Extending Shannon's Demon

Mentioned in the Fortune's Formula book review, I want to express some ideas around applying Shannon's Demon for long gamma option trades. 

Shannon's Demon review

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His experiment, known as Shannon’s Demon, showed how it was possible to profit even from markets that were characteristic of a random walk, as long as they were volatile.

The experiment is simple: Imagine a stock that is highly jittery and either doubled or halved in value every day. You then invest half of your portfolio in the stock, while the rest remains in cash. At noon each day you rebalance the portfolio back to a 50-50 even split. So, if you started with $1,000 and the stock got cut in half, the following day your portfolio would be $750 ($250 in the stock $500 in cash). After rebalancing, the portfolio would have $375 in stock and $375 in cash. As the chart below shows that after rebalancing only 72 times our $1,000 initial investment is now worth just under $100,000! That is not a bad chunk of change given that we didn’t have to do any stock forecasting to make this profit! In fact, had you bought and held this stock you would make zero profit.

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GestaltU

So we would require a very volatile asset to simulate this. Simply using leverage would not be practical for many risk management purposes. I think taking long option trades may be a good first step.

Long Gamma Option Trades

Roger Lowenstein has said
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Markets can remain irrational longer than you can remain solvent.
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Well not if I do it with long options. But that still doesn't mean it'd be profitable.

The price for risk mitigation is theta. Therefore, the trader must still over come the cost of theta to work Shannon's Demon into a trade with decent EV (Expected Value).

Adding to Winning Directional Bets

Having seen many documentaries of professional (directional) traders talking about adding to winning positions, I had a little brainstorm of why this helps with profitability of trades. Here’re some reasons I’ve come up. 

So the basic idea is to only add to a winning position, and reduce position size as it moves negatively. We can already see how this replicates option delta, where the trade becomes essentially long Gamma, without risks around Vega, Theta, and other Greek uncertainties.

 

1)      It gives a convex payoff; it creates monster winning trades with respect to average losing trade size. (Convexity vs. Concavity)

2)      Having a convex payoff requires much lower win-rate for a trading strategy to be net profitable i.e. maintain a positive EV.  

3)      The trade would have a significantly reduced probability of taking relatively large losses. We’ve all heard stories of people blowing out from short Gamma trades, such as adding to losing positions, selling naked options.

4)     Counter-Intuitive, and we know going against the crowd is usually a GOOD thing in this industry.