Volatility, Psychology, and Trading – Oh My!
There is a special relationship between Volatility, Psychology, and Trading. If you’re a bit sophisticated, you might already know what direction I’m going. However, if you’re relatively new to trading, you might have no idea what I’m talking about.
The Basics
Let’s start with the basics. In order to Trade, you need Volatility. In the simplest terms, Volatility is just a measure of how much an asset goes up and down. In more official terms,
“Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured from either the standard deviation or variance between returns from that same security or market index.” -Investopedia
People may debate over how to best measure Volatility but the overall concept is the same. The more Volatile something is, the more the price fluctuates.
Is Volatility a good thing or a bad thing?
If you’re a trader, Volatility is great!
If you’re an Investor, Volatility is really really annoying.
This is why I want to start with the basics. A lot of people get this all mixed up. They think like an investor when they want to trade and they think like a trader when they want to invest. What’s the difference?
Investors make money from compound interest over long periods of time
Traders make money from changes in asset prices based on changes in perception
Investors HATE Volatility because it makes their portfolio look risky. Traders LOVE Volatility because it gives great opportunities to make trades that have a high reward to risk profiles.
Traders want to take on a lot of risk to balance out the winners and losers. Investors want to buy high quality companies to hold forever.
So where does Psychology come into play?
Volatility and Risk
More Volatility necessarily entails more risk. This means the more volatile the asset, the greater the risk of losing money. However, at the same time, the greater the risk of losing money, the greater the reward if you’re on the right side of the Volatility.
Risk is inherently linked to uncertainty. The more uncertain people are about the value of an asset, the asset will be bought and sold at wildly different prices.
Let’s imagine a simple example of a company that makes $100 million a year. It makes $100 million a year consistently with no changes. This is regardless of economic conditions and it produces a product that people will need indefinitely. It runs its business well so there are very predictable outcomes.
As you can imagine, the valuation of such a company would be fairly simple. Just run it through some fancy formulas and you’ll get your discounted cash flow for the company. Therefore, the company’s price is well known and will likely hover around a consensus amount.
In contrast, let’s look at Bitcoin as an example of a Volatile asset. When it first came out, no one knew what Bitcoin was, or how it would be used, or what the future would hold for it. People would argue back and forth about whether it was going to revolutionize the world or just be another Ponzi scheme. Technically speaking, the verdict is still out.
With such a wide range of views, it’s no wonder that the Volatility of Bitcoin is very high. With such a High Volatility, a lot of people made huge fortunes from it.
High Volatility means prices fluctuate a lot. However, underneath the price fluctuations is related to uncertainty and disagreement about the value of the underlying asset. That is the fundamental psychological component of Volatility – Uncertainty and disagreement.
Building a Portfolio on Uncertainty and Disagreement
In the beginning of this article, I talked about how Traders need Volatility in order to make money. If we replace Volatility with Uncertainty and Disagreement, it’s clear to see that Traders need uncertainty and disagreement in order to make money.
Therefore, Traders need to be where there is the most uncertainty and the most disagreement to make the most out of their money.
However, if Traders are always where there is uncertainty and disagreement, isn’t that asking for trouble?
The short answer is: Yes – That is why 90% of traders lose 90% of their money in 90 days.
However, there is more going on.
If the world stayed the same, everything would be fairly predictable. People would go to their jobs. They would eat the same food every day. They would get raises on the regular. And they would retire as expected. Everything would be pretty much the same over and over.
There’s something else that would be the same. The rich would stay rich and the poor would stay poor. There would be no upward mobility at all if the world stayed the same.
However, the world is not so static. Rather, it moves and is constantly being disrupted. There are earthquakes and typhoons. There are bankruptcies and government collapses. There are also technological disruptors that create billionaires seemingly overnight.
The world changes and if you are a part of the positive part of that change, your quality of life improves. If you stand by and allow the world to pass you by, your quality of life will worsen.
This is life as it is. No embellishment, no sugar coating. Life changes all around us.
