> Adapted from “Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis” by The Wall Street Journal’s Scott Patterson, to be published on June 6 by Scribner.
TL;DR Black swan events happen. Some hedge funds specialize in them. Book advertisement.
Hedge fund guy here. I actually met NNT, fun character. Irreverent as always.
He was talking exactly about this strategy when he came in. The thing is, trading often presents you with a tough choice:
- Do something that on most days makes a bit of money, but sometimes creates big losses.
- Do something that on most days loses a bit of money, but sometimes gives you a big payday.
Your problem is then what to do. If you've decided that you want to wait for the big payday, how are you going to stay in business until your ticket comes in? How do you keep your investors faithful until then? This is the actual skill in this trade, btw.
If you're wondering about taking the other side, the trope is that you get an even bigger job after you get fired for losing a huge amount of money in an "unforeseen event".
I would look at Universa's record, it is horrible.
I know a few guys who make money doing this but it does require more than Universa appear to be doing. Practically, I have found short-selling funds are even better...but, for reasons you mention, the economics of running these funds mean that very few exist.
For publicly traded options there isn't much counterparty risk unless the financial system completely melts down. Counterparty risk is more of an issue with other derivatives traded off market. That risk can sometimes be partially hedged, for example by purchasing credit default swaps on the counterparty.
It's a risk, not something that you couldn't deal with. You have to have a sensible prime broker mainly. Any of the big ones will have systems in place to protect them well in advance of you putting on this huge put option. The only guys who would blow up from this were merged earlier this year.
This is assuming the entire trade is just S&P500 puts of course. A proper doom merchant might put it on in a bunch of ways, with various swaps against counterparties in different assets. It's really just OTC risk you'd care about but again if your PB isn't incompetent you will know where you can do this.
NNT is very entertaining. He's also blown up two hedge funds. Ever notice that running a fund is an asymmetric option? The management makes money either way at least until the investors leave, but there's no clawback if the fund blows up. So, I enjoy NNT. I respect his wit and intelligence. I'll even use his insights to steer my thinking. But he's not where I want my money going. And with his books and his trips to Washington perhaps he's gotten that bigger job.
What were the hedge funds, what happened? I’m a fan of NNT, but I want to get a more complete picture of whether his “stuff” works or not, and good info is hard to come by.
A less successful example of this type would be Hugh Hendry, who after the implosion of his Eclectica fund is now seeking listeners willing to pay via Patreon for his weekly podcast recordings.
Anyone can be permanently bearish (it works both ways - the permanent market cheerleaders are just as bad in reverse) and then go on CNBC and tell everyone they correctly called every recession or bear market.
Typically these people have called 176 of the last 8 recessions.
There are plenty of fund managers out there that make some when its a bull market and make some in a bear market, they dont tend to go on tv and talk their book though.
I'm less familiar with put and call options , compared to common shares and selling short;
But one of the challenges to sell short, compared to buying long, is that your upside is limited and liability unlimited.
Whereas the inverse for common stock, upside is unlimited and liability is limited.
If you place 176 bets and win big 8,
I think will be more successful buying long , like the venture capital model.
People say this, but of course if you invest via a hedge fund (or other similar corporate structure), your total downside is just whatever you invest. The fund maybe run up 1tn, or 1000tn in loses somehow, but that just means a lot of disappointed creditors meeting limited liability...
Interestingly, it just occurred to me that VC is the exact opposite of this. Many VCs have called 176 of the last 8 unicorns. You can still make bank doing this though.
VC's put "early investor in Google and Uber" on their bio, not "passed on Series A Facebook because MySpace has already won the social media war, then begged to be in the last funding round before the float".
> Your problem is then what to do. If you've decided that you want to wait for the big payday, how are you going to stay in business until your ticket comes in? How do you keep your investors faithful until then? This is the actual skill in this trade, btw.
I’ve been to one of the Wilmott-Taleb seminars in London. Taleb answered that question this way:
1. You buy way out of the money calls or puts which will eventually get you your big payday. Most sellers of these sort of options use Black-Scholes or similar model to price them, underestimating the frequency and/or magnitude of payout, and thus mis-pricing them.
2. Simultaneously you sell in-or-near-the-money puts or calls, which are more mathematically tractable, model-able, and thus manageable. Results in small and predictable income and payouts which you can manage to keep the fund afloat until #1 pays off.
3. Make sure your fund LP’s understand that this is essentially an insurance policy. People are accustomed to paying regular small payments for insurance against big unexpected events, and tend to accept that model for the fund too.
As you say, the skill in this trade is in discovering options for #1 that are indeed mis-modeled and mis-priced, and in #2 managing that in/near-the-money portofolio as optimally as possible to cover or minimize the steady bleed from #1. It’s not easy.
I don’t know, no one asked that followup question, everyone just accepted it. There’s probably more to it he didn’t elaborate on.
