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Greed, Fear, and Volatility

I enjoyed reading Fred Wilson’s short post about fear and greed. The post can be summarized by the piece hanging behind Fred’s office desk:

Last summer I wrote a post about why the stock market is a great optical illusion. When prices march much higher, realized volatility decreases but embedded instability (potential energy) in the system increases. The opposite is true after a big fall. Realized volatility is high but the embedded stability of the market increases. The post can be summarized by the picture below.

These statements lead us to state the following dualities:

  • Perceived instability is potential stability.
  • Perceived stability is potential instability.

What works for the investor/trader at the greed/buy part of the cycle are:

  • Long stocks.
  • Short volatility.
  • Short correlation.

What works for the investor/trader at the fear/sell part of the cycle are:

  • Short stocks.
  • Long volatility.
  • Long correlation.

If he allocates capital following what works, he will repeat until broke.

Michael Bigger. Follow me on Twitter and StockTwits.

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Reader Comments (2)

Awesome post. One of my favourite post last year about the Physics reference to Potential and Kinetic energy.

January 27, 2011 | Unregistered CommenterAris

Short and sweet! Thanks Aris.

January 27, 2011 | Registered CommenterMichael Bigger

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