Last summer I wrote a post about why the stock market is a great optical illusion. When prices march much higher, realized volatility decreases but embedded instability (potential energy) in the system increases. The opposite is true after a big fall. Realized volatility is high but the embedded stability of the market increases. The post can be summarized by the picture below.
These statements lead us to state the following dualities:
- Perceived instability is potential stability.
- Perceived stability is potential instability.
What works for the investor/trader at the greed/buy part of the cycle are:
- Long stocks.
- Short volatility.
- Short correlation.
What works for the investor/trader at the fear/sell part of the cycle are:
- Short stocks.
- Long volatility.
- Long correlation.
If he allocates capital following what works, he will repeat until broke.