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Tariffs and Subsidies…on Money

June 7, 2019 1 comment

Many, many years ago (27, actually) I wrote a paper on how a tariff on oil actually has some beneficial effects which needed to be balanced against the beneficial effect that a lower oil price has on economic growth. But since the early 1990s until 2015 or so I can count on the fingers of one hand how many times the issue of tariffs came up in thoughts about the economy and markets. To the extent that anyone thought about them at all, it was to think about how lowering them has an unalloyed long-term positive effect. Which, for the most part, it does.

But the economics profession can sometimes be somewhat shamanistic on the topic of tariffs. Tariffs=bad; time for the next chapter in the book. There is much more complexity to the topic than that, as there is with almost any economic topic. Reducing economics to comic-book simplicity only works when there is one overwhelmingly correct idea, like “when demand for a good goes up, so does the equilibrium price.” The end: next chapter.

Tariffs have, though, both short-term and long-term effects. In the long-term, we all agree, the effects of raising tariffs are deleterious. For any given increase in money and velocity, we end up with lower growth and higher inflation, all else equal. It is important to realize that these are largely one-time effects although smeared out over a long period. That is, after equilibrium is reached if tariffs are not changed any longer, tariffs have no large incremental effect. It is the change in tariffs that matters, and the story of the success of the global economy in terms of having decent growth with low inflation for the last thirty years is largely a story of continuously opening trade. As I’ve written previously, this train was just about running out of track anyway so that we were likely to go back to a worse combo of growth and inflation, but reversing that trend would lead to significantly worse combinations of growth and inflation in the medium-to-long term.

In the short-term, however, tariffs can have a positive effect (if they are expected to remain) on the tariff-imposing country, assuming no retaliation (or even with retaliation, if the tariff-imposing country is a significant net importer). They raise employment, and they raise the wage of the employed. They even may raise the real wage of the employed if there is economic slack. The chart below shows the y/y change in manufacturing jobs, and ex-manufacturing jobs, for the last 40 years. Obviously, the manufacturing sector has been shrinking – a story of increased productivity, but also of trade liberalization as manufacturing was offshored. The Obama-era work programs (e.g. “Cash for Clunkers”) temporarily reversed some of that differential decline, but since 2016 – when we got a new President – manufacturing payrolls growth has caught up to non-manufacturing. That’s not a surprise – it’s the short-term effect of tariffs.

The point is that tariffs are a political winner in the short-term, which is one reason I think that people are overestimating the likelihood that “Tariff Man” is going to rapidly concede on trade and lower tariffs. If the Administration gets a clear “win” in trade negotiations, then I am sure the President is amenable to reversing tariffs. But otherwise, it doesn’t hurt him in the heavy manufacturing states. And those states turn out to be key.

(This is a relative observation; it doesn’t mean that total payrolls will rise. The economic cycle still has its own momentum, and while tariffs can help parts of the economy in the short term it doesn’t change the fact that this cycle was very long in the tooth with lots of imbalances that are overdue for correction. It is no real surprise that employment is softening, even though it is a lagging indicator. The signs of softening activity have been accumulating for a while.)

But in the long run, we all agree – de-liberalizing trade is a bad deal. It leads among other things to bloat and inefficiency in protected sectors (just as any decrease in competition tends to do). It leads to more domestic capacity than is necessary, and duplicated capacity in country A and country B. It promotes inefficiency and unbalanced growth.

So why, then, are investors and economists so convinced that putting tariffs or subsidies on money has good (or even neutral) long-term effects? When the Fed forces interest rates higher or lower, by arbitrarily setting short-term rates or by buying or selling long-term bonds – that’s a tariff or a subsidy. It is protecting interest-rate sensitive sectors from having interest rates set by competition for capital. And, as we have seen, it leads in the long run to inefficient building of capacity. The Fed evinces concern about the amount of leverage in the system. Whose fault is that? If you give away free ice cream, why are you surprised when people get fat?

The only way that tariffs, and interest rate manipulations, have a chance of being neutral to positive is if they are imposed as a temporary rebalancing (or negotiating) measure and then quickly removed. In the case of Federal Reserve policy, that means that after cutting rates to address a temporary market panic or bank run, the central bank quickly moves back to neutral. To be clear, “neutral” means floating, market-determined rates where the supply and demand for capital determines the market-clearing rate. If investors believed that the central bank would pursue such a course, then they could evaluate and plan based on long-term free market rates rather than basing their actions on the expectation that rates would remain controlled and protective.

