Nassim Taleb’s book “The Black Swan: The Impact of the Highly Improbable” is a powerful concept applied to trading. In the worst bear market during 2008, Universa profited from rare events because when those rare events occur, they are in for a big payday.
Universa purchased far out-of-the-money “put” options on stocks and broad market indices. Universa made a lot of small bets and watches most of them go bad. However, when one hits, it’s big.
The foundation was first revealed in his book, Fooled by Randomness. His philosophy was :
We are genetically still very close to our ancestors who roamed the savannah. The formation of our beliefs is fraught with superstitions. Just as one day, some primitive tribesman scratched his nose, saw rain falling and developed an elaborate method of scratching his nose to bring the much needed rain, we link economic prosperity to rate cuts by the Federal Reserve Board.
Taleb asserted that we frantically search for causal connections where non exist. Investors neglect to account for rare or random events. We almost always discard data that falls outside of the statistical norm. We call it “crazy, this is not counted,” instead of acknowledging that “crazy things do happen, let’s factor this in.”
Volatility is always an unforeseen event. Low volatility has been true and so high volatility is deemed a rare occurrence.
Wealthy people assume they gained their wealth through skill, knowledge and hard work. However, if you invite 1,000 monkeys to play roulette 10 of them will end up fabulously rich. A huge factor is still determined by random luck.
Universa paid 90 cents on put options. When the S&P 500 dropped from 1200 to 900 in a month the options traded to 60 dollars. Univresa cashed out at 50 dollars for a 5455% gain.
Universa paid 1.29 for a put option on the insurance company AIG. It went to 25 a share by September. They were able to sell at 21 apiece.
Most of the time, Taleb just stands on the sidelines. He’s one of the rare few managers who can be patiently waiting for rare events for his big payday,. Every decade, he bets on that “rare event.” If there will be a once-in-a-century tsunami, you might as well always bet on a market meltdown even if its probability is close to 1 or less than 1%.
This is a good reminder to us. Perhaps it is a rare event to get a V-Shaped Recovery. Perhaps successful investors and traders need to follow Taleb’s advice to be conservative, not think about “get rich quick” methods, and instead — patiently wait.
We fell to the abyss in March, had a V shape strong recovery till June. What’s next for the next 6 months? anything goes but you want to have cash locked in just in case.
- Faceless Trader