I first read Taleb's story on virtue of buying cheap options in 2000. It was a tough time for an option believer in those days in India. Out of my basement stint for an e-broker, which was struggling under startup pressures with "nobody seems to be interested in futures" statement mailed to me, Taleb inspired me at a critical time.
Eight years, I still believe his cheap option strategy is virtuous, but there is lot about Taleb's random strategy that troubles me to the extent of challenging it. I have mentioned some of my disagreements prior, but the guru's work deserves a serious debate.
First and foremost, Taleb makes no claims of being able to beat markets. What this means is that Taleb is not in the predictive business. His hedge fund Empirica was into hedging solutions and not into predictive forecasts. We at Orpheus are into the predictive business, but we also make no claims of beating the market. But, there is a difference. There are many ways you can beat a market. You can either give more returns than DOW Jones or Sensex over a year. Or you catch every multi week move that the DOW or Sensex might make over the year.
For example, 2007 Sensex saw six major turns starting 07 January 2007 at 13,860, followed by an up-move to 14,538 on 11 February 2007, after which we saw a dip till 18 March 2007 till 12,430, from the week ending 18 March 2007 till 22 July 2007 Sensex pushed up till 15,565, a small dip followed till 19 August 2007 at 14,141 and then one way upmove above 20,000 till 13 January 2008.
On a net basis, though, the Sensex moved up 50 per cent, but on a gross basis markets move up 77 per cent and down 23 per cent in total six moves averaging 20 per cent each.
A derivatives trader is not concerned about net yearly moves, but all tradable moves whether up or down. So, beating the market would mean capturing the entire 101 per cent gross move in the Sensex for the year, a tall benchmark and a near impossible task to achieve.
But, capturing 50 per cent of the net return of 2007 was easy for a buy and hold investor invested from 07 January 2007 till 13 January 2008. But, this passive investor may have beaten the market in 2007, but the market is beating him in 2008 now that it is down 28 per cent for the year.
Beating the market hence is a misnomer, a jargon which does not mean anything. Any hedge fund that operated from 1975 till 2000 and caught the 1987 meltdown can claim to have beaten the market. It is more about double digit or triple digit returns that suggest predictive knowledge and trading expertise. Like what Robert Prechter did when he made 444 per cent in a three month monitored options trading account. Just like many traders do, day in and day out, some survive and some shine. But then trading itself is a hard task, you can actively trade from the age of 26 to 45, like what Taleb did, but then market cycle overtakes the human cycle, the very reason we continue to live the illusion of beating the yearly return of a market and not some supernormal or triple digit returns. Taleb's philosophy is not for the traders who want to beat the markets and want to make triple digit returns. Taleb's 1987 jackpot was the one off event that he admits hit him from out of the blue and it had nothing to do with predictive value.
Second. His idea of Randomness is flawed. There is not one man who saw the 1987 crash (I know three of them), or one trader who saw the 2000 tech bubble bust, or one Goldman Sachs, which saw the subprime mess shorting opportunity, there were many who saw the real estate crash in US. Randomness is for the masses. As they don't understand how markets work. Markets are clock work and not random as Taleb claims.
Forecasters have proved it again and again giving not only great calls but also timing them. There are technicians who timed a short call two days before September 11, and there are technicians who said after September 11 that markets should bottom anytime soon. In 21 trading days, DOW hit base and in 40 trading days markets were back above September 11 levels.
Taleb's hypothesis is weak and does not comprehend random events like earthquake and disasters that don't affect the markets. Recent Chinese earthquake was all over the news, and the SSEC (Shanghai Index) went up for three days after the earthquake. Even the deadliest Tsunami, which killed more than 225,000 people in eleven countries, was followed by rise in stock market valuations around the globe.
Assassination of presidents and prime ministers are random events with poor correlation with market crashes. Market randomness is predictable and has nothing to do with event randomness, which may or may not affect the market. All that does influence the market is non random in nature and is non linear mathematics, pure in its structure. Power law, fractals, cycles and sentiment measuring tools have high predictive power. And, Black Swans have nothing to do why DOW goes up or down.
Third. Though recent broker inventiveness and rush for trading volumes have lead to the mushrooming of a zillion leveraged products (example 1 to 100 leverage), classically Options offered a protected leverage compared to Futures. No wonder, the upside was unlimited compared to the downside. The only catch was that 85 per cent of the Options generally expired worthless. And, if you are just buying cheap Options, volatility or chance will definitely make you rich on that black day like 1987. Volatility is cyclical and starting 2007 is moving up in a 25 year cycle, which should top somewhere in mid 2015. This means that chances for buying cheap Options are going to be few, but profitable.
Good forecasts cannot be subdued with randomness talk. And there are living legends like Richard Russell forecasting markets day after day starting 1958. Options are versatile instruments that can do better than wait for that 1987 crash again. Being on the long side helps as Option writing has unlimited risk that can implode and cause more than a Barings' failure.
We still remain negative on the market with NIFTY 4,000 potential targets. But, end of June is when we are looking at an intermediate bottom. Starting June, a simple LONG Strangle gave 100 per cent return without transaction costs. And, this is not one set of 10 trading days NIFTY options can perform. They can repeat this performance month after month. But, what a trader needs is more than just cheap Options to deliver this profitability. He needs predictive knowledge, which is rarer than knowledge on fair value and low volatility. So, till we scale up on the forecasting part, some cheap Option exercise can help you understand
