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"The Black Swan" (Cygnus Atratus) is a type of water bird that is only found in Australia and New Zealand and was once thought to be extinct only to be rediscovered in Southern hemisphere. There is an author by the name of "Nassim Nicholas Taleb" (Taleb for this article) who has written a book titled, "The Black Swan", which has nothing to do with these black birds but has everything to do with financial markets. The author "Taleb" metaphorically compares "Black Swans" to financial calamities (think financial crisis of 2007) and says that just as the black swan reappeared out of the blue on the surface of this earth, financial calamities also surface without warning out of nowhere. And this would exactly happen when people have completely forgotten that such an event could ever take place. Per Taleb, financial disasters would keep on coming whether you like it or not, and investors should be prepared in such a way that they gain from such an event and not burnt by it. Now perhaps Taleb just got lucky with his timing as this book came out in early 2007 just before the financial melt-down and was has been described in a review by the Sunday Times as one of the twelve most influential books since World War II.

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The Black Swan

"The Black Swan" problem:

Black swan events were originally introduced by Nassim Nicholas Taleb in his 2001 book Fooled by Randomness, which talked about financial collapses and people's perception of such events. His premises is that when times are good and people are totally unconcerned with a possibility of a catastrophic financial event, a disaster is imminent at that time. Taleb says that all large institutions have risk managers who are well paid but cannot predict the future risk of the black swan. So per him, what good are they? Incidentally he was invited at Morgan Stanley offices in New York City in early 2007 to speak to some 40 risk managers where author presented to them that their risk models did not work. As you can very well guess how well received Taleb's presentation would have been at the time but the very same managers saw a complete melt-down of their financial models just months later. Maybe author was just lucky with his timing but he has a point which we will discuss later. This article is not intended to be a book review although I will present some excerpts from the book "Fooled by Randomness" and will bring to light Taleb's ideology and see if this makes sense for investors out there. Then you can make your own decision if his ideology is something that you can benefit from since it is highly debated. The term "The Black Swan" has become so common in financial circles in New York that our sources tell us that if you don't know this term in a job interview you are likely rejected for a trading job. I don't know if this is really true to this extent but definitely a point would be deducted from your eligibility if you don't know this term.

I have thoroughly read the book, "Fooled by Randomness", and it certainly makes some good points. Few investors that I personally admire, such as Howard Marks of Oaktree capital, makes a mention of concepts from "Fooled by Randomness" in his own book, "The Most Important Thing". It is obvious that catastrophic events show up in financial markets and typically take everyone by surprise. I am talking about events such as the market crash of 1929, the crash of 1987 and financial melt-down of 2007. So when nobody can predict such events how could investors prepare for these and not lose their shirt when a black swan shows up. So let's start with a very important concept that Taleb discusses in his book when he says that people including many financial experts confuse probability with the expectation of a gain or loss. Let's examine what Taleb is talking about by looking at the graphic below from the book:

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In the chapter on "Skewness & Asymmetry" he draws the above table and describes events A & B with different probabilities - with A's probability being 999/1000 and B's probability being 1/1000. However it should be noted that A's payoff is only $1 but if event B takes place, the maximum loss is $10,000. Thus although highly unlikely to occur, if B indeed does occur, it can wipe you out. Thus in aggregate, your expected loss with the above scenario is - $9.001. His point is that traders make bets every day in the markets to gain a little and many of them use extreme leverage to accomplish large returns. Many traders make a living this way where they put at risk leveraged capital to make money but they do not have any concession for a big negative event (the black swan) and thus when it occurs they lose everything. The story of "Long Term Capital Management" turned out to be in the same way where some Nobel Prize winners decided to use extreme leverage to bring meaningful returns until a "black swan" showed up and wiped them out. Just as a side note, Warren Buffett tried to unsuccessfully buy the company while vacationing in Alaska with Bill Gates in 1998. Warren Buffett's long time biographer, Carol Loomis, provides complete details in her book titled, "Tap Dancing to Work". She says that while negotiations were on to buy Long Term Capital Management, Bill Gates took a picture of Warren Buffett actually talking with Wall Street moguls and the company management from a remote phone in their Alaskan resort. It is presented below for your viewing pleasure.

