"You are uncertain, to varying degrees, about everything in the future; much of the past is hidden from you; and there is a lot of the present about which you do not have full information. Uncertainty is everywhere and you cannot escape from it." Dennis Lindley, Understanding Uncertainty (2006).
So just get on and deal with it, we say.
Frank Knight of the University of Chicago was one of the first to distinguish in 1921 between risk, which can sometimes be measured, and uncertainty, which cannot. In a recent paper OECD economist Patrick Slovik returned to this theme where he distinguished between market risk - which is part of our 'known information set', and uncertainty - unknown factors which may destabilise financial markets. The former does not challenge the validity of efficient market pricing while the latter questions the hypothesis. He also notes that lack of information, lack of knowledge, and lack of experience will affect different assets in a variety of ways, especially when combined with a bias in the corporate and public sectors to promote knowledge and conceal the lack of it.
Risk: The possibility of incurring misfortune or loss; hazard. From Greek rhiza cliff (from the hazards of sailing along rocky coasts). Collins English Dictionary.
Instinctively most people understand this. Business commentators tend to focus on the Vix index - which most of us would agree is a very narrow measure. The point, though, is that it is a measure, it can be measured (albeit a bit rule of thumb), and we can protect against it.
Volatility can also be measured, the cost of insuring against it likewise, and compared between asset classes. Usually plain vanilla price action is steadier than niche products, long-dated options are cheaper (per day) than short dates, deep out-of-the-money likewise.
With the above in mind, how would you react to and answer the following statements?
We live in unprecedented times; this is uncharted territory.
Something has got to give; the currency market is weak.
Volatility blows up the best laid plans.
Looking through the noise, the trend is intact.
I could go on but how often have you heard these sort of phrases, usually uttered in rushed and incredulous tones by presenters and pundits who do not understand what's going on. Or punters whose latest trade has just gone badly awry and blame their broker, algos, or an evil giant squid.
The market does not care; it does not have a personality, has no moral compass, does not take prisoners and is neither friend nor foe. Whether you like it or not, every action, or lack of on your part, affects prices.
Brokers and market makers hate inactivity. They make a living out of commissions and bid/offer spreads so if nothing happens ergo no income. Speculators embrace risk, want the unexpected to work in their favour, and will move on to the next playground. Investors need returns and in the land of zero interest rate policy have moved out along risk profiles. Traders like risk.
Uncertainty, risk and volatility are part and parcel of everyday life.
MORE FROM NICOLE ELLIOTT...
Nicole Elliott is a long standing Member of the Society of Technical Analysts and has just taken over the IC's trading coverage. She is regularly interviewed and quoted by the financial media, is a conference speaker, and author of several books on charting.
