August 2013 - Richard 'Jerry' Haworth: The financial casino

A traditional casino as we know it exposes us to a priori risk. We know, and the casino owners know the odds of success or failure IN ADVANCE with every play of a card or spin of a wheel.

 

The financial casino is similar but different in two important aspects:

Firstly, being financial market participants, we are both the casino owners and players as we can choose to either buy or sell risk. Secondly, we have a new type of risk thrown in: uncertainty. Now if there was only a priori risk in financial markets i.e. risk that we can accurately calculate the odds of, the prices would never change. Both buyers and sellers would equate price and value and this would not change. This is intuitive, the odds on red or black on a roulette wheel will always be roughly 50/50 (less the odds of zero) despite how bullish or bearish we become. So we can conclude that prices change in the financial casino because the level of uncertainty changes. The greater the uncertainty the greater the need for constant price change i.e. volatility. That seems obvious.

 

But what if the level of uncertainty in the financial casino is roughly constant and it is only our PERCEPTION of it that changes? What if we become overly complacent because uncertainty is not APPARENT and then when it does present itself we become overly FEARFUL?  When all the time the ACTUAL level of uncertainty has remained fairly constant just our AWARENESS has changed. Then we would have to assume that value recognition in the financial casino is counterintuitive at extremes of complacency and fearfulness where participants do exactly the WRONG thing.

 

Now if volatility is the index which measures the level of uncertainty in the markets, surely this too is counterintuitive at sentiment extremes? So when volatility is low we should expect a reversion to the mean or beyond rather than a continuation of further low volatility. This is what we observe in reality.

 

How great is it to find a predictable cycle i.e. the volatility cycling between periods of high and low volatility, where market participants do exactly the wrong thing at the wrong time! It’s like finding an 80% off sale of your favourite product where your fellow product enthusiasts get put off by the low prices.

 

The options markets are primarily driven by volatility and as such makes this phenomenon eminently investable. At $65 trillion1notional investment globally in options, there are plenty of options around on all asset classes in all geographical areas, mostly at different stages of their fear/complacency cycle.

Global volatility worldwide has reached very low levels where central bank intervention is masking true uncertainty/volatility and thus provides a perfect breeding ground for extreme complacency. This complacency is already obvious, evidenced by low options prices. i.e. a blasé attitude toward protection against uncertainty.

 

Mmmmmmm…