Btw, it seems like there’s a little bit of a paradox here. Suppose the participants in a market are all well-calibrated about whether they have market-beating information. And in expectation everyone will stumble upon some market beating information at some time or another.
On the one hand, everyone should be able to get market returns, by just investing in the market. But since everyone has market-beating information some of the time (and are well-calibrated), they should actually be able to beat the market, by diverging from the market portfolio only when they have market-beating information.
But then you’d have everyone beating the market, which can’t be possible.
I think the resolution is the same as Zvi’s point in the Sources of Disagreement and Interest (aka Suckers at the Table) section of Prediction Markets: When Do They Work? In the scenario I describe, no one would be able to profit off of their private information. As soon as they go to buy on positive information (or sell on negative information), they’ll find that everyone else (who’s well-calibrated) raises (or lowers) their prices to exactly match. (Or that no one was showing any bids or offers in the first place, since they knew any fills would face adversarial selection.)
In reality, I think the way this works is that you have both suckers (people who are miscalibrated), and also people who are willing to go forego market returns—that is, people who have some natural reason to buy (e.g. new investors) or sell (e.g. in order to spend).
Suppose the participants in a market are all well-calibrated about whether they have market-beating information.
That part seems particularly unrealistic. If that were true, we’d be living in a very different world.
Many large market participants have perverse incentives when trading other people’s money. Their customers would prefer low volatility over optimal Kelley bets, and many would have to panic sell in a drawdown if volatility wasn’t kept under control. You don’t have to be smarter than them to exploit them, since they’re optimizing a different goal: keep their customers happy, instead of making maximum money for them.
And then, most people are irrational. Going by base rates, you should expect other market participants, even big ones, to trade emotionally as well.
You don’t have to be smarter than them to exploit them, since they’re optimizing a different goal: keep their customers happy, instead of making maximum money for them.
Sell puts when implied volatility (IV) is higher than usual, on stocks where the IV tends to exceed the historical volatility (this is most of them, actually).
Whales have to buy puts for more than they’re really worth to protect their customers’ portfolios from scary market volatility.
Buy them back for less than you were paid for them when IV reverts to the mean. It’s like selling insurance. You have to control your bet size and hedge (maybe with a cheaper put, like reinsurance) so you don’t get wiped out when the disaster actually happens, but you’ll get more than enough premium to make up for your losses.
Btw, it seems like there’s a little bit of a paradox here. Suppose the participants in a market are all well-calibrated about whether they have market-beating information. And in expectation everyone will stumble upon some market beating information at some time or another.
On the one hand, everyone should be able to get market returns, by just investing in the market. But since everyone has market-beating information some of the time (and are well-calibrated), they should actually be able to beat the market, by diverging from the market portfolio only when they have market-beating information.
But then you’d have everyone beating the market, which can’t be possible.
I think the resolution is the same as Zvi’s point in the Sources of Disagreement and Interest (aka Suckers at the Table) section of Prediction Markets: When Do They Work? In the scenario I describe, no one would be able to profit off of their private information. As soon as they go to buy on positive information (or sell on negative information), they’ll find that everyone else (who’s well-calibrated) raises (or lowers) their prices to exactly match. (Or that no one was showing any bids or offers in the first place, since they knew any fills would face adversarial selection.)
In reality, I think the way this works is that you have both suckers (people who are miscalibrated), and also people who are willing to go forego market returns—that is, people who have some natural reason to buy (e.g. new investors) or sell (e.g. in order to spend).
That part seems particularly unrealistic. If that were true, we’d be living in a very different world.
Many large market participants have perverse incentives when trading other people’s money. Their customers would prefer low volatility over optimal Kelley bets, and many would have to panic sell in a drawdown if volatility wasn’t kept under control. You don’t have to be smarter than them to exploit them, since they’re optimizing a different goal: keep their customers happy, instead of making maximum money for them.
And then, most people are irrational. Going by base rates, you should expect other market participants, even big ones, to trade emotionally as well.
What trades does this suggest?
Sell puts when implied volatility (IV) is higher than usual, on stocks where the IV tends to exceed the historical volatility (this is most of them, actually).
Whales have to buy puts for more than they’re really worth to protect their customers’ portfolios from scary market volatility.
Buy them back for less than you were paid for them when IV reverts to the mean. It’s like selling insurance. You have to control your bet size and hedge (maybe with a cheaper put, like reinsurance) so you don’t get wiped out when the disaster actually happens, but you’ll get more than enough premium to make up for your losses.