Widespread Panic?

• Posted by Derek
• on June 18th, 2011

“I know it when I see it.” Potter Stewart

While many focus on either the wisdom or irrationality of markets, I find them to be a wonderful combination of the two…Dan Ariely’s book “Predictably Irrational” is not a trading or investing book but I think an apt description of the market’s DNA.  After reading Robert Sinn’s excellent work this week, I thought I’d share some thoughts to go with his thoughts on the subject of panic.

I like trends, but am not beholden to a pretty chart.  I’m beholden to my assessment of supply and demand.  When supply appears exhausted, I want to buy.  When demand appears unfulfilled, I want to buy.  Rinse and repeat.  They reason I use charts and data is to ensure that I’m reading the collective psychology and not my own;  I am the crowd if I don’t measure objectively.

We can measure fear a number of ways from $VIX to credit spreads to put:call ratios to sentiment surveys, but I know of only one way to measure panic…bar size.  A stock that consistently trades with a range of “X” will continue to trade with a range near “X” until emotion takes over.  At that point, we see a bar(or candle) of 2X or 3X or whatever.  On its own, this doesn’t indicate bull or bear or up or down; it just shows that someone freaked out.

So we see this enormous bar, and decide that someone(or lots of someones) caved in.  Now what?  Combine that with the path taken to get there, and we can venture a guess as to collective psychology but more importantly the coming reaction to that psychology.  A huge bar following a series of bars in one direction.  Scary, and ugly looking on a chart, but perhaps an opportunity to exploit the withdrawal of panic.  It’s not the panic from which we attempt to profit, it’s the unwinding of it…simple cause and effect.

Fear is a feeling, but panic is an action.  Those hedging with puts or cutting exposure to longs may be right.  Those abandoning alternative scenarios and throwing in the towel are most definitely not right.  A scalper’s panic might be a trader’s breakout might be an investor’s target price…none is invalid on its own but what matters is to apply the measurement to OUR time frame.  A one hour selloff ending with a 3X bar may trigger an awesome 15 minute reversal, but the longer time frame will dictate the next move so we need to sell.  A multi-week selloff ending with a 3X bar may end a bear market, offering a totally different holding period as both traders and investors react to the exhaustion of supply.  The very real Thursday afternoon panic from 1PM to 3PM was an example of one that fell in between these extremes; I expect more of these as this very real downturn tricks and treats.

Building a strategy based on buying panic at the end of a bear market is a little silly, but liquid stocks and indices like $SPY & $IWM & $TLT offer exploitable short-term panics if we resist the urge to buy the kind of fear lacking panic.  Once we get that far, then the right “time in” is way more important than the right “timing” because the reaction to a true panic is often fleeting but always substantial.  Now, if you can just find me someone to measure the appropriate level of patience once the trade is on…

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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