My earlier post wrote about how one approaches the markets would differ according to one’s fundamental view about the markets. I came across some articles about Victor Niederhoffer and Nassim Taleb that I think illustrate this very well.
In a way, Nassim Taleb is to trend-following as Victor Niederhoffer is to countertrend trading. Taleb goes for many small losses, small chance of large gains, and no chance of large losses, while Niederhoffer goes for many small gains (magnified with leverage), little chance of large gains, small chance of large losses.
- Hard to distinguish luck from skill
- Great investors/traders could have consistently made money due to pure luck
- Need to protect portfolio against black swans
- Cannot trade based on observed statistical probabilities. In the markets, unlike in the physical universe, the rules of the game can be changed.
- The market has fat tails, so we cannot pursue any strategy that had any chance of blowing up.
- Nobody can have any skill in selling options. Selling options leaves one vulnerable to blowing up.
- During the financial crisis, David Viniar, Goldman Sach’s CFO complained “We were seeing things that were twenty-five standard-deviation moves several days in a row.”
- Investors should sacrifice the urge to maximize short-term returns by assuming too much unhedged risk
- Not interested in the small frequent payouts, want the infrequent huge payouts.
- The conventional way of investing in the market will have a fairly large chance of making a small amount of money in a given day from dividends or interest or the general upward trend of the market, with almost no chance of making a large amount of money in one day, and a very small possibility that if the market collapses we could blow up. The unconventional way is to take small losses most of the time, but with no chance of blowing up, and have a small possibility of making a huge amount of money.
Strategy (Empirica hedge fund)
- Never sell options, only buy options.
- Never bet on the market moving in one direction or another since we don’t understand the market.
- Don’t buy stocks, since we don’t know whether the future would improve.
- Since everyone is underestimating the possibility of rare events, buy out-of-the-money options for hundreds of stocks, and keep buying even if they expire worthless.
- Use computer systems to price options every night and produce bids so as to buy options in bulk cheaply.
- Keep reserves in Treasury bills
- Able to guarantee investors a max loss amount based on the amount paid for the options (e.g. won’t lose more than 13% a year)
Strategy (Universa Investments fund, with Mark Spitznagel)
- Buy far-out-of-the-money put options on equities and far-out-of-the-money calls on commodities.
- Usually with prices 20% or more away from the then market price, and 6 months to expiry.
- Sep 1985: Made a lot of money by accident when Plaza Accord was signed and Taleb was holding currency options.
- Oct 1987: Made $35-$40 million from out-of-the-money calls on Eurodollar futures on Black Monday.
- 2000: Made 60% when dot-com bubble burst.
- 2003-2004: To profit from low volatility, sold at-the-money options.
- “Everything that can be tested must be tested”
- Over short periods — hours or days — there are sometimes predictable patterns that can be exploited.
- However although markets sometimes move in predictable ways, the patterns change constantly, and reliance on mathematical algorithms to automatically place orders can be disastrous.
- Most of the time, these computer analyses [of similar events in the past] don’t work, but it gives you an anchor.
- Large rewards go together with large risks
- The idea that you can make a lot of wealth in a steady, unspectacular fashion, with no great gyrations, is a canard. If you are going to try and make forty or fifty per cent a year, tremendous variations are inevitable.
- Discretionary approach anchored by analysis of how the current market pattern unfolded in the past, e.g. when the market is down 12 points at 1 o’clock and it has been down significantly the previous two days, how did the market play out over the next 72 hours?
- Over the long term the market goes up, but over the short term it constantly reverses itself.
- Generally, buy in panics / weakness
- Oct 1997: Blew up because he sold a large number of S&P naked put options because he felt that the odds of the market going down so heavily that he would be wiped out were minuscule. He was wiped out in a single day on October 27, 1997 when the market plummeted 7%.
- Fall 2001: Sold a large number of options in Fall 2001 betting on low volatility, and got caught when 9/11 happened.
- 2002: Started Matador fund
- 2003: + 40+%
- 2004: + 40+% return
- 2005: + 56%
- 2006: flat
- Aug 2007: Forced to close his funds when they declined in value by more than 75%.
- 2002: http://www.frontieradvisorsllc.com/files/1257437345_Blowing%20Up.pdf
- 2007: http://www.newyorker.com/magazine/2007/10/15/the-blow-up-artist
- 2008: http://www.bloomberg.com/apps/news?pid=nw&pname=mm_0508_story1.html
- 2011: http://www.forbes.com/forbes/2011/0627/money-guide-11-spitznagel-black-swan-cnbc-protect-tail.html