Talking Points
Here is a chronological list of distinct topics, claims, and statements from the transcript:
1. The Market Measures segment focuses on testing trading concepts, specifically the Kelly criterion. It will explain why position sizing is crucial and how mistakes can limit growth.
2. The Kelly criterion is a mathematical theorem relevant to both trading and poker, especially concerning expected and implied value. It is important to understand this concept.
3. The Kelly criterion helps determine the optimal fraction of capital to allocate to maximize long-term growth while reducing the risk of ruin. It aims to maximize growth and control risk through proper sizing based on edge.
4. The Kelly formula is F = (P - Q) / B, where F is the optimal capital percentage, P is the probability of profit, Q is the probability of loss, and B is the net odds received. Q is also equal to 1 - P.
5. Using an iron condor example with a $100,000 portfolio, an 85% probability of profit, 15% probability of loss, and 20% net odds, the Kelly criterion recommends allocating 10% of capital. This allocation aims for optimal long-term growth with virtually no risk of ruin.
6. Risk of ruin is defined as depleting capital if bet sizes are too large, which prevents the ability to absorb negative variance. Proper sizing is embedded in this concept.
7. With a 10% capital allocation, a sample portfolio is expected to achieve a 25% final profit after 100 trades with a zero chance of depleting capital. The mean final value is $125,000, and the average drawdown is 37%.
8. Even with proper 10% allocation, average drawdowns can still be significant. Higher allocations would lead to even larger drawdowns.
9. A Monte Carlo simulation with 100 runs projects a zero ruin rate. A higher number of simulations (e.g., 5,000-10,000) would bring results closer to the expected value.
10. If one feels good about the results of a trade or adjustment run a thousand times, it likely indicates a positive expected value situation.
11. A 25% profit with a zero ruin rate is very good, with the ruin rate being the most important factor. Trading small accounts is challenging, but over-leveraging leads to ruin due to an inability to absorb volatility.
12. Even during years with 20-30% annual returns, there are highly volatile periods, such as a VIX of 60, which people tend to forget quickly.
13. If the probability of profit remains 85% but the net odds change, the optimal Kelly allocation will also change; higher odds support larger, more aggressive position sizing.
14. When odds are lower, mean returns shift negative, and average drawdown and ruin rates become significant, even with a 5% change in odds. Lower probabilities of profit necessitate sizing down.
15. Higher odds allow for greater capital allocation due to a significantly higher ratio of winners to losers. Turning losing trades into smaller losses or scratches makes a massive difference in projected year-end results.
16. Slightly higher odds with more than double the allocation (from 10% to 25%) can nearly double the average drawdown. Even with a 25% allocation, drawdowns can remain quite high.
17. Kelly criterion provides a mathematical framework for optimal position sizing. Many traders use fractional Kelly (25-75%) to reduce volatility.
18. Option strategies fit the Kelly criterion well because probabilities and payouts are known before entry. One should match probabilities, for example, collecting 50% of the width for an at-the-money spread (50% probability).
19. Understanding these mathematical principles helps traders identify favorable situations and avoid forcing trades.
20. After a 10% decline in the market, it is expected to be higher six months later.
21. A 10% drop in the S&P 500 within one month is uncommon; historically, it takes an average of 25 days for the first 10% correction in any 30-day period.
22. 10% drops happen regularly and will continue to occur even in a bull market, leading to perceptions that "the world is ending."
23. Sizing is critical because a 10% drop can extend to 15-20%. Believing a 10% drop won't happen and sizing up to account for it is a common mistake.
24. Accounting for inevitable drops by maintaining small position sizes allows for enduring variance, especially in the S&P, where recoveries are historically consistent over time.
25. Within a 30-day window after a 10% market drop, the market fell further in 32% of occurrences. Only two instances (11%, both in 2008) saw a rally back to pre-drop levels.
26. The average return during the 30-day period after a 10% drop was less than 1%, indicating that the market recovers much more slowly than it declines (the "escalator up, elevator down" adage).
27. Recovery chances improve with extended duration; higher chances of recovery occur after two months. Less than half of events saw a full recovery after three months, but almost 40% full recovery in 90 days is substantial.
28. A 10% downside correction requires almost a 20% rally from the new price point for a full recovery, representing a significant opportunity.
29. It took less than a month to rally back 50% of the original price, which is quicker than generally expected. Only one occurrence (in 2022) took longer than six months to recover 50%.
30. The year 2022 experienced extended and heightened volatility, with elevated VIX levels and rapid market movements during press conferences.
31. Full recovery from all losses typically took about three months, with partial recovery being more realistic early on.
32. Maintaining some negative delta and selling premium at high implied volatility (IV) may help before full recovery. Given the median three-month recovery, leaning bullish in these situations is advisable.
33. Adjustments include picking up some delta or planning to offset delta to the upside during quick recoveries to trade the new range. Longer deltas (one to two months out) are preferred as recovery takes time.