Somehow I got the LTCM and VN stories stuck together. LTCM is really the situation Im alluding too. but I think short selling of the tail still amounts to a Black Swan problem
i dont know where did you get this info from, but LTCM did not sell options (at least not in the pure sense of that world). They where betting on the corps/govies spread to narrow (it was quite wide over the boom years) and off-the-run/on-the-run to narrow. Instead, when the "N-sigma" events happend, they fell victim to "flight to quality" - everyone wanted T's and on-the-run T's, too.
I wasn't trying to say that LTCM was or wasn't selling options (since I obviously got my story screwed up). Im sure your right btw, its just that I dont have the story straight myself so I personally wouldn't know. Sorry for any confusion this caused.
They only reason i know this is because I was doing exactly the opposite at the time and a whole bunch of people was dancing on their coffin.
I agree with former poster that Nasim seems to have a very dark view on life. Given his background I could see how he could see the world in charcoal coated glasses. Reading the book made me a little depressed. How would you feel if someone of"authority" says that one could be making a great living trading for 10 years and still be lucky and his next trade would be the black swan event that will negate the 10 years of success. After a certain x number of years of making money who cares if you are lucky, bottom line is that you made the $ and as long as you dn't get too stupid you should do well.
I think too much is sometimes made of the strategy and not enough of the execution. I include money and risk management within the execution category. A perfectly reasonable strategy, selling volatility, becomes unreasonable when it assumes a bet-the-farm level of risk due to excessive leverage. Ansbacher claims extremely good returns from selling index options, but I read in an interview of him that he has rigid risk parameters. Plus, he's not always naked short. The VN death spiral described in an earlier post is not that different from the near-death experience Jim Cramer had in his fund in 1998. As I recall, the only thing that saved him from blowing up was a series of Hail Mary trades his wife connected on.
Actually LTCM was short something close to a billion dollars in index premium. Not only in the US markets but also the cac 40 and the futse. This is when LTCM started to panic because they had too much money to put to work and no where to put so they really deviated from their original strategy. They even made directional bets on stocks. The irony here is that is what was their own bond trades that created the panic in the equity markets that led to spike in the index premium. How funny is that?
My understanding of the fat tails is that they are perputually underpriced because they cannot factor in the good luck/bad luck scenarios with any degree of accuracy. Think about it. If all options priced in huge moves to the upside and downside, you could make a killing by selling a very diverse portfolio of premium. And the MM's would get killed. So naturally the premium would have to come in. Think about it this way. What if you went to buy car insurance and they told you that your premiums are going to be 5k a month instead of maybe 30 bucks a month. Would you buy it? No of course not. But the insurance company says well we believe you are going to have a really bad wreck down the line so we are just covering our ass. What about medical insurance, how about 25k a month for a nice healthy person. Of course you are not going to pay that, but you are you are going to get AIDS or Cancer they say. See you can't factor that in. You have to use probability tables. The problem is that these big moves are unlimited in nature so you can't factor in the exact probability. So I say that the tails are almost always underpriced. Can you make a living off of trading them? Sure if you trade like 1% of your account. LOL. Seriously, you can scalp the gamma a little and bleed daily as long as your total equity exposure is low then when you get a big event it will be a large enough move to profit from. But I don't think the returns will be that high since you are using such a small percentage of your equity. But it's workable. Personally I would like to be both long and short options. Not one or the other. But I am always net long options. I don't know any other way to stay in this business over the long run. As far as Taleb's fund, I believe it is a public fund from what I have read on his website. But it has been closed for many years to new investors. I don't know what the performance is but I think he is doing OK because he is still strong on the speaking circuit. It's hard to draw people to your lectures when you blow up! LOL. And he certainly doesn't seem to have a lot of charisma so it's not his personality. LOL.
Right, they were taking on large positions in markets in which it did not have trading experience: equity derivatives, total return swaps, index options, bets on takeover targets and emerging economies. But the ultimate cause of their demise were their basis swap positions (as you rightfully mention, feeding back into more problems).
So, with regard to Nassim's strategy, there are two possible scenarios (as I see it)... A) He is making many (probably small) bets on lots of different stocks because he doesn't know which one is likely to have an extreme move (i.e., I don't know which horse is going to win the race so I'll make a bet on each one). Or, B) He has developed some technique/model for identifying stocks that have a "high probability" of an n-Sigma event occurring in the near future. Concerning the second scenario (which is the more interesting of the two), I believe someone posted that implied volatility alone is not (or would not be) a very good predictor of black swans. Assuming this is the case, are there any reasonable methods for predicting these types of events? I am aware of Sornette. He's definitely pushing the envelope and his work is very interesting. I think one method that might not be very sexy but probably has the potential to be very helpful in this area would be fundamental analysis. My instinct tells me that if you were to dig through the books of a few hundred stocks you could/would find a few that are ripe for a fall, for a takeover, etc. The fundamentals might not be the complete answer, but it might be a decent place to start if you're looking for black swans. Just my $0.02. -SG