Uncertainty intolerance on the trading floor

When markets are uncertain of the outcome of an important scheduled event, like an election or the release of an economic statistic, expected volatility increases. Therefore, the implied volatility, i.e., the estimate of future variance implied by an option’s price, is a sensitive barometer of the market’s collective uncertainty.

It is interesting to note, therefore, that a study published in Philosophical Transactions of the Royal Society B: Biological Sciences in 2010 found that average cortisol levels in a group of 17 male traders in a midsized trading floor in the City of London correlate strongly with implied volatility. These traders experienced acutely raised cortisol in anticipation of higher volatility, which implies that they found uncertainty highly stressful. Psychologists would say that they have high levels of uncertainty intolerance.

I have a strong hunch that uncertainty intolerance tends to undermine risk intelligence by, for example, leading people to see things too starkly in black or white terms, and reacting to ambiguity with feelings of uneasiness, discomfort, dislike, anger, and anxiety that intrude on rational assessment. Getting a fix on your own degree of uncertainty tolerance is, therefore, an important step in improving your risk intelligence. It’s worrying, therefore, that in the questionnaires they filled in, the traders in this study displayed no awareness of of the rampant stress indicated by their cortisol measurements.  Not only were they freaked out by uncertainty, but they didn’t even know they were freaked out.

One thought on “Uncertainty intolerance on the trading floor

  1. Interesting point.

    Another effect of cortisol is to inhibit long-term memory and response to earlier learning, and to create intense “flashbulb” memories with strong behavioral content. In other words, it tends to make people forget long-established rules and create new ones based on dramatic recent events.

    There are situations where that seems like a good thing to do. When a dramatic event overthrows long-held assumptions, it can make sense to throw away the book and start learning fast, even at the risk of overinterpreting recent events. But it’s easy to see that it can also lead to panic, over-reaction and doing things that any calm person would know are stupid.

    It could also induce superstitious behavior. The strong memory formed during the turmoil might continue to have consequences long afterwards. After a few spectacular trading events during triple witching hour in the mid-1980’s, equity traders developed a viseral reaction to those times, which probably contributed to future volatility and reinforced the beliefs.

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