The problem of trading in uncertain times crept up on the Mentor Program
Alumni forum and I have been thinking about my answer. The original answer I
gave is shown below –
I think one of the things you need to be able to do is to define what
uncertainty is. If you opt for volatility as a proxy for uncertainty then you
see something quite interesting. The VIX which is known as the fear index and
should reflect uncertainty is actually at sitting somewhere near its long term
average, indicating that the players who make up this index don’t actually see
any uncertainty and are not asking for an increase in the risk premium they
demand. The same is true if you look at the historic volatility in the Dow
which is also sitting at a 9 year low.
From my perspective is the issue is not uncertainty in markets but
uncertainty in decision making that is brought about by listening to external
sources. If you switched off the news and all the associated commentary and
simply looked at markets what would they tell you?
What has caused me to think further about this overnight is the notion of
what actually is the uncertainty that is being referred to. Is it a true
physical uncertainty or a psychological perception brought on by exposure to
the narratives of others? I had a look at Wikipedia for a more formal
definition of uncertainty and it gave the following –
Uncertainty is a situation which involves imperfect and/or unknown
information. However, “uncertainty is an unintelligible expression without a
straightforward description”.[1] It arises in subtly different ways in a number
of fields, including insurance, philosophy, physics, statistics, economics,
finance, psychology, sociology, engineering, metrology, and information
science. It applies to predictions of future events, to physical measurements
that are already made, or to the unknown. Uncertainty arises in partially
observable and/or stochastic environments, as well as due to ignorance and/or
indolence.
You will notice that the definition holds at its core the uncertainty
inherent in predicting future events. In fact the science of probability is
based around trying to deal with the fact that the universe is an uncertain
place. However, uncertainty is the default setting in trading – the outcome of
all trades is unknown until they are closed. It is this uncertainty that gives
us the potential to be profitable, investments that have known or certain
outcomes have no risk premium attached as such they offer little in the way of
return (think bank deposit). This definition is therefore of little use in
unpacking the notion of a change in traders uncertainty quotient. Granted we
can respond to changes in volatility and we have tools to measure this but this
is a reasonably common occurrence in trading and there are strategies that can
be put in place to deal with this. In fact very basic position sizing and
volatility based stops self-correct to deal with this sort of problem.
So I am drawn back to the idea that what actually changes is the tone and
intensity of the narratives that people surround themselves with. This ever
increasing crescendo of noise is bound to take an effect on peoples psyche
particularity at present when the world appears to be spinning out of control.
However, notice I used the expression appears, I used this term because
appearances and reality are not the same thing. What brings some equilibrium
back to the noise of others is as always context, the markets tell a completely
different story. Whilst the breathless gibbering that is the media may consider
the present to be the most troubled time in history and need to shout about it
at every opportunity neither that markets nor history itself would agree.
This is the most salient point for traders with regards to what is
considered uncertainty. Uncertainty is the environment within which we operate
as a broad observation but beyond that it is actually the markets themselves
that define what actually uncertainty is and they can do this by readily
accessible metrics. When volatility and in turn risk premiums increase then we
can say that uncertainty has increased. However, even here people try inject
their own primitive narrative into events as the VIX which is a widely known
measure of volatility is referred to as the fear index when it is nothing of
the sort. However, this is the natural human desire for drama, we all have a
friend or relative who is addicted to drama and those in the news media,
particularly the financial arena and prime diva’s. So if you find yourself
believing that uncertainty has increased but markets don’t agree then you will
need to do something about what leaks into your brain.
Author: Chris Tate
Traders’ Mindset: Traders' Mindset
www.tallinex.com wants you to become a
successful trader
