Imagine finding a methodological flaw in economics that distorts how it considers individual action and choice under uncertainty that you can’t get published. So here is a breakdown for all of you traders.
The issue comes down to how do you formally take into account uncertainty. This is actually fairly straightforward. For those of you with a physics background this is done with the canonical expression of the Helmholtz free energy:
F = U - TS
Where U is the utility, T is the temperature and S is the entropy.
The Utility is the expectation of the payout of the trade based on the distribution of outcomes.
The entropy is the information entropy of the distribution of outcomes (expected uncertainty)
The temperature is the marginal utility of uncertainty. For the market, this is determined by the volatility. Low volatility corresponds to a high risk preference and correspondingly a high volatility corresponds to a low risk preference.
What you are doing is being Maxwell’s demon. You are trying to maximize your Helmholtz free energy. So what you need to consider is your knowledge of the distribution of outcomes (the hard part) and market volatility. This will inform which set of positions you will take.
For the record, this relationship is derived directly from the axioms underpinning game theory.
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