Trading Stocks Based on Rare Events in the Market

The general press floods us with concepts like "bullish" and "bearish," which refer to the effect of higher (bullish) or lower (bearish) prices in the financial markets. But also, we hear people saying, "I am bullish on Johnny" or "I am bearish on that guy Nassim in the back who seems incomprehensible to me," to denote the belief in the likelihood of someone's rise in life. I have to say that the notion of bullish or bearish are often hollow words with no application in a world of randomness - particularly if such a world, like ours, presents asymmetric outcomes.

When I was in the employment of the New York office of a large investment house, I was subjected on occasions to the harrying weekly "discussion meeting," which gathered most professionals of the New York trading room to talk about trading stocks.

I do not conceal that I was not fond of such gatherings, and not only because they cut into my gym time. While the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street "economists" or "strategists," who make pronouncements on the fate of the markets, but do not engage in any form of risk taking; thus having their success dependent on rhetoric, rather than actually testable facts. During the discussion, people were supposed to present their opinions on the state of the world.

To me, the meetings were pure intellectual pollution. Everyone had a story, a theory, and insights that they wanted others to share. I have to confess that my optimal strategy (to soothe my boredom and allergy to confident platitudes) was to speak as much as I could, while totally avoiding listening to other people's replies by trying to solve equations in my head. Speaking too much would help me clarify my mind, and, with a little bit of luck, I would not be "invited" back (i.e, forced to attend) the following week.

I was once asked in one of those meetings to express my views on the stock market. I stated, not without a modicum of pomp that I believed that the market would go slightly up over the next week with a high probability.

How high? "About 70%." Clearly, that was a very strong opinion. But then someone interjected, "But, Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market would go down. What made you change your mind?" I answered, "I did not change my mind! I have a lot of faith in my bet! As a matter of fact, I now feel like selling even more!"

The other employees in the room seemed utterly confused. "Are you bullish, or are you bearish?" the strategist asked me. I replied that I could not understand the words "bullish" and "bearish" outside of their purely zoological consideration. My opinion was that the stock market was more likely to go up ("I would be bullish"), but that it was preferable to short it ("I would be bearish"), because, in the event of its going down, it could go down a lot. Suddenly, the few stock traders in the room understood my opinion and started voicing similar opinions. And I was not forced to come back to the following discussion.

Let us assume that the reader shared my opinion, that the stock market over the next week had a 70% probability of going up and 30% probability of going down. However, let us say that it would go up by 1% on average, while it could go down by an average of 10%. What would the reader do? Is the reader bullish or bearish?

Accordingly, bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no knowledge in handling risk. Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. It is a pure accounting fact that, aside from the commentators, very few people take home a check linked to how often they are right or wrong. What they get is a profit or loss. As to the commentators, their success is linked to how often they are right or wrong. This category includes the "chief strategists" of major investment banks the public can see on TV, who are nothing better than entertainers. They are famous, seem reasoned in their speech, plow you with numbers, but, functionally, they are there to entertain - for their predictions to have any validity they would need a statistical testing framework. Their fame is not the result of some elaborate test, but rather the result of their presentation skills.

Outside of the need for entertainment in these shallow meetings I have resisted voicing a "market call" as a stock trader, which caused some personal strain with some of my friends and relatives. One day a friend of my father - of the rich and confident variety - called me during his New York visit. He wanted to pick my brain on the state of a collection of financial markets. I truly had no opinion, nor had made the effort to formulate any, nor was I remotely interested in stock markets. The gentleman kept plowing me with questions on the state of economies, on the European central banks; these were precise questions no doubt aiming to compare my opinion to that of some other "expert" handling his account at one of the large New York investment firms. I neither concealed that I had no clue, nor did I seem sorry about it. I was not interested in markets ("Yes, I am a trader") and did not make predictions, period. I went on to explain to him some of my ideas on the structure of randomness and the verifiability of market calls, but he wanted a more precise statement of what the European bond markets would do by the Christmas season.

He came away under the impression that I was pulling his leg; it almost damaged the relationship between my father and his rich and confident friend. For the gentleman called him with the following grievance: "When I ask a lawyer a legal question, he answers me with courtesy and precision.

When I ask a doctor a medical question, he gives me his opinion. No specialist ever gives me disrespect. Your insolent and conceited 29- year-old son is playing prima donna and refuses to answer me about the direction of the stock market!"

The best description of my lifelong business in the stock market is "skewed bets", that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage.

Why are these events poorly valued? Because of a psychological bias; people who surrounded me in my career were too focused on memorising Section 2 of the Wall Street Journal during their train ride to reflect properly on the attributes of random events when it comes to trading stocks. Or perhaps they watched too many gurus on television. Or perhaps they spent too much time upgrading their PalmPilot. Even some experienced trading veterans do not seem to get the point that frequencies do not matter. Jim Rogers, a "legendary" investor, made the following statement:

"I don't buy options. Buying options is another way to go to the poorhouse. Someone did a study for the SEC and discovered that 90 percent of all options expire as losses. Well, I figured out that if 90 percent of all long option positions lost money, that meant that 90 percent of all short option positions make money. If I want to use options to be bearish, I sell calls."

Visibly, the statistic that 90% of all option positions lost money is meaningless, (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%. If we make 50 times our bet on average when the option is in the money, then I can safely make the statement that buying options is another way to go to the palazzo rather than the poorhouse. Mr Jim Rogers seems to have gone very far in life for someone who does not distinguish between probability and expectation (strangely, he was the partner of George Soros, a complex man who thrived on rare events).

One such rare event is the stock market crash of 1987, which made me as a stock trader and allowed me the luxury of becoming involved in all manner of scholarship. Many traders aim to get out of harm's way by avoiding exposure to rare events - a mostly defensive approach. I am far more aggressive than those traders and go one step further; I have organised my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets.

Regards,

Nassim Nicholas Taleb
for The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found