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April 18, 2014  Fri 10:27 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
A recent study and several articles about it have highlighted the role of physiology in trading. We have discussed the role of strategy, logic, and psychology in the markets, but physiology has often been overlooked.

The paper looks at the role of the stress hormone cortisol, noting that it increases with market volatility. When cortisol levels go up, according to the research, traders are less willing to take risk.

If this is true, there must be a very high correlation between cortisol and the CBOE Volatility Index. Higher levels of the hormone would drive the VIX even higher as equity assets get sold and protection is bought to reduce risk.

The researchers concluded that "physiology-induced shifts in risk preferences may thus be a cause of market instability that has been hitherto overlooked by economists, risk managers, and central bankers."

There has been other work in this area, specifically on the role of testosterone in risk-taking behavior. When male traders take risk and win, their testosterone levels rise, inducing them to take even more risk. This may well be one of the real drivers of market bubbles.

The dynamics involving cortisone are kind of the converse. The VIX is known as the "Fear Index" because it goes up when the S&P 500 sells off. The VIX is an index of implied volatility and is most correlated to the market's actual volatility, which rises when stocks fall. But there is a function of fear when traders must buy the insurance of SPX puts when it is expensive, much like those in the path of a hurricane that decide much too late that they need to insure their home. Maybe we should start calling the VIX the "Cortisol Index."

Most traders believe themselves rational and logical beings. But all of the work done in behavioral economics has exposed our various psychological biases, which tend to hurt us in our trading and investing. The impact of physiology, however, has been mostly overlooked. Early indications show that hormones that drive our behavior are yet another obstacle in the way of trading success.

Can we overcome our psychological and physiological drawbacks by knowing about them? Most of the research says no. That is one the biggest reasons that your trading should be structured in such a way to remove them from the equation.

The first step is having trading rules, ones that you don't break. Using option strategies that limit risk--put protection, call spreads, diagonal spreads--allows you to remove volatility from your accounts even when it assails the markets.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)
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