Rubber Band Effect - Explained
What is the Rubber Band Effect?
Written by Jason Gordon
Updated at October 6th, 2021
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What is the Rubber Band Effect?
The Rubber Band Effect is used to describe a situation in markets whereby a force can create both enormous opportunities and high volatility. This paints a picture of rise and fall in security or capital markets. In as much as the market has the tendency of rising high, there is also a tendency of the market values dropping very steeply. Hence, the rubber band effect creates to market, it indicates increase and declines in market prices. This means the level at which a market stretches to in terms of profit, the market can also have the same decrease stretch or shrink.
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How Does the Rubber Band Effect Work?
Oftentimes, the rubber band effect plays out during a limit order by computer programs. A limit order refers to limit at which at buying or selling of stock at a specific price can occur. However, two main market forces which are seen as the basis of market action are the cause of rubber band theory. This theory identifies that it is the same force with which market prices increase that they decrease, just like the rationale behind a stretched rubber band. The theory also paint the effect of the rubber band theory using a pendulum that swings back and forth, this swinging also takes place in markets.
Understanding how a rubber band theory works in markets requires a basic understanding of elasticity or flexibility of rubber band. When you stretch a rubber band to one side, it builds up energy and this energy is released forcefully when released towards the opposite direction, this also portrays how huge feats are achieved in markets. This instance shows how opportunities are driven in markets. However, on the contrary, volatility collapse can also occur using the same rubber band theory. The easier it is for markets values to rise, the same is applicable to volatility collapse. Hence, the rubber band theory presents markets in cycle.