I suspect that this is a part that some people might not have understood:
This legend was also the origin of what, when I was trying to model fair values for things in various non-efficient markets, my partner called The Green Knight Test—you get to bet into the market (at its midpoint) but the market then gets to bet into your model. And you’re fully ready only if you can beat that. Because that means you actually understand the whole of its nature.
My attempted paraphrase—let’s say you have a model that prices assets that you can bet on (stocks, odds on a boxing match), and you think the model is pretty good. But is it actually good?
Well, the obvious test is whether you can make money from your model, by placing bets when it disagrees with the market. But Zvi is pointing out that there’s really two different versions of this test: the Level 1 test, and the Level 2 test. And he calls Level 2, The Green Knight Test.
For the Level 1 test, when your model disagrees with the market, you get to decide whether to bet or not, and you get to bet at the current market price. So maybe you only bet when the model strongly disagrees with the market, or when the model is highly confident.
For the Level 2 test, you don’t get to decide when to bet. You state your price, and then the market gets to decide whether to bet with you or not. And as long as others are willing to trade at your price you have to keep buying or selling. (Zvi calls this the Green Knight Test, because you’re not just on the offense placing bets—you gotta handle whatever the market throws back at you, like the Green Knight who strikes back.)
To make money on the Level 1 test, you just have to sometimes be more right than the market (and be able to tell when that is). To make money on the Level 2 test, you have to be more right than the market on average, even when the market gets to pick its battles.
Whoa. Thanks for the clarification/elaboration. I’m a big Zvi enthusiast but was unable to follow the idea until you commented. Interesting. It’s the difference between needing to be be able to spot occasional exploitable inefficiencies and to have full-on defenses against everything bad.
I suspect that this is a part that some people might not have understood:
My attempted paraphrase—let’s say you have a model that prices assets that you can bet on (stocks, odds on a boxing match), and you think the model is pretty good. But is it actually good?
Well, the obvious test is whether you can make money from your model, by placing bets when it disagrees with the market. But Zvi is pointing out that there’s really two different versions of this test: the Level 1 test, and the Level 2 test. And he calls Level 2, The Green Knight Test.
For the Level 1 test, when your model disagrees with the market, you get to decide whether to bet or not, and you get to bet at the current market price. So maybe you only bet when the model strongly disagrees with the market, or when the model is highly confident.
For the Level 2 test, you don’t get to decide when to bet. You state your price, and then the market gets to decide whether to bet with you or not. And as long as others are willing to trade at your price you have to keep buying or selling. (Zvi calls this the Green Knight Test, because you’re not just on the offense placing bets—you gotta handle whatever the market throws back at you, like the Green Knight who strikes back.)
To make money on the Level 1 test, you just have to sometimes be more right than the market (and be able to tell when that is). To make money on the Level 2 test, you have to be more right than the market on average, even when the market gets to pick its battles.
@Zvi, did I get it right?
Whoa. Thanks for the clarification/elaboration. I’m a big Zvi enthusiast but was unable to follow the idea until you commented. Interesting. It’s the difference between needing to be be able to spot occasional exploitable inefficiencies and to have full-on defenses against everything bad.