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Warren Buffett negotiating a deal from Alaska, top left (Photographer: Bill Gates)

Taleb gives out examples from his real life when he used to be a trader and how he saw many of his fellow traders becoming bankrupt or losing their jobs due to such events. Thus the take away is that one should not bet so much that one big event can wipe you out. Under sunny skies it is easy to forget that someday it can also rain but this is just human nature.

Nassim Taleb has done a lot of research on human behavior and he says that humans cannot "naturally" think in terms of probabilities. First of all probabilities are not intuitive and even mathematicians get them wrong- Why? - Because Math is intended to give an exact answer while probabilities are inherently a vague answer with a range of outcomes (possibilities) rather than a definitive answer. Thus there is a constant struggle between researchers in comprehending the right way to deploy probabilities in their models and I think that Taleb brings about a great point of asking everyone to think in terms of "expected results" as opposed to absolute probabilities. He gives another good example when he talks about being invited to address a group about investing. He was asked by them whether he was "bullish" or "bearish" on the market. Taleb provided a perplexing answer by responding that he is short on the market while expecting the market to go up. Why one would place a bearish bet while being bullish on the market perplexed his audience. So once again he was asked that if he thinks that market would go up or down, to which he responded that although the probability of market going up is 70%, if this happens it will only go up 1%. However he thinks that probability of market going down is 30% but if this happens, it would go down by 10%. Thus the total expected results is negative (-2.3). See the graphic below from the book, "Fooled by Randomness".

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In one set of experiments, Taleb asked people that suppose you are visiting an exotic resort in a remote part of the world where there is a flight once a year that takes you to another remote island. People who have visited that island compare it to the paradise. However you are also informed that there is a slight risk of a plane crash with the probability of one accident happening in a thousand years. You probably won't come to this part of the world ever again and taking this flight, which flies only once a year, seems to be a chance of a lifetime. Would you take the flight? 99% of the people responded affirmatively; i.e. they would take the flight.

Then Taleb asked people if they would take a flight if there is a chance of a plane crash if one thousand planes take off in a year and there is a chance of one plane crash per year. About 30% of the people refused to take the flight although odds of the above two scenarios are exactly the same. Author's point is that people do not perceive two events presented to them slightly differently, which have exactly the same probabilities, in the same light. People typically perceive probabilities based on their own biases and this is what gets them into trouble in financial markets.

Taleb's ideology: Routinely lose a little to "occasionally" gain a lot

We need to keep in mind that Taleb was originally an options trader who decided to quit his job one day and became a writer. Thus we need to be cognizant of his biases from his past profession. So what does Taleb recommend to protect against black swans? If you guessed "use options", you are right on. Now we all know that options don't come free but we also know that many companies (think of oil majors) use PUT options to hedge their positions. Although derivatives such as swaps can be created free of cost, options do have true costs. I look at options as tools with which you can do good or bad deeds. For example, Einstein introduced the equation, E=mc^2, and it has been very useful in creating atomic reactors to generate electricity but at the same time it has been used to create atomic bombs. So it is up to you as to how you use a particular tool. Now let's examine how Taleb implements his theory of "losing a little regularly to gain a lot occasionally".

For those of you who are new to options, a fellow SA author by the name of "Tom Armistead" wrote a series of articles on options, which can be found here. (Tom: Would love to hear from you if you are reading this article). So it would be good to understand options and then form strategies to gain from them. Since Taleb mostly talks about protecting from a catastrophic event (The black swan), and not having met him personally, I would assume he is talking about buying PUTs on all securities that you already own in your portfolio. Obviously the price of options is going to vary based on market volatility and how far out you want to buy. I have some reservations about how one can gain a lot once the market tanks? I think the assumption is that by not losing a lot, you have gained a lot - or does it mean to exercise your PUTs and buy more shares at now depressed prices for future gains? Let's look at few examples how a portfolio can be protected using options and how feasible it is to do so for various classes of investors.