It is no different than with tariffs. So for central bankers criticizing the trade policy of the Administration, I say: let those among you who are without sin cast the first stone.

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A Real Concern About Over(h)eating

I misread a headline the other day, and it actually caused a market analogy to occur to me. The headling was “Powell Downplays Concern About Overheating,” but I read it as “Powell Downplays Concern About Overeating.” Which I was most delighted to hear; although I don’t normally rely on Fed Chairman for dietary advice[1] I was happy to entertain any advice that would admit me a second slice of pie.

Unfortunately, he was referring to the notion that the economy “has changed in many ways over the past 50 years,” and in fact might no longer be vulnerable to rapidly rising price pressures because, as Bloomberg summarized it, “The workforce is better educated and inflation expectations more firmly anchored.” (I don’t really see how an educated workforce, or consumers who have forgotten about inflation, immunizes the economy from the problem of too much money chasing too few goods, but then I don’t hang out with PhDs…if I can avoid it.) Come to think of it, perhaps the Chairman ought to stick to dietary advice after all.

But it was too late for me to stop thinking about the analogy, which diverges from what Powell was actually talking about. Here we go:

When a person eats, and especially if he eats too much, then he needs to wait and digest before tackling the next course. This is why we take a break at Thanksgiving between the main meal and dessert. If, instead, you are already full and you continue to eat then the result is predictable: you will puke. I wonder if it’s the same with risk: some risk is okay, and you can take on more risk up to a point. But if you keep taking on risk, eventually you puke. In investing/trading terms, you rapidly exit when a small setback hits you, because you’ve got more risk on than you can handle. Believe me: been there, done that. At the dinner table and in markets.

So with this analogy in place, let’s consider the “portfolio balance channel.” In the aftermath of the Global Financial Crisis, the Fed worked to remove low-risk securities from the market in order to push investors towards higher-risk securities. This was a conscious and public effort undertaken by the central bank because (they believed) investors were irrationally scared and risk-averse, and needed a push to restore “animal spirits.” (I’m not making this up – this is what they said). It was like the Italian grandmother who implores, “Eat! Eat! You’re just skin and bones!” And they were successful, just like Grandma. The chart below (source: Enduring Investments) plots the slope of the securities market line relating expected real return and expected real risk, quarterly, going back to 2011. It’s based on our own calculations of the expected real return to stocks, TIPS, Treasuries, commodities, commercial real estate, residential real estate, corporate bonds, and cash, but you don’t have to believe our calculations are right. The calculation methodology is consistent over time, so you can see how the relative value in terms of risk and reward evolved.

The Fed succeeded in getting us to eat more and more risky securities, so that they got more and more expensive relative to safer securities (the amount of additional risk required to get an increment of additional return got greater and greater). Thanks Grandma!

But the problem is, we’re still eating. Risk is getting more and more expensive, but we keep reaching for another cookie even though we know we shouldn’t.

Puking is the body’s way of restoring equilibrium quickly. Abrupt market corrections (aka “crashes”) are the market’s way of restoring equilibrium quickly.

This isn’t a new idea, of course. One of my favorite market-related books, “Why Stock Markets Crash” by Didier Sornette, (also worth reading is “Ubiquity” by Mark Buchanan) talks about how markets ‘fracture’ after bending too far, just like many materials; the precise point of fracture is not identifiable but the fact that a fracture will happen eventually if the material continues to bend is indisputable.

My analogy is more colorful. Whether it is any more timely remains to be seen.


[1] To be fair, I also don’t rely on Fed Chairman for economic advice.

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

Inflation and Castles Built on Sand

April 4, 2018 2 comments

Note: my articles are now released somewhat earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed. Moreover, my monthly live tweets during the CPI report are only available on that feed.

Also note: if you haven’t heard it yet, you can listen to my appearance on the Bloomberg Odd Lots podcast last month here. For that matter, you can listen to it at that link even if you have heard it yet.


Now that we can stop focusing on the imminent destruction of wealth in the stock market, for at least today (I am underwhelmed at the rebound on light volume), we can get back to something that matters: inflation.

The chart below shows a straight, unweighted average of core or median inflation in the US, Europe, Japan, the UK, and China. (The chart looks similar if we only include the US, Europe, and China and exclude the recent ‘outlier’ Japan and UK experiences).

We know that, in the US, measured inflation is going to be rising at least until the summer, as the one-offs from 2017 drop out of the data. The prior decline, and the current rise, obscure the underlying trend…which is for steady acceleration in prices. But it’s important to realize that this is not merely a US trend, caused supposedly by ‘tight labor markets’ or somesuch. It is a much broader phenomenon. The chart below shows four of those five countries.

