This is a more difficult topic, but one which demands attention from all investors, not just option traders. Much ink has been spilled on the topic of portfolio diversification, wherein it is said that those who trade in multiple different underlyings, can be said to “spread off their risk”. In other words, rather than having all of your eggs in one basket, say, by just investing in Google, you try to invest in multiple symbols at the same time, so that the risk of one symbol is spread off by investing many symbols. But does this really work?
Part of Tim’s shorting strategy relies on investing on many underlyings at once (sometimes), and I assume investing small amounts like $1-2000 at a time so that the gap losses, when they happen, will be small (intraday losses are minimal because of tight stops – when they are employed). However, as we shall see, this is partially a false sense of security.
We see in one study that up to an n of 30, increasing the number of instruments in one’s portfolio does indeed reduce volatility and risk. Standard deviation (risk) initially might be 49% with one instrument, but only 20.9% (a reduction of about 60% of the risk) with up to 30 instruments. However, beyond 30 there are limited returns.
So as I’m sure everyone noticed, price sped up a bit this past week. It might have taken some of us (including myself) by surprise, but in the bigger picture, ever since Nov 9th kicked this rally into full gear, price has been fairly relentless ever since. Just take a look at the 100MA deviation envelopes.
The Pareto principle, and the true distribution of the market
The Pareto principle is one of the most important empirical properties in nature.
“Patience is waiting. Not passively waiting. That is laziness. But to keep going when the going is hard and slow – that is patience.” ~ Unknown
Note from Tim: The Director, one of my beloved Slope Plus members and a frequent commenter here on the blog, got in touch with me and composed this post. He and I have been exchanging emails about having more of this kind of content on the site, and I’d be interested to hear what you have to say. Leave questions and remarks in the comments section, as always.
“The caribou feeds the wolf, but it is the wolf who keeps the caribou strong. ” – Eskimo saying
With P/E of 208 and a pattern that looks like this, it seems to me relatively likely that Amazon will have a much lower price before this year is out, which could make some put owners very happy.