How Taleb turned disaster into an investment strategy

One day in 1996, Nassim Nicholas Taleb,  a Wall Street trader, went to meet the famous hedge fund manager Victor Niederhoffer.

“In those days, he (Niederhoffer) played tennis with the billionaire financier George Soros. He had just written a best-selling book, The Education of a Speculator.  Niederhoffer, like Buffett and Soros, was a brilliant man. He had pioneered the idea that through close mathematical analysis of patterns in the market, an investor could identify profitable anomalies,” writes Malcolm Gladwell, in a chapter titled Blowing Up, in a collection of his essays for The New Yorker magazine — What the Dog Saw and Other Adventures.
Obviously, Taleb respected Niederhoffer a lot. As Taleb said and Gladwell quotes in Blowing Up, “Here was a guy living in a mansion with thousands of books, and that was my dream as a child. He was part chevalier, part scholar. My respect for him was intense.”

But despite this awe and respect for Niederhoffer, Taleb “could not escape the thought” that the success of Niederhoffer “might all have been the result of sheer dumb luck.” And Taleb had a logic for it as well.

As Gladwell writes “Taleb could do the arithmetic in his head. Suppose there were ten thousand investment managers out there, which is not an outlandish number, and that every year half of them, entirely by chance, made money and half of them, entirely by chance, lost money. And suppose that every year, the losers were tossed out and the game was replayed with those who remained.

At the end of five years, there would be 313 people who had made money in every one of those years, and after ten years there would be nine people who had made money every single year in a row, all out of pure luck.”

Given this logic Taleb thought “who was to say that he (Niederhoffer) wasn’t one of those lucky nine? And who was to say that in the eleventh year Niederhoffer would be one of the unlucky ones, who suddenly lost it all, who suddenly, as they say on Wall Street, ‘blew up’?”

And that is what exactly happened. On October 22, 1997, Niederhoffer lost it all and blew up. As Gladwell writes, “He (Niederhoffer) sold a very large number of options on the S&P index, taking millions of dollars from traders in exchange for promising to buy a basket of stocks from them at current prices, if markets ever fell, he bet in favour of the large probability of making a small amount of money, and against the small probability of losing a large amount of money and he lost.

On October 22, 1998, the market plummeted 8%, and all of the many, many people who had bought those options from Niederhoffer came calling all at once, demanding that he buy back their stocks at pre-crash prices.

He ran through his $130,000,000, his cash reserves, his savings, his other stocks and when his broker came and asked for still more, he didn’t have it. In a day, one of the most successful hedge funds in America was wiped out.”

On this disaster, Taleb based his investment strategy. Most investors try and make money waiting for the markets to go up. Taleb, on the other hand, keeps waiting for disasters such as the one that wiped out Niederhoffer and his fund, and makes money on those. And how does he do it?

“Emperica (the fund run by Taleb) follows a very particular investment strategy. It trades options. Imagine, General Motors stock is trading at $50, an options trader comes up to you with a proposition. What if, within the next three months, he decides to sell you a share of GM at $45? You look at the history of GM and see that in a three-month period it has rarely dropped 10%. So you say you’ll make a promise, or sell that option, for a relatively small fee, say, a dime. You are betting on the high probability that GM stock will stay relatively calm over the next three months and if you are right, you’ll pocket the dime as pure profit,” writes Gladwell.

And what is the trader betting on? “The trader is betting on the unlikely event that GM stock will drop a lot, and if that happens, his profits are potentially huge. If the trader bought a million options from you at  a dime each and GM drops to $35, he’ll buy a million shares at $35 and turn around and force you to buy them at $45, making himself suddenly very rich and you substantially poorer.”

This is the strategy that Taleb follows waiting for a big fall in the markets to make his money on the options. As Gladwell writes “Taleb, by contrast, has constructed a trading philosophy predicated entirely on the existence of black swans, on the possibility of some random, unexpected event sweeping the markets. He never sells options then. He only buys them.” And as the financial crisis struck, Taleb’s fund made tonnes of money.  

And what happened to Niederhoffer. As Gladwell writes, “In the fall of 2001, Niederhoffer sold a large number of options, betting that the markets would be quiet, and they were, until out of nowhere two planes crashed into the World Trade Center. Niederhoffer shook his head, because there was no way to have anticipated September 11. That was a totally unexpected event.”