Optimalf 169
between 2 and 3 standard deviations in price to the upside (whatever dol-
lar amount that would be to you trading one unit over the next day, hold-
ing period), whose probability would be. 9986 −. 9772 =.0214, or 2.14%
probability.3.You can use the distributions of possible monetary outcomes for trading
one unit with the given market approach over the next holding period.
This is my preferred method, and it lends itself well to portfolio con-
struction under the new framework.
Although I strongly recommend using the third item from the preceding
list, whichever method you use, remember thatyou want to be constantly
updating your scenarios, their outcomes, and the probability of occur-
rences as conditions change. Then, you always want to go into the next
holding period with what the formulas presently tell you is optimal.The
situation is analogous to that of a blackjack player. As the composition of
the deck changes with each card drawn, so, too, do the player’s probabil-
ities. However, he must always adjust to what the probabilities currently
dictate.
Although the quantity discussed here is a quantity of money, it can be a
quantity of anything and the technique is just as valid.
If you create different scenarios for the stock market, the optimal f
derived from this methodology will give you the correct percentage to be
invested in the stock market at any given time. For instance, if thefreturned
is .65, then that means that 65% of your equity should be in the stock market,
with the remaining 35% in, say, cash. This approach will provide you with the
greatest geometric growth of your capital in a long-run sense. Of course,
again, the output is only as accurate as the input you have provided the
system with in terms of scenarios, their probabilities of occurrence, and
resultant payoffs and costs.
This same process can be used as an alternative parametric technique
for determining the optimal ffor a given trade. Suppose you are making
your trading decisions based on fundamentals. You could, if you wanted,
outline the different scenarios that the trade may take. The more scenar-
ios, and the more accurate the scenarios, the more accurate your results
would be. Let’s say you are looking to buy a municipal bond for income,
but you’re not planning on holding the bond to maturity. You could outline
numerous different scenarios of how the future might unfold. Now, you can
use these scenarios to determine how much to invest in this particular bond
issue.
Suppose a trader is presented with a decision to buy soybeans. He may
be using Elliot Wave, he may be using weather forecasts, but whatever he