Nassim Taleb – a Genius Mathematician and Trader

He became famous for writing books like Fooled By Randomness and The Black Swan that challenged conventional views about financial models and the mathematical statistics on which they are based.

In the 1980s Nassim Taleb worked as an options market maker. That means he made most of his money by supporting customer flow. He sold options for slightly higher prices than he bought them, and counted on the orders evening out so he had little net position. If he started building up a net position, he would change his prices to equalize things.

Nassim was a profitable trader and doing quite well, but his big killing came the day of the October 19, 1987 stock market crash. He had accumulated a large position in near-worthless out-of-the-money Eurodollar futures puts. The Eurodollar future is a bet on the three month bank interest rate, and pays $25 per one basis point move (such as from 7.5% to 7.51%). A big day is a 10 basis point move, $250 per contract. But October 19, 1987 saw a move 10 times that size, $2,500 per contract as rates moved from about 7.5% to 8.5%.

The swings on an out-of-the-money put (which makes money when interest rates go up) are even larger. A short-term put at 8% might sell for $100 when rates were 7.5%, but would be worth maybe $1,500 when rates went up to 8.5%.

Nassim was holding enough of these puts to make $35 million. This was his biggest win in the markets by far, and he attributed it to luck. It started him thinking that five years of constant work was worth less than one lucky break.

Taleb’s most famous forecasts

In 2003 Nassim Taleb predicted a high probability of the government-sponsored institution Fannie Mae collapse. While Fannie Mae was considered a highly trusted expert on risk management in the mortgage market, Taleb analyzed its risks and gave an extremely negative outlook. He compared it to sitting on a barrel of dynamite vulnerable to the slightest hiccup. This forecast caused a wave of outrage and a lot of attacks in the financial world, but finally came true. Eventually, the collapse of Fannie Mae cost the US taxpayers hundreds of billions of dollars.

On October 19, 1987, Black Monday, when the Dow Jones Industrial Average dropped 22.6%, gave Taleb profit of about $40 million. It was the largest market drop in modern history. The occurrence of the event lays outside of something that anyone except Nassim Taleb could have imagined on the previous day. Later it was qualified as a Black Swan.

In his forecasts for the near future, he asserts that for the time being there is no need to fear a third world war, since countries that can afford it prefer to do this by others’ hands. He talks about the “Black Swan” of confrontation between the West and China or the West and Islam.

So, what is Nassim Taleb’s trading strategy?

Taleb considers himself less a businessman than a researcher of randomness, and says that he used trading to attain independence and freedom from authority.

1. Taleb makes bets on hard-to-forecast events (Black Swans).

Taleb talks about “Black Swans” as hard-to-predictable and rare events that happen unexpectedly, deliver positive or negative consequences and strongly affect the entire initial system.

2. He safeguards his investor’s money against negative “Black Swans”.

Taleb was a pioneer of tail risk hedging (now called "black swan protection"), whereby investors are insured against extreme market moves. He says that reaping dividends the way he has means dwelling in the land of "Mediocristan" instead of “Extremistan”.

Mediocristan are the events that can be predicted on the basis of previous data. Take 1000 people from all over the world. African and Chukchi, the fattest man in the world and a Chinese woman. The average value (2 eyes, average weight, 4 limbs, and m) will give a complete picture of the properties of the entire sample. And even the thickest person in the world won’t make significant changes in the mean.

Extremistan describes social, not physical, phenomena. Take the cash prosperity of 1000 people around the world. And add to this sample, for example, Bill Gates. The average earnings in this sample will be 99.9% for Bill Gates (and will not say a word about the sample of 1000 people). “In Extremistan the inequality is so big that one single example can give a disproportionately large increase in the aggregate or the general amount,” Taleb says.

3. Nassim Taleb keeps a balance between the risk for earning and the need for maximum retention of funds.

As a trader, his strategy has been to safeguard investors against crises while reaping rewards from rare events (Black Swan), and thus his trading career has included several jackpots followed by lengthy dry spells.

4. The basic position he likes to hold is to sell at-the-money options and buy out-of-the-money options; both put and calls.

The idea is that people overestimate that chance that a normal-sized move will occur. You get rich in general systematically betting that either nothing will happen or something big will happen.

His book “Dynamic Hedging” is about options trading from the practitioner’s point of view. It tells that one must really know what he’s doing, if he does not only understand how this complicated trade works, but is able to exploit the edge cases.

5. Taleb’s strategy is based on the idea that some options are systematically mispriced because the fat-tailedness of the probability distributions of market returns.

When using this strategy, you need to be prepared, both financially and psychologically, to remain calm when you feel that you are “losing” money for years. It is enough to win 1 time to recoup everything!

Taleb says he made fortunes using this method several times over the past two decades. The strategy can make uncapped returns in a very large market move. Why don’t you check it?