Discovering a power law
For the purpose of this recipe, imagine that we are operating a Hedge Fund. Let it sink in; you are part of the one percent now!
Power laws occur in a lot of places, see http://en.wikipedia.org/wiki/Power_law for more information. The
Pareto principle (http://en.wikipedia.org/wiki/Pareto_principle) for instance, which is a power law, states that wealth is unevenly distributed. This principle tells us that if we group people by their wealth, the size of the groups will vary exponentially. To put it simply, there are not a lot of rich people, and there are even less billionaires; hence the one percent.
Assume that there is a power law in the closing stock prices log returns. This is a big assumption, of course, but power law assumptions seem to pop up all over the place.
We don't want to trade too often, because of involved transaction costs per trade. Let's say that we would prefer to buy and sell once a month based on a significant correction (in other words a big drop...
