Sorry, but I don't think most hedge funds use just the EV (with no risk adjustment) for pretty much anything other than HFT (i.e., with arbitrage and front-running being the obvious exceptions).
Certainly not in portfolio optimization.
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Seems like a big factor here is that edge is frequently a decreasing function of size, so if you are big enough, that probably stops linear utility from getting too out of hand.
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I guess the point here is that there is usually an explicit downside risk constraint in most basic portfolio optimization problems; not to mention there are usually leverage constraints, among many other things, which of course aren't captured by just vanilla EV.
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So what hedge funds really do here is:
1) estimate linear EV. This is always the first and most important thing to do.
2) estimate correlated volatility with your portfolio
3) if (1)/(2) is small then just do it
4) if it's short-term just do it
But honestly usually just (1).
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There are exceptions, obviously! Times when the downside risk is significant.
But then you separately think about downside risk for it.
To use something other than linear EV (or similarly sharpe adjusting for correlation with portfolio) would get you laughed out of the room.
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True for spot portfolios, but definitely not true for leveraged derivatives
I don’t know any serious options or swaps trader who doesn’t discount linear EV by time decay or other processes that add in concavity by the nature of the instrument + microstructure
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The instruments are naturally overexposed to gamma/shifts in gamma, so you discount and use sublinear reweighting / constraints
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what do you mean by "time decay"? If you're trading options then it's the linear EV of the option you care about (which is not the linear EV of the stock, of course); "time decay" is built into calculating the linear EV of the option.
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It’s not *really* linear. If I’m trading options on XBI near expiry at 3:30p vs. 2p, the large inflow in XBI purchases of components is affected by expiry and the theta measured at 2p vs. at 3:30p is more (for liquidity reasons) than 1.5h would expect under e.g. B-S
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I'm not saying that the linear EV of an option is linear in time, or that B-S is exactly the right model; just that whatever the linear EV of the option is, is what you should care about, if that's what you're trading
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(unless your position gets large enough that you'll have impact hedging it, in which case you have to discount by that)