lecture25 - Lecture 25 Money Management Steven Skiena...

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Lecture 25: Money Management Steven Skiena Department of Computer Science State University of New York Stony Brook, NY 11794–4400 http://www.cs.sunysb.edu/ skiena
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Money Management Techniques The trading strategies we have studied point towards possible investment opportunities, but usually do not tell us how much we should invest in each. Money management issues are implicit in discussions of (1) risk vs. return, (2) portfolio optimization, and (3) market saturation. Properly allocating capital to investment opportunities can be as or more important than finding them in the first place.
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Leveraged Trading Strategies That investment strategies must modulate risk and return in money management is apparent when studying the impact of leverage. Consider a strategy which borrows money at the LIBOR rate for one year, and invests it in a stock market index (here Nasdaq).
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Nasdaq Leveraged Trading 1990-2000
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Nasdaq Leveraged Trading 2000-2007 The probability of going bust is as meaningful notion of risk as volatility. . .
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Managing Money When You Have an Edge You play a sequence of games, where: If you win, you get W dollars for each dollar bet If you lose, you lose your bet For each game, the probability of winning is p and losing is q = 1 - p You bet some fixed percentage f of your bankroll B each game, for you have (1 - f ) B if you lose and ( W - 1) fB + B if you win. The right value of f is called the Kelly Criterion.
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Rigged in our Favor? Suppose we bet $1 on a fair coin, but one which pays $2.10 if it comes up heads? How much of our bankroll should be bet each time? Bet too much and we lose, even with the odds in our favor!
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After 5000 Coin Tosses Ten straight tails leaves only 1/3 the bankroll at 10%, but almost 2/3 at Kelly (4.5%)
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The Kelly Criterion: History Developed by John Kelly, a physicist at Bell Labs in a 1956 paper “A New Interpretation of Information Rate” published in the Bell System Technical Journal. He used Information Theory to show how a gambler with inside information should bet.
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