I assume it depends partly on asymmetry of information between a more sophisticated option seller (like Universa) and buyers (especially retail). Maybe also the ability of the seller to sell a diverse heterogenous mix of options and construct the mix to achieve a small positive net revenue. Options sellers tend to blow up eventually when they sell way out-of-the-money options, and this strat avoids that at least.
> If the near-the-money options are correctly modeled, how will you make money on them?
In a hand-wavy sense, they're the hedge.
A mis-priced option isn't completely mis-priced: some of the modeling is correct enough. The trick to making money is to buy the mis-priced option, but then sell back the "part" of it that is correctly priced.
That leaves you holding only the part where you think you have an edge, and in turns this is what makes the "insurance" model somewhat viable.
- Do nothing on most days, hold cash, earn a little interest, maybe play bridge to keep yourself entertained, and bet big only when you're sure you'll win big.
Call it the Buffett approach. The main downside to it is that on most days you have nothing to do.
Yeah it’s called if you don’t have a strong view, you are just gambling. Bet big when you see it, but this takes experience as sometimes you think you see it but it’s really noise, or you have 5 big blind spots you didn’t consider
Bosses dont pay you to go home early and play tennis (they should), they pay you to make money and you cant make money unless you sit there and gamble.
A fixed allocation to a one-size-fits-all tail risk fund doesn't work. It won't have positive returns over the long run. And its diversification benefit will not be enough to overcome the drag on performance.
A tail risk strategy that is tailored to the portfolio, point in time, in an opportunistic way (e.g., when vol is cheap) can potentially work. But you need a strat like that to be part of the portfolio construction process.
This has been a topic of significant controversy with Universa because they are selective about what they report (i.e. the ludicrous 3000% number that journalists lapped up) and the guy who runs it has (iirc) repeatedly claimed he isn't just buying puts all the time (despite the performance of the strategy suggesting he is).
But...they claim to be buying moderately OOM puts (10-20%) based on value (i.e. if vol becomes expensive relative to some metric they follow then they do not buy). It is possible if you time this correctly, it is profitable. But the strategy they are actually running (whether they are timing or not, who knows) does not appear to be profitable...which is true for put buying (I am not an options person but I believe this is regime-based, it has been profitable in the past but isn't today).
I wonder how this strategy is affected by the 2008 experience. You see, back then all sorts of, frankly, illegal measures were used to prevent those who bet against the housing market to cash out. Markets were frozen, contracts and even stocks artificially priced, for most investors right until the contracts were worthless due to bankruptcy, as pointed out in "the Big Short". Yes, VERY few investors did exactly the right thing at exactly the right time and got lucky.
Wall Street outright lied to offload known crashed investments to unsuspecting buyers. Again, this is obviously highly illegal. Nobody got punished, we can argue about why not, but one can remark it would have seriously affected the government.
The banks will not play fair. This can be proven by pointing out that they simply can't. If they make profits, they get those out of the company rapidly, and by design, the system cannot pay out the contracts it underwrites beyond a minimal "safety margin". They simply cannot cover the contracts they underwrite in the event of a crash, they don't have the money. You'd have to hope that the FED covers those contracts ... and ... not even if hell freezes over will they do so.
And of course even this is ignoring real "black swan" events. Here's the thing: if a real meteor or comet hits earth, for example, black swan investors won't get paid ... and they won't even care.
It's definitely the case that the truth seems quite different from the marketing speak. For example, NNT was constantly in the news during the 2008 financial crisis pontificating about this and that and yet his fund was far from the best performer during that time even though you'd think that sort of meltdown would be ideal for his supposed crash put strategy.
As always do your own research before you actually put any money into anything.
As always do your own research before you actually put any money into anything.
For most people, trying to do this research would be a waste of time and maybe do more harm than good. This is all very complex and esoteric, not comprehensible by a lay person, even if you can tell the truth from the marketing speak. I think telling someone to do their own research could make people more susceptible to scams.
I disagree with this advice, too. Most people have no formal training in this. That doesn't mean they shouldn't invest. Gatekeeping investments is also an issue contributing to the systemic class immobility in the US, but I supposed that's another issue.
In the same way, my dad isn't an expert in buying or using computers. This doesn't mean he shouldn't buy one, or wouldn't get use out of one. He knows he can ask me for advice or give me a budget and I'll just take care of it for him.
Of course, but that’s not at all what that advice is saying and I think you know that.
He (and I) is not saying don’t invest. He (and I) is saying don’t invest in products you don’t understand. Invest in stocks in real businesses where you can see how and why they make money. Invest in low-cost index funds that (on average) give a really good return over time.
Don’t invest in fancy structured products, hedge funds, options strategies etc unless you are able to understand the strategy and why it makes money, what it’s volatility is etc.