In the US, inflation has been rising steadily (other than that one-off burp caused by cell phones etc) since 2013. In the UK, China, and Europe, inflation has been rising since ~2015, to lesser or greater degree. In the UK, core inflation is showing some signs of topping as the Brexit-related spike fades, and the trend is less convincing in Europe so far. In Japan (see below), inflation has been rising since 2010, but the tax-induced spike in 2014 has messed up the steadiness of the trend. And of course, it is worth pointing out that 0.3% is only high relative to the average of -0.3% since 1999!

I point out these trends because inflation is less of a concern if it happens in one country than if it happens as part of a global inflation process. Imagine that inflation is represented by the proportion of the sand on a beach that is wet rather than dry. There are two ways that sand can get wet: because of random wave action that comes and goes, or because the tide is coming in.

Where you build your sand castle depends on which of these two – tide or waves – is responsible for wetting the sand on the beach.

This isn’t an idle question or speculation. In 2005, two researchers at the ECB[1] discovered that the first principal component of inflation in the G7 countries accounted for about 60-70% of the inflation in those countries. They theorized that this factor was a “global inflation” process and that FX rates compensated for the accumulated idiosyncratic inflation in each country pair. (Enduring Investments subsequently confirmed their work and we actually use this insight to drive some of our strategy models). It makes sense that there is an inflation “tide,” since central bank behaviors as well as fiscal behaviors (and cross-border interactions such as trade liberalization) are somewhat synchronized globally. Over the last decade, everyone has been easing monetary policy and running stimulative fiscal policy. Since the early 1990s, until lately, everyone was liberalizing trade policy and reaching more free trade agreements. So it isn’t a stretch to think that to at least some degree, the global inflation cycle should be synchronized as well.

(Indeed, I would argue that if there had been less synchronization in policy, then the idiosyncratic factor of an aggressively easing Japanese central bank would probably have led to a much weaker Yen and higher inflation in Japan than we have seen. Easy monetary policy is only inflationary in the short-term if there is an FX response – the waves that impact inflation idiosyncratically – which don’t really happen when everyone is doing it.) In the long-run, of course, excessively easy monetary policy changes the tide level. And, like the tide, it isn’t that easy to reverse.

The signs suggest the tide is coming in. Place your sand castle accordingly.


[1] M. Ciccarelli & B. Mojon, “Global Inflation”, ECB Working Paper N⁰537, October 2005.

Nudge at Neptune

Okay, I get it. Your stockbroker is telling you not to worry about inflation: it’s really low, core inflation hasn’t been above 3% for two decades…and, anyway, the Fed is really trying to push it higher, he says, so if it goes up then that’s good too. Besides, some inflation isn’t necessarily bad for equities since many companies can raise end product prices faster than they have to adjust wages they pay their workers.[1] So why worry about something we haven’t seen in a while and isn’t necessarily that bad? Buy more FANG, baby!

Keep in mind that there is a very good chance that your stockbroker, if he or she is under 55 years old, has never seen an investing environment with inflation. Also keep in mind that the stories and scenes of wild excess on Wall Street don’t come from periods when equities are in a bear market. I’m just saying that there’s a reason to be at least mildly skeptical of your broker’s advice to own “100 minus your age” in stocks when you’re young, which morphs into advice to “owning more stocks since you’re likely to have a long retirement” when you get a bit older.

Many financial professionals are better-compensated, explicitly or implicitly, when stocks are going up. This means that even many of the honest ones, who have their clients’ best interests at heart, can’t help but enjoy it when the stock market rallies. Conversations with clients are easier when their accounts are going up in size every day and they feel flush. There’s a reason these folks didn’t go into selling life insurance. Selling life insurance is really hard – you have to talk every day to people and remind them that they’re going to die. I’d hate to be an insurance salesman.

And yet, I guess that’s sort of what I am.

Insurance is about managing risks. Frankly, investing should also be about managing risks – about keeping as much upside as you can, while maintaining an adequate margin of safety. Said another way, it’s about buying that insurance as cheaply as you can so that you don’t spend all of your money on insurance. That’s why diversification is such a powerful idea: owning 20 stocks, rather than 1 stock, gets you downside protection against idiosyncratic risks – essentially for free. Owning multiple asset classes is even more powerful, because the correlations between asset classes are generally lower than the correlations between stocks. Diversification works, and it’s free, so we do it.

