Quote from Cutten:
Every mean-reversion indicator - public bearishness, oversold, depth below the 200 day moving average etc - is saying buy right now. However, the indicator that matters most - market action - is saying sell. We've had 2 bull points (Fed intervention yesterday into commercial paper; global central bank cut today) and both times the market rallied initially, then reversed and traded lower.
So it presents a dilemma - do you trust reversion to the mean, or do you defer to the market action and stay flat with some puts? The latter is the more conservative option, the former may work but you are certainly taking on a lot of risk for the reward you seek.
Respecting price action gives the following results:
1) Rally = 0% return
2) Crash = 10%+ return, and chance to buy at the definite bottom for another 10-20%.
Doing mean reversion gives these results
1) Rally = 10-20% return
2) Crash = -10-20% return, and probably you'll be too freaked out to stay long or double up at the bottom, in fact you will probably puke the lows.
Perhaps the best play is long deep OTM puts and deep OTM calls - even at these high implied vols. That way you make money on a huge rally or a crash, and your risk is limited. You can ratio in favour of the calls or puts depending on your bullish, neutral, or bearish bias.
