The Uncertainty Principle of Financial Markets

In quantum physics, the Werner Heisenberg principle states that there is a fundamental limit to the precision up to which a particle’s physical properties of position and momentum can be known. It means that the more precisely a particle’s momentum is determined the less precisely its position can be determined and vice versa.

Financial markets have their own uncertainty principle, the implication of this principle is that either you can determine the direction of the move precisely or you can determine the timing of the move. For example, we all know (direction) that markets will touch new highs sometimes in future but we exactly don’t know (time) when. In this example we know the long term direction of the market is up but we are unable to determine the exact time of touching new highs. On the other side, before important news events like the recent Federal Reserve or ECB meetings, we knew (time) fairly well that a big move would come on the day of announcement but then we didn’t know precisely (direction) if that move would be up or down, which depending upon the news could be either ways. After the announcement the more the direction became clear, the lesser we knew how long will it continue?

This uncertainty principle particularly applies to options market because the knowledge of a move’s direction and exact timing is most important there.

Nobody can know, at the same time, both the direction and the time of a move. As traders we should always keep in mind our limits and trade accordingly. We traders are managers of risk and player of probabilities.

(Contributed by Jitender Yadav)