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Malcolm Gladwell Article on Nassim Taleb (written in 2002)


claphands22
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So basically he sits around buying put options all day hoping for a black swan. In the meantime he bleeds alittle everyday by paying small premiums.

This means WEB's derivative contracts, which are the sales of put options, which is a Niederhoffer strategy, should go to the dumpsters.

It's an okay strategy, Taleb has made money in this crisis. But it's not my style. It's a trading strategy, as opposed to being a business-man and buying/running a business.

 

How does he figure out what is most likely to produce a black swan (i.e. 9/11 event)? Or does he just roll dice on anything and everything?

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this stategy is suited to a low volatility context, not the present time.

Moreover, there can be no black swan for a very long time.

What if the black swan was the absence of black swan...not plausible but who knows...

 

Now ... would be low volatility would it not??

Back in early 2009, and late 2008 ... that was high volatility ...

 

He must buy long dated put options, b/c whenever volatility spikes, options all of a sudden get expensive ... buying short dated options would be expensive ...

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I don't think Taleb's strategy is so hot. We hear about how his strategy is great now that the market has fallen 40% from its peak, but we never hear about how much money he lost with expired put options over the past 15 years. It is the opposite of Buffett strategy. Buffett is willing to take on CAT risks or put option risks when he is well compensated for taking those risks.

 

Overall, I am not too impressed by Taleb. Most experienced investors knew that markets did and would continue to do weird things from time well before Taleb wrote his books. He seems to think he is a genius and everyone else is an idiot. He is basically peddling his books.

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Did anyone else notice this, towards the end of the article (emphasis mine)?

 

"We say we have a Gaussian distribution, and you have the market switching from a low-volume regime to a high-volume. P21. P22. You have your igon value."

 

He has quite an accent I guess!  ;D

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"...when he contemplated the countless millions that Niederhoffer had made over the years -- he could not escape the thought that it might all have been the result of sheer, dumb luck."

 

One lesson that I take from reading the article is that Niederhoffer continually ignored the small probabilities of a large discontinuity which eventually led to his failure. These guys are greedy and ignore the risk of returning to square one. You can never position your portfolio in such manner that low probability events could wipe you out.

 

The article mentions that Taleb does not have Buffett's confidence, but I believe that Warren always has an eye on the downside. He has talked about the risks of leverage before in investing. He is looking for a successor who is capable of thinking of events that never happened before. His super-cat bets are always capped so that "his cheques will clear". The margin of safety concept is also clearly oriented toward reducing the risk of wipe-out.

 

Regarding Taleb's approach, I find that my portfolio has grown mainly by 1 or 2 positions every year or every second one truly outperforming. I found over time that I don't have any ability to predict which one will outperform for certain. The margin of safety protects my downside on the positions that do not work or move little, but for the ones that really outperform it takes a massive valuation error from the market relative to what the company eventually delivers.

 

So while I consider myself an investor with my value approach, I find that Taleb's risk aversion strategy combined with many low cost "long shots" brings at the end very similar results.

 

Cardboard

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Taleb approach is very different from Buffet, from my point of view:

-Buffet earns interest as time goes by (power of compound interest)

-Taleb loses as time goes by (he purchases volatility and  time value)

 

In other words, Buffet writes insurance while Taleb purchases insurance

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Did anyone else notice this, towards the end of the article (emphasis mine)?

 

"We say we have a Gaussian distribution, and you have the market switching from a low-volume regime to a high-volume. P21. P22. You have your igon value."

 

He has quite an accent I guess!   ;D

 

More likely that Gladwell just doesn't know what an eigenvalue is.  :)

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In think part of the difference between Buffett and Prem is Prem incorporates some of Taleb's ideas (betting on blow-ups with out of the money puts - think hedges and CDSs) while Buffet does not.  This leads to a less bumby ride as when things are good you don't go up as much but when things are down you are protected.

 

Packer

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What's not in here, & what all these quants missed is the very high model risk in this strategy.

