The myth of unpredictable crashes, corrections, and rallies

Can you predict “hard-to-predict” and rare events? The Black Swan strategy for hedging against such an event is a combination of a long-put option and insurance. That is fine but it may take you a while to achieve a successful outcome and you may have some difficulty surviving as a fund manager in the interim. It is a myth that (most) tail is risk is not “predictable”. By predictable I mean it can be estimated in size, probability, and timing with a probability greater than chance. If I have a better than 50% probability of wining, I will play the game. There are two basic ways you can win the game; (1) Get “good’ estimates of momentum plus mean-reversion, (2) Identify herding preceding crashes or rebounds. We will explore the former later. In contrast to a Black Swan, Dragon Kings are identifiable, quantifiable, endogenous, complex, and characterized by accelerating feedback mechanisms. See the book Why Stock Markets Crash by Didier Sornette, 2003 and the many papers. We will be discussing the later in detail in forthcoming blogs.

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