bubbles. 

Recent Bubble Talks...(I will not quote any blogs which reflects more of personal opinions)

Bubble fears as US stocks break records (20 November, 2013) - Financial Times

Link - http://www.ft.com/intl/cms/s/0/3375bc64-4e17-11e3-8fa5-00144feabdc0.html#axzz2lJFTgpvN

Why Stocks Are Undoubtedly Experiencing A Massive Bubble (8 October, 2013) - Forbes

Link - http://www.forbes.com/sites/jessecolombo/2013/10/08/why-stocks-are-undoubtedly-experiencing-a-massive-bubble/

Are We Headed for a Tech Stock Bubble? (18 November, 2013) - USA NEWS

Link - http://www.usnews.com/news/articles/2013/11/18/are-we-headed-for-a-tech-stock-bubble

As market bubbles form, investors may want to take cover (18 November, 2013) - Reuters

Link - http://www.reuters.com/article/2013/11/18/us-markets-bubble-analysis-idUSBRE9AH10J20131118

Bubble Trouble? (16 November, 2013) - Barrons

Link - http://online.barrons.com/article/SB50001424053111904227604579194121510134080.html?mod=BOL_twm_ls#articleTabs_article%3D1

I could go on and on with further links. Idea is to understand mood of market participants. Even during Janet Yellen (New Fed Chairwoman) First Senate Testimony, many senators asked her about stock market bubble. 

When price moves are stronger than ability to comprehend then those moves have a long way to go. Its only when sky is clear, trouble begins. This "Bubble" will burst only when confidence in Fed is lost (which will get reflected in bond and currency markets). 

Too Much of Analysis Leads to Paralysis.....

Fool me once shame on you, Fool me twice shame on me...Fool me all the times and I am Equity Strategist.
O Ashuji....

With so much of information floating all around, ability of understand has come down, while perception of intelligence has gone up. The most important breed in equity markets namely equity strategists have amazing ability to understand "cause effect" relationship. To justify their existence they might even come with explanation between central bankers farts and stock market returns. In past I have written about merits of Fundamental Analysis.

http://speculationanart.blogspot.in/2013/10/fundamental-analysis-heads-i-win-tails.html

Most of the equity strategists analyze market data far too much in terms of variables affecting stock market returns. One can scan through various local and global reports and it will be surprising to see how many variables are being discussed. Greater the number of variables affecting stock market returns poor will be its efficacy. Whenever a strategist talks about large number of variables affecting stock market returns or prices, its an implied acceptance that he has no idea about markets. Best part is with all wonderful analysis target price over one year will be 10-15% (such moves are common to occur over weeks to months). In past, I have discussed about Ridham Desai (Equity Strategist at Morgan Stanley) and his ability to be consistently wrong on markets because of his sheer knowledge on market variables. Such knowledge serves as rear-view mirror type analysis. In India, few guys (I have discussed in my blogs) are extremely knowledgeable and serves as great contrarian indicators. After a long time Ridham Desai appeared today on CNBC....

Expect Sensex to fall 10% in next 1 yr: Ridham Desai

Link - http://www.moneycontrol.com/news/fii-view/expect-sensex-to-fall-10next-1-year_988617.html

Market typically respect such calls in a contrarian way. Market respects humility more than knowledge. 

MarketWatch's Perma Bear Turns Bull ???....

If Bob Prechter (www.elliottwave.com) turns bullish on markets, one wouldn't need reason to sell...Even Bernanke won't be able to save market then...
O Ashuji....

There are certain market commentators who have had brain transplant, most with bullish mind set, while some are bearish. However there are few who are born bearish. There is a character called Paul B Farrell (Commentator on MarketWatch -www.marketwatch.com) who sees dooms day everyday. 2008 crash struck his mind and he is saying crash everyday since then. 

Paul Farrell's (MarketWatch) recent commentaries in 2013...

1) Stock market will blind side investors in 2013 (Jan. 1)

Link - http://www.marketwatch.com/story/stock-market-will-blindside-investors-in-2013-2013-01-01

2) Time bomb to market meltdown ticks louder (Jan. 18)

Link - http://www.marketwatch.com/story/time-bomb-to-market-meltdown-ticks-louder-2013-01-18

3) Critical Warning No. 7: Banks crash economy, again (Jan. 29)

Link - http://www.marketwatch.com/story/critical-warning-no-7-banks-crash-economy-again-2013-01-29

4) Your sequestered brain can’t see next crash coming (March 6)
Link - http://www.marketwatch.com/story/your-sequestered-brain-cant-see-next-crash-coming-2013-03-06

