This is one of my favorites, and every few years I re-blog some portion of this article. The original, I wrote in 2010. The basic question is, what is theway to respond as an investor to increasing uncertainty? In the original blog and in various re-posting edits, I’ve applied a basic idea called the “Kelly Criterion” to explain why responding to market selloffs by trimming a position, rather than adding to it, is often the right strategy .
In most cases, the lower edge implied by higher volatility outweighs the better odds from lower prices, which means that it isn’t cowardly to scale back bets on a pullback butWhen you hear about trading desks having to cut back bets because the risk control officers are taking into account the higher VAR, they are doing half of this.
Now if, on the other hand, you think the market selloff has taken us to “good support levels” so that there is little downside risk – and you think you can get out if the market breaks those support levels – and much more upside risk, then you are getting good odds and a positive edge and probably want to bet aggressively. But that is to some extent ignoring the message of higher implied volatility, which says that a much wider range of outcomes is possible .
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