So let’s talk about inflation protection. And to talk about inflation protection, I bring you…NASA.

How can we prevent an asteroid impact with Earth?

The key to preventing an impact is to find any potential threat as early as possible. With a couple of decades of warning, which would be possible for 100-meter-sized asteroids with a more capable detection network, several options are technically feasible for preventing an asteroid impact.

Deflecting an asteroid that is on an impact course with Earth requires changing the velocity of the object by less than an inch per second years in advance of the predicted impact.

Would it be possible to shoot down an asteroid that is about to impact Earth?

An asteroid on a trajectory to impact Earth could not be shot down in the last few minutes or even hours before impact.  No known weapon system could stop the mass because of the velocity at which it travels – an average of 12 miles per second.

NASA is also in the business of risk mitigation, and actually their problem is similar to the investor’s problem: find protection, as cheaply as possible, that allows us to retain most of the upside. We can absolutely protect astronauts in space from degradation of their DNA from cosmic rays, with enough shielding. The problem is that the more shielding you add, the harder it is to go very far, very fast, in space. So NASA wants to find the cheapest way to have an effective cosmic ray shield. And, in the ‘planetary defense’ role for NASA, they understand that deflecting an asteroid from hitting the Earth is much, much easier if we do it very early. A nudge when a space rock is out at the orbit of Neptune is all it takes. But wait too long, and there is no way to prevent the devastating impact.

Yes, inflation works the same way.

The impact of inflation on a normal portfolio consisting of stocks and bonds is devastating. Rising inflation hurts bonds because interest rates rise, and it hurts stocks because multiples fall. There is no hiding behind diversification in a ’60-40’ portfolio when inflation rises. Other investments/assets/hedges need to be put into the mix. And when inflation is low, and “high” inflation is far away, it is inexpensive to protect against that portfolio impactor. I have written before about how low commodities prices are compared with equity prices, and in January I also wrote a piece about why the expected return to commodities is actually rising even as commodities go sideways.

TIPS breakevens are also reasonable. While 10-year breakevens have risen from 1.70% to 2.10% over the last 9 months or so, that’s still below current median inflation, and below where core inflation will be in a few months as the one-offs subside. And it’s still comfortably below where 10-year breaks have traded in normal times for the last 15 years (see chart, source Bloomberg).

It is true that there are not a lot of good ways for smaller investors to simply go long inflation. But you can trade out your nominal Treasuries for inflation bonds, own commodities, and if you have access to UCITS that trade in London there is INFU, which tracks 10-year breakevens. NASA doesn’t have a lot of good options, either, for protecting against an asteroid impact. But there are many more plausible options, if you start early, than if you wait until inflation’s trajectory is inside the orbit of the moon.


[1] Your stockbroker conveniently forgets that P/E multiples contract as inflation rises past about 3%. Also, your stockbroker conveniently abandons the argument about how businesses can raise prices before raising wages, meaning that consumer inflation leads wage inflation, when he points to weak wage growth and says “there’s no wage-push inflation.” Actually, your stockbroker sounds like a bit of an ass.

John Mauldin and Long Soapy Showers

February 27, 2018 Leave a comment

I feel like I am falling behind in my articles and commenting on other articles that people have recently written about inflation. After years – literally, years – in which almost no one wrote anything about inflation, suddenly everyone wants to opine on the new shiny object they just found. At the same time, interest in the solutions that we offer – investment strategies, consulting, bespoke inflation hedges, etc – has abruptly picked up, so it feels like the demand for these articles is rising at the same time that my time to write them is shrinking…

But I try.

I want to quickly respond to an article that came out over the weekend, by widely-read author John Mauldin. I’ve corresponded over the years from time to time about inflation, especially when he got way out on the crazy-person “CPI is made up” conspiracy theory limb. To be fair, I think he considers me the crazy person, which is why he’s never referred to me as the inflation expert in his articles. C’est la vie.

His recent article “State of Inflationary Confusion”, though, was much more on-point. Honestly, this is the best article Mauldin has written on this topic in years. I don’t agree with all of it but he at least correctly identifies most of the issues correctly. He even seems to understand hedonic adjustment and the reason we need it, and the reason the PCE/CPI debate exists (which is no easy thing – it depends on what you’re trying to do, which one is ‘better’), and that hasn’t always been the case.

Where I agree with him is when he says that ‘None of us are average’. This is obviously true, and is one reason that we have on our website a calculator where you can look at your own CPI by adjusting the components for what you personally spend (though it doesn’t take into account where you live, which is one reason your experience differs).

