Focus On Convexity: Long Or Short, That Is The Question
Imagine that you just started trading the financial markets, and a more experienced investor offers you this choice: Would you prefer Death By A Thousand Cuts, or Getting Flattened By A Steamroller?
Which one would you choose?
Probably neither, since they both sound extremely unpalatable. The bad news is that you have to pick one, simply because most, if not all, trading/investing strategies fall into one of the two categories.
Naturally, these strategies come with their upsides as well.
Long convexity strategies aim to profit in a big way from infrequent low probability events, while short convexity ones try to profit in small ways from frequent high probability events.
Which is better?
A common answer would be, it depends on your risk appetite, or find a strategy that fits your style and personality.
This is excellent advice, but when it comes to how to position yourself with regards to convexity, it is quite lacking.
This is because the consequences of being short convexity are extremely dire; possibly career ending for professionals, and trading account busting for individual investors. On the other hand, relatively few people have the emotional and mental stamina to continuously take small losses in the expectation of long term gain.
As such, both long and short convexity strategies have their time and place, and both, like all things in life, are subject to timing.
Theoretically, if short convexity traders know when the steamroller is coming, they can sell as much vol as they want, picking up pennies to their heart’s content before jumping out of the way just as the steamroller arrives.
Likewise, theoretically, long convexity traders can wait until just before the steamroller arrives before jumping aboard and placing their bets.
But, hold on a minute. If this is the case, then theoretically, wouldn’t the best course of action for traders be to pick up the pennies and just in the nick of time, jump aboard the steamroller?
At this point, it is clear that theoretically doesn’t work very well in markets – no one picks up the pennies and manages to jump aboard the steamroller because no one knows exactly when the steamroller is coming.
In other words, the steamroller is an ever present threat, regardless of a trader’s preferences or personality.
Consequently, traders need to understand whether their chosen strategy (or strategies) is long or short convexity, and actively manage the risks that arise from that.
Short convexity traders can hedge against it by taking some kind of offsetting position, possibly in the options market. This is often called “tail risk” hedging, and people more often than not neglect it because of how complacency settles in during bull markets.
After all, why allocate a portion of precious profits to portfolio hedges when everything is rosy? Unfortunately, history has shown that these are the times when tail risk hedges are needed the most.
On the other hand, those who are long convexity must manage very carefully how much they risk when entering a position. They must size their positions and set their stops in a way that minimizes the amount they lose per trade, which is an idea that is closely linked to the Paretian reality of market returns.
Are you long or short convexity, and how are you managing your risks?
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