IBM (IBM):

Say you are a Hedge Fund manager and you just have gone long on IBM in December 2013. Also assume that you think that some kind of catastrophe is imminent in 2014 and thus you would like to purchase PUTS on your position to limit your downside to 15%, which I think would be a fair protection since a black swan might erase your portfolio value by 30-50%. My recent research shows that if you buy P150 January 2015, which is about 15% out of the money at current stock price, you will have to pay a premium of about 3% per year. Now if you are an individual investor that might sound appealing to you, but believe me, this is not cheap for a fund manager. Many funds nowadays are charging 1-2% in management fees so telling your clients that you are going to lose 3% "on purpose" just to protect against some unforeseen event that you are not even sure about would raise some serious eye brows. Money management is a cut throat business and a Hedge Fund could be out of business in a short period of time if it falls too behind the market. So I seriously question feasibility of implementing Mr. Taleb's ideology here. And by looking at slightly less stable/volatile companies other than IBM (as below), the cost of options would just be higher. Let's examine.

Joy Global (JOY):

Now just for kicks, consider a relatively tumultuous company in the last year such as Joy Global. Suppose a fund goes long Joy Global and wants to protect against a market crash by buying P50 January 2015, which is about 15% out of the money from the current stock price. Again this is to protect against any market crash in 2014. The premium equates to cost of 9% per annum and no professional money manager in his right mind can afford 9% in additional cost to protect against any "imaginary" catastrophe. Now as individual investors, if you are willing to dole out such premium if you believe that sky will fall part in 2014, then good luck. My point here is that for professionally managed funds, it is extremely expensive to hedge against black swans.

Now if Mr. Taleb thinks that you need to purchase some Call options to capture any upside also, this would only add to your expense misery. There is no easy solution to having a bullet proof protection against market gyrations using options. For fun, think of Warren Buffett's dilemma, if he were trying to protect his portfolio with options. He would literally skew the whole options markets, if he would attempt to hedge all his positions. Now I know of some great money managers that use options to hedge positions (think David Tepper of Appaloosa Management LP), nevertheless these options provide huge risk/reward scenarios which are highly skewed in their favor.

Conclusion:

Whether investors should protect their portfolios by buying insurance (aka options) is a matter of personal choice for individuals or smaller funds but for the larger funds, it seems completely impractical given the costs associated with options. I don't know about others but I can tell you with certainly that our clients at Netwall Investments will raise eye-brows if we were to incur regular costs using options. It is extremely rare that we use options but if we do, we have a firm reasoning behind it which is backed by meticulous research. So for example, we could write out of the money PUT options when a stock tanks and we think a company is being unjustly punished. Although not exactly the same, but this is somewhat akin to writing insurance. And we must meet many other criteria, one being the fact that the company must have been on our radar screen long before this calamity hits. Furthermore, we must be willing to keep this position at the assigned price for a long time. So in other words, we just won't keep on chasing the option down further and further if stock keeps tanking. Warren Buffett has famously alluded to the fact that you can't catch the bottom by using options and we are certainly not interested in catching a falling knife. To read more about why we are interested in companies whose stocks are out of favor, click here to read my earlier article titled, "Why I Shake Hands with Losers to Become a Winner".

However I am also aware that there are funds out there that use options regularly in their hedging strategies. We know for sure that many oil exploration companies do this and it is an acceptable practice in that industry. Since options could be used as insurance, when things are good they tend to get cheaper until something bad happens. Those of you who are or have ever been associated with insurance industry understand this very well that right after a catastrophe, insurance rates tend to go higher; although this has always been kind of counter-intuitive to me. For example consider Hurricane insurance - I think that premiums should be most expensive when years have gone by without a major hurricane but in actuality it is quite the opposite. Insurance premiums tend to become most expensive right after a major hurricane and they become cheaper as years go by without a major catastrophe.

I think it becomes a matter of personal choice if you want to implement option hedging strategies in your portfolio as an investor. And the time to prepare for a rainy day is when it's been sunny for too long. Thus it is wiser to use options more often under blue skies rather than waiting for a rainy day because you never know when the black swan would show up. You might think that this is counter-intuitive but this is how a contrarian investor should think. So next year if stock market keeps on rising and you are willing and able to hedge with options, you should buy a load of options for 2015 for two reasons:

  • Options would become relatively cheap to buy
  • You know if it's been sunny for too long, rain might be on its way

If markets remain jittery in 2014, then options would remain relatively expensive. So you might have to pay more if you still insist on hedging your portfolio using options.

In the end, the choice is yours.

Source: What Is This Commotion About Randomness In Financial Markets?