Imagine a coin flipping game -
- Heads - The player can double her money;
- Tails - The player loses half.
Probably this game has better expectancy than many trading methods peddled on the net. Also the game has a high positive skew i.e., one can win a lot (when multiple heads in a row) but one can lose only the initial investment.
Now the interesting part -- if one plays this game long enough betting all proceeds on each flip, even with this positive expectancy, an investor/trader will likely not make profits over long term or worse will actually lose money. Why?
Two reasons - Over large number of flips, it will lead to equal number of heads and tails. When you are betting all proceeds, equal number of heads and tails lead to zero long term expected growth. Actually the trader will lose money overall because of the frictions i.e., commissions & slippage.
So how do one make profit from this game? The key here is in taking advantage of the volatility present in the game and harvesting profits from it. The following two charts (from the paper) describe well the difference in growth (g) rate between playing the game with betting all proceeds vs harvesting the volatility.
The later parts will cover details of how volatility is harvested, why it works, how one can use this concept in actual markets and finally may be a study post if there is interest. For mathematically inclined readers, journal paper is available here. (Note: requires an account to download full paper).
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