 

For Taleb to win he needs to able to sustain a cash bleed every day, & then periodically collect big from a wide range of people when there's a market discontinuity - every few years. Academically correct.

 

But ....

 

In the real world he's really betting against very few people (one), & hoping that when the payoff event happens those people can pay up the cash immediately - ignoring the proven reality.

 

He's really short cash & long a long-term unsecured low quality note - if the event itself doesn't first put the counterparty under.

 

Very similar to having AIG as your counterparty on the other side of your CDS trade.

 

SD

   

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Plus, black swans are not necessarily unusually bad events, even if the most recent example in the market was unusually bad.  You can have unusually good events too.  (e.g. Harry Potter, Bill Gates, maybe oil going from $10 to $143).  I don't think exclusively playing the downside is a requirement of the theory.

 

Richard

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Taleb is playing the extremes.  It's why he likes the Biotech model. It's a sector you can make many bets and lose a little money along the way, then one drug hits and you have a significant payoff that more than makes up for your other losses (at least that's the idea).

 

In the Black Swan, he provides many examples.  It's another reason he thinks the banks should be regulated like Utilities.  In his mind they take all risk on the downside in lending with the upside being they hope to get paid back with a little interest. 

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  • 1 year later...

I know this is an old topic, but i figured i would try to work the math on talebs strategy.  He buys put options and hopes for a big drop.  Lets classify a big drop here as a drop of 10% of the SPX in 1 month.  Using Shiller's Excel File i went back to 1871 and looked at all the months with drops of 10% or more.  There were 28 (out of 1666 months).  So in any given month there is a 1.7% of a 10% drop, all else being equal (the % was around 2% when current 10 year PE was above 20)

 

Looking on fidelity i saw the price for put options with a strike price of 1210, expiring on March 19, 2011 (unfortunately there were no options expiring exactly 1 month from today, so we are not exact, but pretty close) were priced at $7.70.  if there was a drop of 10% from current 1304 level, that puts the SP500 at around 1170.  If it made that drop, you would pocket $40 (1210-1170) or a 519% gain on your $7.70 investment. 

 

I know this a huge approximation but you have a 1.6% of winning, and the payoff for that is about 5X.  Doesn't seem like a very good game to be playing.  Is my math right?  I'm still a bit new to options and part of this is me just checking my logic too.

 

I guess if you had some insight on when the SP500 might drop, that could help, but i found that to be negligible (again when sp500 10 year pe is over 20, you still only see a 10% monthly drop in about 2% of the months).---Furthermore, it sounds like taleb is not very picky about when he buys the options, he pretty much buys them all the time (not just when the market is high).  Thoughts?

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Speaking abstractly with the numbers given.

 

32.3 per contract gain / 7.7 basis = 418% return

Likelihood: 1.6%

Expected value: ~7.1%

 

BUT, you lay out this bet every month, so the annualized returns could be interesting, especially over the short run, coupled with propitious timing.

 

 

I know this is an old topic, but i figured i would try to work the math on talebs strategy.  He buys put options and hopes for a big drop.  Lets classify a big drop here as a drop of 10% of the SPX in 1 month.   Using Shiller's Excel File i went back to 1871 and looked at all the months with drops of 10% or more.  There were 28 (out of 1666 months).  So in any given month there is a 1.7% of a 10% drop, all else being equal (the % was around 2% when current 10 year PE was above 20)

 

Looking on fidelity i saw the price for put options with a strike price of 1210, expiring on March 19, 2011 (unfortunately there were no options expiring exactly 1 month from today, so we are not exact, but pretty close) were priced at $7.70.  if there was a drop of 10% from current 1304 level, that puts the SP500 at around 1170.  If it made that drop, you would pocket $40 (1210-1170) or a 519% gain on your $7.70 investment. 

 

I know this a huge approximation but you have a 1.6% of winning, and the payoff for that is about 5X.  Doesn't seem like a very good game to be playing.  Is my math right?  I'm still a bit new to options and part of this is me just checking my logic too.

