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Panicking The Euro

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By Dr. Stephan Ludewig
27.May 2010

Panic is a fear or an acute case of anxiety which dominates or replaces thinking and often affects groups of people. Panics typically occur in disaster or violent situations which may endanger the overall existence of the affected group. The word panic derives from the Greek πανικός, "pertaining to Pan”, because the ancient Greeks credited the battle of Marathons victory to their goat-god, Pan. They used his name for the frenzied, frantic fear exhibited by the fleeing enemy soldiers. Humans are also vulnerable to panic and it is often considered infectious, in the sense one person's panic may easily spread to other people nearby and soon the entire group acts irrationally.
In financial markets panic selling is a wide-scale selling, in order to get out of an investment. A rapid increase in sales order for a particular investment, which pushes down its price. This can cause a spiraling effect or "vicious cycle" in which investors see a rapidly decreasing price as a sign to get out of a investment, which further depresses the price and prompts more investors to sell. This type of selling is often related by a fear of loss. The main problem with panic selling is that investors are selling in reaction to pure emotion and fear. Almost every market crash is a result of panic selling.

Fig.1: Euro Panic Selling, 01. March – 21. May 2010

Furthermore "Loss aversion" (being more averse to losses than gains), as it is known in the world of behavioral finance, is validated within the VIX world. The VIX concept was first introduced in a research paper by Professor Robert E. Whaley at Duke University. With the introduction of the new VIX index in 2003, volatility has become an asset class, tradable through the use of futures. VIX futures and options are both negatively correlated with equities market performance.
The development of this new asset class is one of the more important developments in the options market since the introduction of the Black-Scholes pricing model in 1973. The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis.

Fig.2: VIX (Volatility Index), 01. March- 21. May 2010

Investors believe that a high value of VIX translates into a greater degree of market uncertainty, while a low value of VIX is consistent with greater stability. Although the VIX is often called the "fear index", a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of fear of volatility in either direction, including to the upside. A high value means that higher volatility is expected. Also, extremely high readings usually indicate stock market bottoms and extremely low readings usually indicate stock market tops.

Fig.3 DOW, 01. March- 21. May 2010

Fig.4 DAX, 01. March- 21. May 2010

Although the VIX directly refers only to stock and equities, currency investors can take advantage of VIX by investing into currencies that are highly related to stock markets. Higher readings in the VIX, derived from prices paid for Standard & Poor's 500 Index options, indicate traders expect larger share-price swings in the next 30 days, so one can consider VIX as very useful indicative tool of market expectations. In cases of very high implied volatility one can even expect big collapses of stock prices and high gains on currency front. For currency speculates volatility is the best period of profits. Talking About VIX investors tend to believe that high value of it translates to higher risks in the market and lower value to more calm and stable markets.

Fig. 5: Spearman rank correlation between EUR/USD and VIX (n=30, r = - 0.913). VIX is negatively correlated to EUR/USD, 01.03-21.05.2010.

Panic selling naturally creates great buying opportunities for well-informed traders and investors. Those who know when the selling is over can benefit from the retracements that often occur afterwards.
Eventually, fear arises in investors as they start to think that the market is not as strong as they initially assumed. Inevitably, the market collapses on itself as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the mania started, and from which it will likely take years to recover. The crowd is never wrong, reflexivity in financial markets or sell in may and go away ?

Ludewig S, et al. Decision-making strategies by panic disorder subjects are more sensitive to errors. J Affect Disord. 2003 Sep;76(1-3):183-9.
Ludewig S, et al. No lasting effects of moderate doses of MDMA (Ecstasy) on memory performance and mood states. Biol Psych, 2003:205 San Francisco
Ludewig S, et al. Information processing deficits and cognitive dysfunctions in panic disorder. Can J Psych Neuroscience, 2005

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