That isn’t gatekeeping, it’s a simple defense against getting ripped off while also allowing you to invest in the things that have historically given the best returns over time (especially risk-adjusted).
I invest in low-cost index funds, but I'd be lying if I said I understood them.
I certainly don't really understand money market funds, and those are supposed to be the most reliable, safest investments out there.
Hell, I don't really understand how a car is made, and I invest my life in it every time I drive one.
I don't think that advice makes a lot of sense. People in modern society rely on the specialized expertise of others every day. A better way to phrase this is "don't invest in products you don't trust, and understand why you should or shouldn't trust a particular product."
> Taleb has argued that our increasingly unstable world is the paradoxical result of humankind’s efforts to control it with technology, quantitative models, and ubiquitous just-in-time optimization, resulting in an ever-more-complex, human-built, fragile society susceptible to shocks. Extreme events “are necessarily increasing as a result of complexity, interdependence between parts, globalization and the beastly thing called ‘efficiency’ that makes people now sail too close to the wind,” he wrote in his 2012 book “Antifragile.”
When the market can respond to events faster, efficiency increases. But, as anyone who's done any synthesizer can tell you, if you have faster feedback loops, you also increase the potential amount of resonance in the system.
The market is a highly interrelated graph of feedback loops. As those get faster and with less damping, we should expect wilder and wilder oscillations.
>The stock market was crashing.
>He had no idea why. No one did
That's because some of the largest hedge funds had invested at capacity and retail investors had huge call volume. The market always has a contrarian approach.
Currently the SPX is on a ripping bull market that's because most of the retail is short. It started with the one word tweet by Michael Burry "sell" which caused retail to pile on shorts. The current market is awfully bearish and SPX bull market is roaring even if inflation came in higher than expected and NFP was twice the consensus.
The bull market beatings will continue till the short sellers morale improves.
Markets will remain irrational longer than you can remain solvent.
49 comments
[ 2.9 ms ] story [ 68.3 ms ] threadTL;DR Black swan events happen. Some hedge funds specialize in them. Book advertisement.
He was talking exactly about this strategy when he came in. The thing is, trading often presents you with a tough choice:
- Do something that on most days makes a bit of money, but sometimes creates big losses.
- Do something that on most days loses a bit of money, but sometimes gives you a big payday.
Your problem is then what to do. If you've decided that you want to wait for the big payday, how are you going to stay in business until your ticket comes in? How do you keep your investors faithful until then? This is the actual skill in this trade, btw.
If you're wondering about taking the other side, the trope is that you get an even bigger job after you get fired for losing a huge amount of money in an "unforeseen event".
But "picking pennies up in front of a steamroller" has it's downsides, too.
And you can be absolutely correct about what is going to happen, but off on the date and get wiped out.
I know a few guys who make money doing this but it does require more than Universa appear to be doing. Practically, I have found short-selling funds are even better...but, for reasons you mention, the economics of running these funds mean that very few exist.
This is assuming the entire trade is just S&P500 puts of course. A proper doom merchant might put it on in a bunch of ways, with various swaps against counterparties in different assets. It's really just OTC risk you'd care about but again if your PB isn't incompetent you will know where you can do this.
Typically these people have called 176 of the last 8 recessions.
There are plenty of fund managers out there that make some when its a bull market and make some in a bear market, they dont tend to go on tv and talk their book though.
Levine talks about this in Money Stuff in the sense of 'oh, they trusted you to lose a quadrillion dollars? You must be good'.
Me, too. I hosted him at Google and now I have a signed copy of The Black Swan
https://www.youtube.com/watch?v=S3REdLZ8Xis
Anyone who talks about "permanent bears" does not get the concept.
Welcome to Startup Land
* (or a lot)
I’ve been to one of the Wilmott-Taleb seminars in London. Taleb answered that question this way:
1. You buy way out of the money calls or puts which will eventually get you your big payday. Most sellers of these sort of options use Black-Scholes or similar model to price them, underestimating the frequency and/or magnitude of payout, and thus mis-pricing them.
2. Simultaneously you sell in-or-near-the-money puts or calls, which are more mathematically tractable, model-able, and thus manageable. Results in small and predictable income and payouts which you can manage to keep the fund afloat until #1 pays off.
3. Make sure your fund LP’s understand that this is essentially an insurance policy. People are accustomed to paying regular small payments for insurance against big unexpected events, and tend to accept that model for the fund too.
As you say, the skill in this trade is in discovering options for #1 that are indeed mis-modeled and mis-priced, and in #2 managing that in/near-the-money portofolio as optimally as possible to cover or minimize the steady bleed from #1. It’s not easy.
I assume it depends partly on asymmetry of information between a more sophisticated option seller (like Universa) and buyers (especially retail). Maybe also the ability of the seller to sell a diverse heterogenous mix of options and construct the mix to achieve a small positive net revenue. Options sellers tend to blow up eventually when they sell way out-of-the-money options, and this strat avoids that at least.
