I kind of like burgers. Yes, it’s true. (Please do bear with me, there will be a pertinent market related point to his discussion, by the next paragraph). I also would speculate that most people like burgers. Admittedly, this is a broad generalisation. However, for the sake of our example, we’ll simply make that assumption. However, perhaps the more important question is whether I like burgers, compared to the broader population. In other words, do I like burgers more than average or less than average? We might argue that even this categorisation is too broad. After all, people tend to have a wide spectrum of views. Simply trying to aggregate all the information into a single number, an average, ends up wiping out a lot of the variation. For example, our population might have very polarised views on the subject of burgers, with some very positive and some very negative, and very little in the middle. Hence, potentially an even better way of a comparison is to observe the distribution of various opinions. In essence, where do I fit on the burger scale?
When it comes to financial markets, we can ask ourselves precisely the same questions, although admittedly, we might substitute the question of burgers, with our expectations for the price of a certain asset. Understanding how market expectations differs from our own expectations is more important than simply observing our view in isolation. Let us take for example the release of nonfarm payrolls. We might have a view on the number, but this is only relevant to trade if we compare it with what the market thinks. If our view is identical to the market, then there might not be much point in trading in this instance. After all, how the price of assets change over the event will be related to the relative surprise to the market. If there’s no surprise, we would not expect the price to move significantly. Of course, this is a very specific example where we can identify a very specific driver for price action. The notion that we should never trade, because other folks share our view is also misguided. It has historically been profitable to be long equities. Being forever contrarian, and selling equities persistently for the past 30 years would have destroyed your capital, even with the bear markets we have seen. The rationale behind trend following is partially behaviour, that a trend will persist as more and more market participants jump on the same trade.
We can also give an example which relates to the upcoming Brexit vote. We can also seek to understand market expectations for the Brexit vote. The binary outcome of the vote is of course very hard to predict. However, we can at least try to understand what the market is pricing for the event, in the GBP/USD market to give an example. Again, we want to understand not only the direction of price action in the event of a leave or remain vote, but perhaps more importantly the market’s probability distribution for subsequent price action. Is the relative probability of a very large move something we can stomach? Furthermore, once we understand how the market is pricing various probabilities, we can see how our view differs from this. We can gauge market expectations around price action around Brexit by examining the GBP/USD implied volatility surface, looking at the cost of options for various strikes. From that we can work out the market probability for various moves. If you’re interested in the results of this exercise, Iain Clark of Efficient Frontier Consulting and I have written a paper on this, mapping out the probability of various GBP/USD moves based on GBP/USD vol market (available for free to download from SSRN). The paper was also featured in the Financial Times and the Telegraph.
In markets (as with burgers), it’s not simply enough to have a binary view. Also being able to attribute probabilities to these outcomes and also the probabilities for subsequent price action is just as important. After all, getting the right direction on a trade is no use, if all the returns of our winning trades, are dwarfed by the losses on our losing trades. Now, I think I shall go and have my burger…