Black Swans

By Cees Quirijns on December 2nd, 2008

Nicolas Taleb’s books have been best sellers around the world. He’s been able to translate complex mathematical subjects into sentences that everybody can understand. What he got to say also proved of great value: in finance we don’t understand much and, more disastrously, we don’t know we don’t understand much.

In order to explain his concepts, Taleb often refers to the concept of a black swan. Most Swans are white. Nevertheless Australia houses black swans. When Dutch sailor Willem de Vlamingh brought one home in 1697 it must have been really something. Until then people believed that only white swans existed on the globe. The black swan can be used as an analogy for the exceptional, that little chance event that makes a huge impact.

In financial markets black swans occur more often than we think according to Taleb and therefore markets have a tendency to under price the risk of shocking events. Traders who know that can obviously benefit from it, but it’s not an easy task.

One way of profiting from these outlier events is to carry portfolios filled with bought out the money call and put options. Mind you an extreme event doesn’t necessarily have to be a negative one: the magnificent rise of Google for instance is just as extreme an event as say the blowup of Enron. Anyway, long option positions give you positive exposure to these rare and extreme events: when a black swan appears you’ll make handsome money. Of course there is a price to pay for this privilege. When nothing happens and the boring status quo continues, you’ll loose your premiums invested. Obviously that happens quite often and this strategy can therefore lead to slowly ‘bleeding to death’ by incurring numerous, but relatively small, losses.

In other words you loose often, but when you win you win big.

Since such a strategy isn’t usually the type that results in steady bonuses or pads on the shoulder from your boss or shareholders, the majority would choose a different approach. Here the idea is opposite: put your money on the white swan and risk the hit of an extreme event occurring. A practical example would be to write out the money options. Generally that will allow you to collect the premiums, however once in a while you’ll loose big. Put differently that strategy can “blow up”.

It is clear that a lot of funds have been taking on the blow up risk, essentially picking up dimes in front of steam rollers. Now that a rare event has hit the markets (mind the comparison of today crisis with that if the 1930s) these funds are tumbling over as if there’s no tomorrow. Actually for many indeed tomorrow never comes.

On the other side are of course the funds who have been bleeding before, but are now reaping the benefits of being long extreme events. These guys won’t be buried in compliments however: the majority of their contemporaries will see them as having gotten a lucky break. I mean these guys have been wrong so often in the past!

But as Taleb has shown us that’s besides the point. It’s not about being right but it’s about making money. Too many investors still mistakenly believe that they’ll make money when being right as often as possible, not realizing that those strategies typically lead to being implicitly short extreme events. Once they realize this it’s generally too late. Better set aside your ego and do what the vast majority won’t be able to do: be wrong often but make it all back plus some once the inevitable black swan roars its head. That way you’ll be long shocking events. There’s certainly no shortage of extreme events these days, just don’t count on getting complimented should you manage to profit from them.

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