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Minyan Mailbag - Confidence Intervals

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Hey John,

Just saw
your piece on being long volatility and thought your last sentence in paragraph 1 is very important. It would take a tremendous sample size (Large portfolio) to get a high confidence interval (Return) for extreme tail events.

An example of this is when the lottery pays over 16 million in the state of Washington. Yes, you have an edge because there are only 15.8 million possible combos of numbers, but you would have to bet a HUGE number of combos to be highly confident that you would win the 16 million, thereby hitting the tail event.

Do you think 200 positions is enough to realize the expected gain from being long volatility? Is the expected edge (AKA being long volatility at these levels) that great that a fewer number of positions will probably (High confidence interval) generate an absolute positive return?

Minyan Mark

Mark,

We have found that selecting 200-250 names with cursory analysis (primarily balance sheet analysis) combined with relative cheapness of vega provides this payoff. If vega were higher, we would need a greater number of names, but the greater number of names at a higher vega worsens the payoff because the barrier for day to day volatility capture would be higher.

Regards,
Prof. Succo

No positions in stocks mentioned.

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