Thursday, 21 April 2011

tactics for a bubble

what is the optimal strategy for taking the most money out of a bubble situations.

number one has got to be not trying to call the top, any strategy that is long during a bubble and plans to sell out based on some sort of valuation ratio is almost always going to fail if its truly a bubble. when a bubble is in a truly frothy expansion, participants are piling in because they're afraid to miss the boat, not even a greedy fool can predict that actions of an even greedier crazy fool.

there are good academic papers that point out that a bubble is characterized by "log periodic power laws" lppl. basically, the price goes exponential, the rate of return increases with time. which in itself fits with observation and with the process that is happening, the higher short term returns attract more investors, who push the asset higher, which creates higher returns attracting more money. clearly this is a situation where momentum is increasing and calls for a trend following strategy.

as such a good strategy would be to pick a moving average of an appropriate length say 100days, and to own the asset when it crosses above that price and to stay long until it falls below, and hope to liquidate there with as little slippage as possible. the Raven has backtested this strategy with stock data from the nasdaq bubble and if he remembers correctly the best window to use was the 200day simple moving average. additionally this has the advantage of being rather robust and minimizing on trading costs. the shorter the window length, the more trades and the sooner one is stopped out of a trade, but the less risk one takes.

update of the numbers for some famous bubbles coming up....

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