The future is … ahem … uncertain

It’s that time of the year when pundits and experts like to make their 2015 market predictions …

What is it about January that causes those of us who are usually cynical about crystal-ball gazing to suddenly crack out the tarot cards and try to read the future?

But there’s a specific word that’s coming up again and again in these reports …

‘beset by uncertainties’

‘uncertainty will reign’

‘expect uncertainty’

‘volatility and a period of uncertainty’

‘too much uncertainty’

‘uncertainty is one of the few certainties’

That’s right – ‘uncertainty’ seems to be the key prediction for 2015.

I’m not sure I’d want to cross anyone’s palm with silver to be told that my future was ‘uncertain’. So, how are ‘experts’ getting away with predictions like this?

Let’s take a look at what a few of those ‘uncertainties’ are …

– opposition to austerity in Greece and Spain could lead to a renewed euro crisis

– deflation fears – could Europe be heading the way of Japan?

– with the approaching election, is the UK moving towards an exit from EU?

– could the falling oil price trigger a financial crisis in oil-producing nations?

We don’t know the answers to these questions. Nor can we calculate the risk of these events happening … which is what makes investors nervous …

But what does that mean in practical terms for traders?

We’re used to dealing with uncertainties – prices go up, prices go down. It’s what we face every day.

But before I go into the effect of uncertainty on traders, I’d like to run through two quick bits of ‘theory’ – here comes the science stuff …

1. Feedback loops

Back in the days when traders wore bowler hats, there was a theory called the Efficient Market Hypothesis. Amazingly, this theory is still banded around by some – although generally by people who have never actually traded in their lives.

The theory goes something like this … we get information about the fundamentals of the market … traders make rational decisions on that information … and prices always reflect genuine values.

George Soros has an alternative theory on the markets, called Reflexivity.

According to Soros, we get information about fundamentals … traders make decisions on that information … the decisions traders make then affect the fundamentals … and so on.

This gives us a circular loop – just like feedback on an amplifier, where the reactions of traders affects the way other traders behave. It’s how markets get hyped up to create bubbles. And how panic spreads to cause crashes. And it’s why uncertain times cause volatility – a small worry about prices falling, turns into a big slump … a little optimism, turns into a huge spike.

The gist is that markets just aren’t efficient machines, they are as emotional as the people who trade them.

So, when markets are jittery, we naturally find increased volatility.

2. Uncertainty aversion

A few months back, I gave you a choice or two pairs of gambles you could take …

You’re faced with a urn which contains 30 red balls, and an unknown number of black and yellow balls, which add up to a total of 60, meaning there are 90 total balls in the urn.

Gamble A: you win £100 if you draw a red ball from the urn
OR
Gamble B: you win £100 if you draw a black ball from the urn
and
Gamble C: you win £100 if you draw a red or yellow ball
OR
Gamble D: you win £100 if you draw a black or yellow ball

Most people choose gamble A and gamble D, because they have known probabilities. But, as I pointed out back then – there’s a flaw in the logic – the first gamble assumes there are more red balls than black ones – a scenario which would make gamble C a better choice.

(You can read more about this theory here)

But the key thing we take from this is that people don’t like uncertainty, and will undervalue choices with uncertain outcomes.

So, assets aren’t just cheap because the risk involved in holding them – they’re discounted because of risk … and again because of uncertainty …

And, for us traders, if something’s undervalued – that’s where we can make a profit.

How to take advantage of these two principles

Successful trading is all about trying to figure out what others are thinking … and acting before they do. The more uncertainty there is … the more uncertain we are about what others are thinking.

So, if uncertainty means we have assets that are ‘too cheap’ … so, when uncertainty is resolved, we’ll see exaggerated price swings.

Add to this the effect of the feedback loop caused by rumour and panic … and we’ve a recipe for wild volatility.

Volatility doesn’t have to be a bad thing for traders … it’s all in the preparation.

– Increased volatility doesn’t mean you have to increase your tolerance to risk. Know your limits, and stick by them.

– Consider widening your trade parameters (but not your risk levels). Keep an eye on the average daily range and how this is changing – it could be wise to increase your stop limits and targets accordingly, but remember this must go hand-in-hand with reduced stakes.

– Protect your trades with hedging, rather than relying on stop losses. In volatile times, stop losses really show their weaknesses. This is where a carefully matched hedge will give you far more security.

As traders, we don’t need to be afraid of uncertainty or volatility – we simply need to understand the effects it has on the markets around us, and take some sensible precautions.