01/14/2021 — Known Unknowns

“We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know…”

Almost two decades ago, media outlets and the much of the population laughed heartily when then Secretary of Defense Donald Rumsfeld uttered these words. Maligned as an hack politician fluent in the language of bullshit, the man and the soundbite were forever tied together and remain so to this day. Those interested in more than a mindless political laugh understood that not only was this an astute observation with respect to armed conflict, but it applies to many other disciplines.

Options, when used correctly as a form of financial insurance, can defend against market turmoil by providing a counterweight to the potential deleterious effects of volatility. The aforementioned quote helps to explain why certain events send volatility levels through the roof while others barely move the needle.

Intelligence reports state that many protests, some of them armed, will likely take place over the next few days, coinciding with the inauguration of President Elect Joe Biden. Medical experts believe that up to 100,000 people may die of pandemic related illness over the next three weeks. Yet, the VIX sits lazily at a hair over 23. How could this be? Shouldn’t these potential scenarios juice the volatility to at least something in the thirties? The answer is, “not for today.” If bombs exploded, or pandemic deaths rose exponentially, volatility would pop — then. The mere knowledge of the possibility of riotous behavior resulting in death, or hospitals becoming overwhelmed does not send the vol into a frenzy. In fact, it is the very knowledge of these possibilities that places them into the category of “known unknowns.” We don’t know what if these scenarios will come to pass, or to what degree they may be realized, but we can look into the future and imagine them, even if only crudely. This foreknowledge, however speculative and incomplete, takes the edge off of our collective worry and keeps present volatility in check.

So what is an “unknown unknown?” The answer is, “I don’t know.” I can’t give you a current example of one, or even describe what it would look like. It is better to explain that category of events by looking at its shadow — its effect on options pricing. If tragedy struck on Inauguration Day, or yet another, even deadlier strain of the virus emerged, the market might respond by shedding a couple hundred S&P points in a hurry, but it seems unlikely that the result would have markets down nearly 50% a week after. If you agree with this analysis, then it might surprise you to know that in option series only a week out from the present, there are usually non-zero bids for puts with strike prices reflecting a halving of market value.

What could possibly drain our financial wealth reservoirs with that kind of speed and severity? China using a nuclear weapon? A monstrous solar flare that decimates our electrical grid? A zombie apocalypse a la “The Walking Dead?” Neither I nor the people bidding for such options can describe what event(s) they are preparing for, only that somewhere at sometime they exist. We tend to write books about these to explain their occurrence, but only after the fact. They are sometimes referred to as black swan events — the unknown unknowns.

“…And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.”

Substitute markets for country and countries and Rumsfeld might as well have been the Secretary of the Treasury.

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A running soliloquy covering the life and times of a financial trader. Opinions, insights, commentary, and stories from past and present…served with a healthy dose of irreverence.

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Willie Witten

Willie Witten

Writer, thinker, trader, musician, builder and beer aficionado. Find me at williewitten.com

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