Nassim Taleb and Empirica

[palawan]

I read both the article and Nassim's book, and for a while I was a big fan... I still am, to some degree.

I've lost a lot of money being long options (puts and calls) the past couple of years and made some money year 2000. A lot is a relative term... About $8K for the combined years 2002 and 2003 give or take $1K. I made about $5K or so in 2000. I only trade on the side and have a full-time job as an Engineer. If I continue losing, so be it, but I definitely know that I don't want to be short the tails (on either side) of the options. Mark Cook (Market Wizards) can explain that much better than I can. He not only lost all his money (profits included), but he ended up owing several hundred thousand dollars when he sold naked options.

As I said in the beginning, I was a big fan of Nassim, when I first read his book and the article. Why? because he validated what I have been doing all this time. By the way, he's neither bearish or bullish, he just plays for the extreme moves, and from what I read in the book, he buys out of the money calls and puts and doesn't care which side the extreme move goes to. There's a section in the book where he went to a meeting (he's a very cynical person) and when asked about a particular direction, he replied (I'm paraphrasing here from memory) he thought "it" (index or stock, i don't remember) would go up 10 or 20 points, and the other person replied, then why are you buying puts?? because if the direction goes to the downside, then he's expecting a 100+ point move. What he was saying was 70% chance of an up move x 20 points equals 14 points, while 30 percent chance of a down move 100 points equals 30 points. Bigger payoff.

I'm not much of a fan now, because I read a sentence on the Motley fool message board saying that the reason Nassim's strategy is like that is because he's not a good trader. Bingo! It's true... He's no George Soros, or Bill Lipschutz or Michael Lauer, where they analyze information and make a bet. If they're wrong, they cut their losses and analyze some more and make some more bets. They put their money on the line based on their ideas.

I'm a big fan of the Market Wizard books (all three of them). I've learned so much, not on what to buy or sell, or how to trade, but on Discipline and Hard Work (ie Mark Cook, Tony Saliba) and intelligence in the analytical sense (i.e. John Bender, Bill Lipschutz).

The section on John Bender (Stock Market Wizards) is probably the best explanation on why it's better to go long the tails. Because they're fatter in reality than what the normal-distribution curve is implying. Let's give an example, if IMCL ($39.24) is going to release information on the FDA approval or rejection of Erbitux tomorrow and no one knows they're releasing this info. Isn't IMCL more likely to be over 45 or under 35 by Friday (2 days from now) and you would be able to sell the 40 calls and buy a bunch of 45 calls and sell the 40 puts and buy a bunch of 35 puts, and making a killing. The tails are MORE LIKELY to happen than the at-the-money strikes.

I'm still in the game and maybe I'll make it... I'm just waiting for that one day where I'll hit the lottery (like what I did year 2000 with my COMS calls) and have enough money to play other strategies - all of which involve long options and directional plays.

Disclosure: no position in IMCL

 

[jem]

Sleeping giants post was the point I was making about looking for black swans. Warren buffet said in his letter to investors a few years ago it is hard to price catastrophes and Insurance companies competing for premium frequently do not properly discount "insurance black swan's". So wouldn't one of the startegies be to figure out which insurance companies to short vis a vis the others and then wait for the options or the spreads to be priced favorably. Perhaps you could ratio back spread the spread and only bleed a little or not at all while the position was on. There seems like there would be hundreds of ways to have fun putting stuff like that on if you had the money.

 

[Cutten]

Quote from SleepingGiant:


Concerning the second scenario (which is the more interesting of the two), I believe someone posted that implied volatility alone is not (or would not be) a very good predictor of black swans. Assuming this is the case, are there any reasonable methods for predicting these types of events? I am aware of Sornette. He's definitely pushing the envelope and his work is very interesting.

I think one method that might not be very sexy but probably has the potential to be very helpful in this area would be fundamental analysis. My instinct tells me that if you were to dig through the books of a few hundred stocks you could/would find a few that are ripe for a fall, for a takeover, etc. The fundamentals might not be the complete answer, but it might be a decent place to start if you're looking for black swans.

I agree and this is the basis for my strategy. I don't do it on individual stocks, but rather using a global macro fundamental analysis to look for possible booms, bubbles, or crash scenarios. Although sometimes something like Enron, Worldcom or the dot coms come along and taking an individual stock position makes more sense.

Generally whenever I feel tempted to take a large position in the underlying, there is a big skew between the probability distribution implied by the options market, and my perception of the likely price distribution going forward. Often this can be exploited to generate a better risk/reward than the underlying position. For example a very undervalued market, once it starts moving up significantly, has a far higher probability of continuing to an even larger move than it does of moving the same distance back down again. A market which has moved a long way in a short time, to approach a major level, is either going to blow through that level or reverse back sharply - it is highly unlikely to start ranging around that level.

 

[DTK]

... but to simply answer the original questions...
1) Yes
2) Yes (imho)
3) Long

btw - Long Taleb's book & haven't got around to Niederhoffer's yet.

Quote from SleepingGiant:


So, a few questions for the group...

1) Do you think Nassim Taleb is right in that traders underestimate the probability of a drastic move in the underlying product?
2) Can a strategy like this work over the long run?
3) If you had to choose one, would you rather be short the tails (Niederhoffer) or long the tails (Taleb)?


-SG

 

[joethemoustache]

A big problem is that profiting on black swan events puts you at direct odds with general public and institutions. Explosions in volatility favour downside moves, and generally, as has been pointed out, most the financial community is long-only funds who press exchanges for restrains in dramatic moves to the downside.

Basically the long tails strategy colud be seen as hoping for more 9-11 events. Great, eh?

As for selected positions in stocks/commodities thats another story.

 

[TempusFugit]

Quote from SleepingGiant:


So, a few questions for the group...

1) Do you think Nassim Taleb is right in that traders underestimate the probability of a drastic move in the underlying product?
2) Can a strategy like this work over the long run?
3) If you had to choose one, would you rather be short the tails (Niederhoffer) or long the tails (Taleb)?


-SG

1) Not really. The "volatility smile" we see in most options chains indicates that traders are already pricing in fat tails.

2) Not in volume. Even if you could find the exceptional mis-pricings I wonder if there is enough liquidity (far OTM contacts seem to be very thinly traded) to make the play worth it for someone running as much money as he seems to be. And certainly retail traders (or anyone else paying the bid-ask spread) could not pursue this strategy without being eaten up by transaction costs.

3) Building on my answer to 2) and given that I trade retail I would have to go short to have a chance to make any money. I believe with neurotic, paranoid, disciplined position management one could even survive a black swan. But, it's not my cup of tea. I prefer to get a good night's sleep.

SG: Thanks for the great thread.