But I disagree with him when he says “Reducing this complexity to one number and then using that number to guide monetary policy is asking for trouble.” What an odd remark. We do that for every other piece of data: GDP, home sales, home prices, durable goods sales, retail sales, unemployment, and so on, and we use that information to guide all sorts of policy. Why would it be the case that CPI, of all of the figures, isn’t very useful for this reason? Look, your personal unemployment number is not 4%. It is either 0% or 100%. Totally binary. If Mauldin was making a compelling argument here, you’d throw out the Unemployment Rate long before you’d throw out CPI.

Indeed, if you play with the numbers on our calculator you will find that unless your consumption basket is wildly different, your CPI is likely to be fairly similar to the average. This is why TIPS make sense for many investors – it’s “close enough” to what your consumption basket is actually doing. And it is certainly close enough for policy.

The problem with monetary policy isn’t that they’re using PCE or CPI when they should be using the other, or that neither PCE nor CPI reflects the exact experience of most people. The problem with monetary policy is that policymakers don’t know what the right policy response is given the numbers because they don’t believe in monetarism any more. So their models don’t work. And that’s the problem.

Here’s an analogy (and you know I love analogies). You’re taking a shower, and your impression is “hey, this seems too hot.” It doesn’t really matter if you are using Celsius or Fahrenheit, or just a general visceral sense that it’s too hot. You simply think the water is too hot. So, to solve your problem you apply more soap.

That’s what the Fed is doing. The water is too hot, so they’re applying soap. And they’re really confused when that doesn’t seem to make the water any colder. So they say “gosh, our model must be wrong. The water temperature must be somewhat less sensitive to the amount of soap applied than we thought it was. So let’s recalibrate and apply more soap.” It never occurs to them that they’ve got the wrong model.

That’s the problem with central banking. It isn’t what you use to measure the water temperature, as long as you’re close; it’s how you respond to it that matters. And policymakers don’t understand inflation and, as a result, don’t understand how to affect it.

Kicking Tails

February 12, 2018 5 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed. Moreover, until this Friday you can use the code “onefree” at checkout to get $10 off, which means you get a free month when you sign up!


Like many people, I find that poker strategy is a good analogy for risk-taking in investing. Poker strategy isn’t as much about what cards you are dealt as it is about how you play the cards you are dealt. As it is with markets, you can’t control the flop – but you can still correctly play the cards that are out there.[1] Now, in poker we sometimes discover that someone at the table has amassed a large pile of chips by just being lucky and not because they actually understand poker strategy. Those are good people to play against, because luck is fickle. The people who started trading stocks in the last nine years, and have amassed a pile of chips by simply buying every dip, are these people.

All of this is prologue to the observation I have made from time to time about the optimal sizing of investment ‘bets’ under conditions of uncertainty. I wrote a column about this back in 2010 (here I link to the abbreviated re-blog of that column) called “Tales of Tails,” which talks about the Kelly Criterion and the sizing of optimal bets given the current “edge” and “odds” faced by the bettor. I like the column and look back at it myself with some regularity, but here is the two-sentence summary: lower prices imply putting more chips on the table, while higher volatility implies taking chips off of the table. 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 but correct to do so.

When 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. They’re not really taking into account the better odds associated with lower prices, but they do understand that higher volatility implies that bets should be smaller.

In the current circumstance, the question merely boils down to this. How much have your odds improved with the recent 10% decline in equity prices? Probably, only a little bit. In the chart below, which is a copy of the chart in the article linked to above, you are moving in the direction from brown-to-purple-to-blue, but not very far. But the probability of winning is moving left.

Note that in this picture, a Kelly bet that is less than zero implies taking the other side of the bet, or eschewing a bet if that isn’t possible. If you think the chance that the market will go up (edge) is less than 50-50 you need better payoffs on a rally than on a selloff (odds). If not, then you’ll want to be short. (In the context of recent sports bets: prior to the game, the Patriots were given a better chance of winning so to take the Eagles at a negative edge, you needed solid odds in your favor).

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 (and higher implied volatility moves the delta of an in-the-money option closer to 0.5).

This is why sizing bets well in the first place, and adjusting position sizes quickly with changes in market conditions, is very important. Prior to the selloff, the market’s level suggested quite poor odds such that even the low volatility permitted limited bets – probably a lot more limited than many investors had in place, after many years of seeing bad bets pay off.


[1] I suspect that Bridge might be as good an analogy, or even better, but I don’t know how to play Bridge. Someday I should learn.

Categories: Analogy, Investing, Theory, Trading
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