 

I guess if you had some insight on when the SP500 might drop, that could help, but i found that to be negligible (again when sp500 10 year pe is over 20, you still only see a 10% monthly drop in about 2% of the months).---Furthermore, it sounds like taleb is not very picky about when he buys the options, he pretty much buys them all the time (not just when the market is high).   Thoughts?

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jb85 & widemoat,

 

The correct math assuming a 10% drop in the index is as follows:

 

Expected value of the bet = prob of winning* winning take - (1-prob. of winning)*price paid

 

Thus equals $40*1.6%-98.4%*$7.70 = -$6.94

 

Therefore this is a losing bet and should not be placed. It will be interestng to work out the odds for a 30% drop in the market.

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If I remember correctly he buys way out of the money options. Options are priced with the assumption of something like normal (lognormal) distribution. Thus way out of the money options are underpriced if returns do not follow the neat lognormal distribution i.e. black swan type scenarios tend not to be incorporated into the price. So his strategy losses small amounts of money regularly with the occasional home run.

 

Thanks

 

Vinod

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Options are priced with the assumption of something like normal (lognormal) distribution.

 

Not true at all. Option market makers are quite sophisticated. You can observe "volatility smile" and "volatility skew". Volatility smile means that implied volatility is higher for out of money options than at the money options. And volatility skew means that the implied volatility is higher on one side of the strike price than the other side. This is completely contrary to log normal distribution.

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Options are priced with the assumption of something like normal (lognormal) distribution.

 

Not true at all. Option market makers are quite sophisticated. You can observe "volatility smile" and "volatility skew". Volatility smile means that implied volatility is higher for out of money options than at the money options. And volatility skew means that the implied volatility is higher on one side of the strike price than the other side. This is completely contrary to log normal distribution.

 

You are correct indeed. However, the point I think Taleb makes is that option pricing models as much as they are tweaked (either via a skew or assumptions of higher volatility), do not really price black swan type events.

 

Vinod

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jb85 & widemoat,

 

The correct math assuming a 10% drop in the index is as follows:

 

Expected value of the bet = prob of winning* winning take - (1-prob. of winning)*price paid

 

Thus equals $40*1.6%-98.4%*$7.70 = -$6.94

 

Therefore this is a losing bet and should not be placed. It will be interestng to work out the odds for a 30% drop in the market.

 

Haha, I would bet a 30% drop would still be negative EV. How much of a payoff is expected on a 30% drop? 100,000% too high?

 

 

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I think that generally betting on Black Swans by purchasing out of money options is a losing bet. It is possible that occasionally when the market is at a cyclical peak and is dominated greed as opposed to fear, you may (or may not) be able to purchase cheap puts as insurance. But I think doing it day in and day out is a losing proposition as illustrated by the previous expected value calculation & due to the fact that this insurance is priced mostly right.

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If I remember correctly he buys way out of the money options. Options are priced with the assumption of something like normal (lognormal) distribution. Thus way out of the money options are underpriced if returns do not follow the neat lognormal distribution i.e. black swan type scenarios tend not to be incorporated into the price. So his strategy losses small amounts of money regularly with the occasional home run.

 

Thanks

 

Vinod

 

Yup.  This is an accurate take on his strategy.  Once in a blue moon, he will make a big score that will more than make up for the small losses.  However, after such a big loss event, a " smile " phenomenon developes where the way out of the money options assume a pattern that is less reflective of the supposed normal distribution.  Then his strategy is less likely to work for a while until the market loses its memory of the black swan.

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I think this whole Taleb black swan is bogus when it comes to making money. or at least for individual investors. It is a great mathematical concept that has practical relevance in some fields like engineering, national security etc

 

Where are his last 20 years of returns? why is he not a billionaire yet? I can make a bet that he made more money off his books than his returns.

 

there is so much controversy over his returns

http://www.businessinsider.com/wait-before-you-invest-in-nassim-talebs-new-fund-2009-6

 

what he is trying to sell is this. An inverse correlated returns with the market. there are lots of suckers for this kind of fund.

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