5) Bond crash dead ahead: tick, tick ... boom! (March 21)
Link - http://www.marketwatch.com/story/bond-crash-dead-ahead-tick-tick-boom-2013-03-20

6) New Critical Warning as 2013 shocker looms (March 25)
Link - http://www.marketwatch.com/story/new-critical-warning-as-2013-shocker-looms-2013-03-23

7) Critical Warning No. 13: Stockman’s ‘Apocalypse’ (April 6)
Link - http://www.marketwatch.com/story/critical-warning-no-13-stockmans-apocalypse-2013-04-06

8) GDP killing the future of American capitalism (May 13)
Link - http://www.marketwatch.com/story/gdp-will-make-a-generation-of-americans-miserable-2013-05-11

9) Doomsday poll: 87% risk of stock crash by year-end (June 5)
Link - http://www.marketwatch.com/story/doomsday-poll-87-risk-of-stock-crash-by-year-end-2013-06-05

10 ) New Doomsday poll: 98% risk of 2014 stock crash (June 29)
Link - http://www.marketwatch.com/story/new-doomsday-poll-98-risk-of-2014-stock-crash-2013-06-29

Suddenly Perma Bear has a Bull Vision Till 2017 in his latest commentary....

Shiller’s hot P/Es powering a ‘Roaring Bull’ till 2017

Commentary: As in 2004, market can keep going higher

http://www.marketwatch.com/story/shillers-hot-pes-powering-a-roaring-bull-till-2017-2013-11-06?pagenumber=2

Indian Market - Direct Play on Fed's Loose Monetary Policy....

In Markets - Being early is as good as being wrong...
O Ashuji....

Indian market is pure beta play on Fed's Loose Monetary Policy. I will not get into how bad things are in real economy nor will try to understand how marginally things can only improve from here. This subject is better left to Financial Comedians (experts on CNBC) who will have views both ways depending on the market levels. Basic Crux is Indian market is direct beta play of loose monetary policy.

Indian Market - Direct Play on Fed's Loose Monetary Policy....

1) Huge Dichotomy between perceived quality stocks (IT, Pharma, FMCG) and cyclicals (Banks, Capital Goods, Metals, etc). There has been endless debates about how polarized the market has been but when capital floats around the world and India has to receive its share, such outcome is very "rational". Indian retail mood is making lower tops with each all time highs. (On lighter side - that's huge divergence). Indian market will be vulnerable to whims of Ben Bernanke till broader market improves (broader market is sign of improving local financial conditions)

2) With hint of tightening (aka tapering) Indian currency was the worst performing currency (June-Mid Sep) and stock markets (particularly banks) collapsed. When Ben woke up from tightening dream, Indian market and currency bounced back sharply since Mid-Sep 2013. Both episodes were clear signs of how Indian market is slave to global capital.

3) It is really sad state of affairs when Finance Minister of country has to interpret Fed's Language after each Fed Meeting (One can frequently see FM's comments post FOMC) and Prime Minister talks about Fed Tapering in Parliament. All this is just the outcome of over reliance on dollars.

Be extremely careful about new highs and euphoria in markets (though must say sentiments have been making lower tops). Market lacks character of being stable and is extremely vulnerable. Bull markets start with far lower swings in prices than what we have seen in last 3-4 months and broader market participation is far higher. 

US Market Beautifully Set Up For A Crash.....

Going against crowd is the most difficult thing to do...yet in hindsight it turns out to be the smartest thing...
O Ashuji...

US market is through with all perceived risks (perceived risk hardly matters they are good for media debates) and actual risks keep on mounting. Please refer previous blog on "Risks - Perceived and Actual" http://speculationanart.blogspot.in/2013/10/risks-perceived-and-actual.html.

Everything Points to Nasty 3-6 month Outlook....
When markets are distorted as they are now, markets need not go to euphoric top. Crashes are more likely in distorted markets then secular downtrend. 

Hope of liquidity is the only thing that drives the market and one can get that sense to how market reacts to "bad" economic numbers. 

Most market participants are aware that markets are not being driven by fundamentals but yet participate in it because they know downside will be protected by Fed. 

Markets have all green signals in terms of all clear perceived risks. Its precisely during these times nasty surprises are more likely. 

Sentiments as measured by Daily Sentiment Indicators or AAII says "ALL IN" behavior. (DSI - 83% Bulls, AAII - 47% Bull, 17% Bear) 

All Actual risks will  sound common sense in hindsight, but they can only warn in the present. 

TIME TO AGGRESSIVELY BUY PUTS....