Leverage & Degree of Thinking

If we can understand how much leverage a market has, we will have a better understanding of how the market will move given a pricing momentum.

A market could be leveraged in many ways - margin accounts, warrants, options, futures, CDOs, derivatives, etc. The more a market has of such vehicles, the more leveraged it is.

A higher leveraged market will have higher degree of thinking. Degree of thinking can simply be explained as how many iteration that you think the rest of the world will behave. Eg. If you think that the world will sell a particular stock at $10, you may want to sell at $9 to avoid getting caught in the selling frenzy. However, if you think that many people will come to this same conclusion, you may decide to sell at $8. Again, if you think that quite a number of people will come to this conclusion and sell at $8, you will probably sell at $7. The more cycles you think (and thus arrived at an ever smaller $ value), the higher the degree of thinking.

A sophisticated and matured market has a higher degree of thinking. Conversely, a developing or young market will likely have a lower degree of thinking.

Leverage, together with degree of thinking, could be the major explanation why the seemingly irrational behaviour that we had observed during this financial crissis, is actually rational.

When the prices started to come down, those leveraged players (eg margin players) would be pressured to sell (eg. margin call). Thus they will start selling to ease the pressure. Observers who see this selling, will predict that more margins will be triggered as the price comes down and thus conclude that more selling will be on the way, and they too, start selling. Thus selling begets selling and that is what we get in this financial crissis.

So what results in the reversal? Again, leverage (actually the lack of) and degree of thinking. As players become less leveraged, they will be more willing to take risk and even take up some leverage again. And as people started to think that the market will bottom, at say STI 800, the degree of thinking effect comes into play. Some will be willing to enter at a higher level, say 1000. Others coming to this conclusion (that people will be willing to enter at 1000), will start entering at 1200. And there you have it. Simple?

The tough part is getting a feel of how much leverage and degree of thinking is in the market...