Nassim Taleb

Risk Management researcher, Black Swan author

his book reviews on Amazon

Fourth Quadrant - 2008-09-16-TalebLimitsOfStatistics

How did he actually make money? Can you replicate it?

  • Three times now he has made money when few others did. The first was in the 1987 Black Monday stock market crash, when he made $35 million to $40 million as a trader. The second was the tech stock crash of 2000, when Taleb's own fund, Empirica, gained 60 percent. And the third is Universa... a hedge fund for which Taleb serves as guru and adviser, gained more than 100 percent last year (2008) and now holds $6 billion... Taleb's basic trading insight was that he could buy "deep out of the money" options that would pay off in a dramatic market fall. Most of the time, such options expire worthless. But in a market crash, they deliver a big payoff. In effect, Taleb's strategy has been to buy insurance, reasoning that folks underestimated the likelihood of catastrophic events. It's a lot like buying $200,000 of insurance on a $150,000 house. If it burns down, you've made money. Taleb's idea was that this insurance was underpriced. The problem with catastrophism, however, is that it's very difficult for anyone in the market to wait around for the unexpected. And while Taleb buys insurance, most other market players prefer to sell it... Over the long run, the anti-catastrophists often do fairly well (if they don't get too greedy and make bets that cost them all their money in even a small market drop). But it is the catastrophists, a la Taleb, who look smarter. If you're always planning for crisis, you look like a genius when it does come.
  • In 1986, Taleb moved to First Boston Inc. (now part of Credit Suisse Group), where fellow traders called him Nassim the Dream,'' recalls Demetrios Diakolios, a former colleague. At First Boston, Taleb, then 28, built what he terms amassive'' position in out-of-the-money calls on Eurodollar futures. On Oct. 19, 1987, he was sitting at a row of desks on First Boston's trading floor at Park Avenue Plaza in Manhattan when his dream came true. The Dow Jones Industrial Average plummeted 22.6 percent in the biggest one-day drop in U.S. stock market history. The crash caused Eurodollar futures to surge after the U.S. Federal Reserve pumped liquidity into the banking system, lowering interbank borrowing rates. Taleb's positions exploded once again.
  • Empirica wasn't like most hedge funds. The Russian financial crisis and the collapse of Long-Term Capital Management after $4 billion in losses had spooked many investors. Taleb began offering hedge fund clients protection against a blowup like LTCM by offsetting some of their trades with options. Empirica ended up acting like a superbroker or clearinghouse for buying out-of-the-money options. After spending millions on computer systems and giving their software programs code names like Igor, Taleb and Spitznagel would download 600,000 option prices every night and produce bids on 30-40 big blocks, getting them cheap by buying in bulk, Taleb says. The goal was to protect investors against market crashes. Knowing how much they would pay for options, the two guaranteed investors they wouldn't lose more than 13 percent a year. "Our aim was not to make money," Taleb says. "I make no claims of being able to beat markets." Empirica did outperform the market. In 2000, its returns rose by about 60 percent on the back of high volatility and the bursting of the dot-com bubble, Taleb says. The next year, after the Sept. 11 terrorist attacks, nervous investors came flocking. Then volatility dropped as the stock market slowly drifted down, removing the opportunities to profit from wide market swings.
  • Universa purchased far out-of-the-money “put” options on stocks and broad market indices. A put option gives the owner the right, but not the obligation, to sell an underlying asset at a set price within a specified time period. It’s a bet that a stock or market is going down... Universa makes a lot of small bets and watches most of them go bad. However, when one hits, it’s big... Universa keeps 90% of its assets in cash or cash equivalents and simply tries to break even as it places small bets on rare events.

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