To Trade OR Not To Trade...

We are in an economic and financial environment of heightened uncertainty (or, to quote Ben Bernanke, the environment is "unusually uncertain")

While this is not entirely new (since we have had many instances of episodic volatility in the past 3 years), increasingly there seems to be a belief that we are reaching the endgame of the 2008-09 recession.

I believe markets trade on perceptions of fundamentals. And it is precisely those perceptions which are significantly muddled and unclear right now.

Trading is a significantly different ballgame from investing. In trading, the path of price movement is important. The swings in prices (volatility) are important - both in frequency and amplitude. And hence, timing is important.

We base the decision to invest in an asset on its expected returns, adjusted for expected risk.

Similarly, the decision to trade in an asset should be based on the expected movement in that asset and how much of that movement we reasonably expect to capture. And this is where the problem lies. Right now, the environment is uncertain.

The use of the word 'uncertain' to characterize the environment in financial markets is important. Frank Knight famously made the distinction between risk and uncertainty. In both cases, the outcome is unknown. However, in case of risky situations, the probability distribution of possible outcomes is known beforehand. In case of uncertain situations, the distribution is not known.

Today's environment undoubtedly belongs to the latter category. And that has major implications for any trading strategy.

Trading is based on the application of some logical system to the movement of asset prices. Some sort of set of possible outcomes, with expected probabilities, needs to be defined. Note that it is not necessary to have a rigorous quantitative probability distribution in place always. Most humans in fact have subjective qualitative distributions for asset price movements. They use bounded rationality and inductive reasoning, biases, judgmental shortcuts and many other behavioural aspects to arrive at the same.

However, if the movement of asset prices is uncertain (i.e. if the probability distribution of the set of possible asset prices cannot be determined in advance), then trading will fail. 

Thus, ANY trading model, post the structural changes and dislocations that we have witnessed in the 2008-09 period in financial markets, should first attempt to answer the question: To Trade OR Not To Trade - is the current market environment suitable for trading?

To answer this question, a model would need to evaluate whether asset price movements are uncertain. I am not sure of the exact mechanism or mathematics that will be needed to prove this. It's quite possible that the proposition is indeterminate. However, I believe measures of volatility, market transaction volumes, idiosyncratic movements / noise could be some quantitative inputs while perceptions of market participants, environment feel etc could be some qualitative inputs in trying to decide. The fundamental question is - How does one test asset markets for the presence of Knightian uncertainty? The answer to this question will also tell us whether or not to trade.