Of Black Swans and Put Options

by Manshu on June 26, 2009

in Opinion

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Nicholas Taleb is famous for his black swan concept, and also for making a lot of money when everyone else is losing it.

So, I was intrigued to read this piece by Janet Tavakoli via Market Folly.

It says:

A recent GQ article quoted Nassim Nicholas Taleb as saying that in the falling market he “made $20 billion for our clients, half a billion for the Black Swan fund.” 1

I checked with Nassim Taleb regarding the $20 billion in gains and asked if he were misquoted. He responded via email: “The quote is inaccurate. THe [sic] 20 billion might correspond to the face value of positions.” This response is both vague and different in character from the mythical $20 billion in gains inaccurately quoted in GQ‘s article. The total gains could be a tiny fraction of what Taleb loosely describes as “face value.” 2….The black swan fund’s strategy is purportedly to buy out‐of‐the‐money put options on stocks and broad market indices and hedge tail risk for clients. The strategy may produce long periods of mediocre-or even negative-returns followed by a large gain and vice versa. No one can tell you for certain exactly when (or for how long) large gains are possible. Initial success in a newly created fund may not be replicated in the future, and there is always the problem of scaling. Scaling refers to the fact that an individual fund may make a high return on an initial investment, say 100% on $100 million, but lose 10% on $1 billion.

I first read “Fooled by Randomness” by Taleb, about a couple of years ago and wrote a post about probability v expectations and gaining from big crashes in the markets.

The idea is that you position yourself to gain from the spectacular crashes that are bound to occur once in a while, and so buy “cheap” put options in that anticipation (like the black swan fund strategy).

Here is what I thought at that time and is still valid:

I have heard my dad telling me once that these market crashes are inevitable and every month one should buy a ‘cheap’ PUT so that when once in a year the market falls spectacularly that PUT is worth a gold mine and covers up for all the remaining 11 months when the market followed its due course. He was talking about low probability and high expectation and I think a lot of investors do think about this but not really do anything about it.

I myself have never tried buying PUTs hoping that the market crashes and certainly do not recommend it to anyone but it is certainly a thought that is worth a thought. And while one is at it why not buy a ‘cheap’ Call as well just to take care of the ridiculous 1000 points upward moves too!

I never did carry this thing out and I am glad I didn’t do anything like that because although I did anticipate that there will be long periods of no gains, from the performance of Taleb’s fund, it looks like even when the black swan appears – you are not guaranteed to make a killing.

Photo Credit: Ennor

{ 2 comments… read them below or add one }

Mark Wolfinger June 27, 2009 at 7:06 pm

It’s not easy (to pull the trigger) buying cheap put options. But even if you do, the black swan event that your dad suggests would arrive on an annual basis is not what happens in the real world. Sure the market may decline, but if you buy a put that’s rally cheap, it will probably remain worthless unless there is a large, sudden decline.

5% is not enough. And 10% may not be good enough either.

Right now SPY is 92. The Jul 83 put (10% out of the money) is cheap: 29 cents.
If SPY were to drop to 83 Monday, the put becomes at the money. The current at the money put, the Jul 92 put, is currently $2.10. If the 10% drop does occur, implied volatility would rise, and the (now at the money) Jul 83 put would be higher than $2.10.

Let’s be generous and suppose it’s $5.80 – or worth 20x the cost. That’s a very nice profit. But how many would you have to own to see ‘gold.’ A profit of $550 on a one lot is not enough to offset losses for a normal, long-only, portfolio.

I’m not knocking the idea. Just pointing out that you have to own a bunch of these puts, and most people would not be comfortable spending too much money on this longshot. Especially month after month.

I am not knocking Taleb and his work. But the more likely outcome would be for the market to decline by less than 10% and to take a longer time to do it – most years. When that happens, you lose on both the puts and your portfolio.

It’s great to own end-of-world-as-we-know-it insurance. After all, 1987, 9/11/01, 2000, and 2008 did happen. And will happen again. But it is expensive to own enough puts. Your last line says it all: You are not guaranteed to make a killing.

Good post.

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Manshu June 28, 2009 at 10:27 am

I did try it out and discovered what you are saying Mark. I think at about Jan last year, I bought a Put which expired in three months and was out of the money. At the end of three months it expired worthless. And I was wondering what to do next.

Should I go ahead and get another one or just let it be. In the end I just left it because as they say, the market can stay irrational longer than you can stay solvent.

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