Trading is about taking advantage of changes in our world. For equities, it’s about changes in industries. Which industries are dying, which industries are rising? Who is serving more people at an exponential rate, who is barely keeping up with their competitors? Does anyone remember Blockbuster?
When the world moves, there is uncertainty and disagreement about how the world will move. However, you’re allowed to have an educated opinion on it. If your opinion is educated enough, you might come out ahead of various bets you make in the marketplace. If your opinion is absolute garbage, you’ll need lady luck to do you some favors.
Regardless of how the world moves, being a successful Trader is about chasing Volatility, which means chasing uncertainty and disagreement. However, it’s really about having a pulse on our ever changing world.
Volatility and Psychology: The Role of Perception
Who dictates what changes will occur and when they will occur? Did Elon Musk force electric vehicles to the public? Or was the time right for the public to accept electric vehicles? Or is Elon Musk going to fail spectacularly with Tesla after this article is published on the internet?
No one knows. That’s why there’s Uncertainty. That’s why there’s Disagreement. That’s why there’s Volatility.
However, the stock price right now of Tesla has to be based on something. Someone is buying and selling Tesla at a specific price because the person buying believes it will go up and the person selling believes it will go down. There really is no other reason to buy or sell an asset.
This market dynamic of buyers and sellers meeting is entirely based on perception. In fact, some could say that all markets are based on perception.
Perception is a funny thing. It’s an opinion that is neither objective nor necessarily true. It is specific to the perceiver and can be incorrect. Yet, it’s the best mechanism we have for assessing the price of assets.
So once we’ve accepted that markets are all based on perception, the role of psychology become obvious. People’s psychology affects their perception and, as a result, affects the prices they are willing to buy and sell.
So how do you use Psychology to understand Perception to understand Asset Prices?
Perception as a Tool for Trading
If you understand yourself very well, you can begin to understand others by placing yourself in their shoes. If you are unaware of yourself and why you do what you do, you will have a lot of challenge understanding the motivations of others.
There are numerous market participants in the market. However, they all have one goal: To make money. And they all make money in different ways.
If you want to understand the perceptions of the market, you need a strong process to gather the information needed to get a better idea of what’s going on.
For example, when Tesla was growing, there was a lot of debate over whether they could produce as many cars as they claimed. There was a lot of discussion over whether the electric vehicle was viable. A lot of people were calling for Tesla to become bankrupt while others had a price target of $4,000. With such a wide range of views, it’s anyone’s guess who would have the correct one.
However, this is why the value of Tesla fluctuated so much. Some days, the bulls would win and other days the bears would win. By understanding the fundamentals of the company, you can begin to build both the bull and the bear case. You can begin to understand what the Hedge Fund manager is seeing, what the average retail trader is seeing, what the long-term investor is seeing.
When you combine everything together, you begin to understand what’s happening with the Tesla. Once you’ve reached that point, you can begin to trade Tesla. You can begin to understand if the bears are too bearish or the bulls are too bullish. It’s about taking an amalgamation of all sorts of information and data to understand all the moving parts.
There’s one problem: You will never have all the information. And your information will always be imperfect.
If your information is incomplete and imperfect, you will be uncertain. And if you are uncertain, you will have Volatility. And if you have volatility, you will have Risk.
And that is okay. That is trading at its core. Taking on Volatility through process that creates consistent results in the long run.
Bringing it All Together
Volatility is a complex subject. I likely didn’t do it justice in this article. I went through a lot of concepts and it’s probably challenging to keep track of everything. But it all connects. Allow me to summarize how everything fits:
Traders Need Volatility to make money.
Volatility means Uncertainty and Disagreement.
Traders seek out changes in the world, changes that are very uncertain where people disagree.
When the world changes, Perceptions change. Traders stay on top of
understanding Perceptions.
They do this by understanding their own Psychology to better
understand the Psychology of others.
Traders recognize they cannot know everything. They accept Volatility as necessary risk.
A consistently profitable Trader has a strong process that builds a portfolio of High Volatility assets. These volatile assets are an accumulation of trades that have a high Reward to Risk Profile based on an analysis of perception.
I hope you found that helpful. I’ll see you next time.
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