In a hand-wavy sense, they're the hedge.
A mis-priced option isn't completely mis-priced: some of the modeling is correct enough. The trick to making money is to buy the mis-priced option, but then sell back the "part" of it that is correctly priced.
That leaves you holding only the part where you think you have an edge, and in turns this is what makes the "insurance" model somewhat viable.
- Do nothing on most days, hold cash, earn a little interest, maybe play bridge to keep yourself entertained, and bet big only when you're sure you'll win big.
Call it the Buffett approach. The main downside to it is that on most days you have nothing to do.
A tail risk strategy that is tailored to the portfolio, point in time, in an opportunistic way (e.g., when vol is cheap) can potentially work. But you need a strat like that to be part of the portfolio construction process.
I dont believe that is what they are doing.
Is there a timed protocol they use to buy those options, or do they just buy when their gut tells them ?
But...they claim to be buying moderately OOM puts (10-20%) based on value (i.e. if vol becomes expensive relative to some metric they follow then they do not buy). It is possible if you time this correctly, it is profitable. But the strategy they are actually running (whether they are timing or not, who knows) does not appear to be profitable...which is true for put buying (I am not an options person but I believe this is regime-based, it has been profitable in the past but isn't today).
https://www.youtube.com/watch?v=SQTbbUASPLQ
Wall Street outright lied to offload known crashed investments to unsuspecting buyers. Again, this is obviously highly illegal. Nobody got punished, we can argue about why not, but one can remark it would have seriously affected the government.
https://www.youtube.com/watch?v=whlzFWwVv98
It would have made both parties unelectable for a century because Will Emerson would have been forced "to take his hand off the scale".
https://www.youtube.com/watch?v=2f2kGHcdJYU (second part of this clip, after 1m05s)
The banks will not play fair. This can be proven by pointing out that they simply can't. If they make profits, they get those out of the company rapidly, and by design, the system cannot pay out the contracts it underwrites beyond a minimal "safety margin". They simply cannot cover the contracts they underwrite in the event of a crash, they don't have the money. You'd have to hope that the FED covers those contracts ... and ... not even if hell freezes over will they do so.
And of course even this is ignoring real "black swan" events. Here's the thing: if a real meteor or comet hits earth, for example, black swan investors won't get paid ... and they won't even care.
As always do your own research before you actually put any money into anything.
For most people, trying to do this research would be a waste of time and maybe do more harm than good. This is all very complex and esoteric, not comprehensible by a lay person, even if you can tell the truth from the marketing speak. I think telling someone to do their own research could make people more susceptible to scams.
As Warren Buffet said if he’s in an investment meeting and someone starts using calculus he keeps one hand on his wallet and heads for the door.
In the same way, my dad isn't an expert in buying or using computers. This doesn't mean he shouldn't buy one, or wouldn't get use out of one. He knows he can ask me for advice or give me a budget and I'll just take care of it for him.
He (and I) is not saying don’t invest. He (and I) is saying don’t invest in products you don’t understand. Invest in stocks in real businesses where you can see how and why they make money. Invest in low-cost index funds that (on average) give a really good return over time.
Don’t invest in fancy structured products, hedge funds, options strategies etc unless you are able to understand the strategy and why it makes money, what it’s volatility is etc.
That isn’t gatekeeping, it’s a simple defense against getting ripped off while also allowing you to invest in the things that have historically given the best returns over time (especially risk-adjusted).
I certainly don't really understand money market funds, and those are supposed to be the most reliable, safest investments out there.
Hell, I don't really understand how a car is made, and I invest my life in it every time I drive one.
I don't think that advice makes a lot of sense. People in modern society rely on the specialized expertise of others every day. A better way to phrase this is "don't invest in products you don't trust, and understand why you should or shouldn't trust a particular product."
When the market can respond to events faster, efficiency increases. But, as anyone who's done any synthesizer can tell you, if you have faster feedback loops, you also increase the potential amount of resonance in the system.
The market is a highly interrelated graph of feedback loops. As those get faster and with less damping, we should expect wilder and wilder oscillations.
We didn’t have supply chain fragility, before everything HAD to be ultra lean. We didn’t HAVE to squeeze every single dollar. Etc
The quote from the 2012 book has me beat on even casually realizing the issues with supply chain by a decade. I should probably read it!
That's because some of the largest hedge funds had invested at capacity and retail investors had huge call volume. The market always has a contrarian approach.
Currently the SPX is on a ripping bull market that's because most of the retail is short. It started with the one word tweet by Michael Burry "sell" which caused retail to pile on shorts. The current market is awfully bearish and SPX bull market is roaring even if inflation came in higher than expected and NFP was twice the consensus.
The bull market beatings will continue till the short sellers morale improves.
Markets will remain irrational longer than you can remain solvent.