Traders' Roundtable

What is the relationship between volatility and degree of certainty of an outcome?

My own observations about stocks and markets are that the higher the degree of certainty of an outcome the higher the volatility one must put up with in order to hold the position. Does anyone have any clues as to why this is so?

I worry that this hypothesis might not work well for people who invest in bonds. If Tina is choosing between bonds 1 and 2 which are listed in Barrons

1. US Government bond, matures Dec 2029, Yield=4.72%
2. Ford Motor Company corporate bond, matures Dec 2029, Yield=14.15%

Then it occurs to me that bond 1 has the higher degree of certainty. The price of both bonds will fluctuate as interest rates change, but bond 1 is very unlikely to default. Bond 2, on the other hand, has a very good chance of defaulting since the business prospects of Ford Motor Company in the next 23 years are grim. And that's why bond 2 sells for such a low price / has such a high yield. Bond 2 has the lower degree of certainty; we don't know whether Ford will default or not but we are extremely confident the US Government will not default.

It also seems to me that bond 2 will have more volatility, because there are two things that can toss around its price: prevailing interest rates, AND the fluctuating prospects of the Ford Motor Company. Bond 1, on the other hand, can be tossed around only by the prevailing interest rate.

So it seems to me that bond 1 has higher certainty and lower volatility, which is opposite to your observation.

dispassionate,

How are you measuring degree of certainty in this case? My observation is that volatility has little to do with whether a position moves in your favor or not.

If you have an exit strategy based on some measure of volatility, then you will simply have position-sizes in proportion to your estimate of the prevailing volatility - which is just a proxy for risk. This says nothing about "degree of certainty".

Are you saying that your biggest winners tend to be in the most volatile instruments? If so that's simply because higher volatility implies more chance of a large move in your favor (but also against you). Again, no degree of certainty involved.

Paul

sluggo and PK - let me think about this. I need to articulate properly what I'm seeing in my mind!

How about fully accept the concept of uncertainty?


Uncertainty principle
From Wikipedia, the free encyclopedia

In quantum physics, the Heisenberg uncertainty principle or the Heisenberg indeterminacy principle — the latter name given to it by Niels Bohr — states that when measuring conjugate quantities, which are pairs of observables of a single elementary particle, increasing the accuracy of the measurement of one quantity increases the uncertainty of the simultaneous measurement of the other quantity. The most familiar of these pairs is the position and momentum.

Overview
Until the discovery of quantum physics, it was thought that the only source of uncertainty in a measurement was caused by the limited precision of the measuring tool. It is now understood that no treatment of any scientific subject, experiment, or measurement is accurate until the probability distribution for the measurement is specified. Uncertainty is the characterization of the relative narrowness or broadness of the distribution function of a particular measurement and is sometimes referred to as the error in the measurement.

kianti wrote:How about fully accept the concept of uncertainty?

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You mean we're not talking about setting up T-Bill ladders here? /\/\/\/
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i am uncertain as to what is meant by the above.

woah i feel like i'm getting a little more volatile though....