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Long-Term Capital Management headed for trouble

In the summer of 1997, Taleb predicted that hedge finds like Long-Term Capital Management were headed for trouble, because they did not understand this notion of fat tails. Just a year later, L.T.C.M. sold an extraordinary number of long-dated indexed options, because its computer models told it that the markets ought to be calming down. And what happened? The Russian government defaulted on its bonds; the markets went crazy; and in a matter of weeks L.T.C.M. was finished. Mark Spitznagel, Taleb`s head trader, says that he recently heard one of the former top executives of L.T.C.M. give a lec-ture in which he defended the gamble that the fund had made. What he said was ˜Look, when I drive home every night in the fall I see all these leaves scattered around the base of the trees,` Spitznagel recounts. ˜There is a statistical distribution that governs the way they fall, and I can be pretty accurate in figuring out what that distribution is going to be. But one day I came home and the leaves were in little piles. Does that falsify my theory that there are statistical rules governing how leaves fall? No. It was a man-made event.` In other words, the Russians, by defaulting on their bonds, did something that they were not supposed to do, a once-in a lifetime, rule-breaking event. But this, to Taleb, is just the point: in the markets, unlike in the physical universe, the rules of the game can be changed. Central banks can decide to default on government-backed securities.

One of Taleb`s earliest Wall Street mentors was a short-tempered Frenchman who dressed like a peacock and had an almost neurotic obsession with risk. He would call Taleb from Regine`s at three in the morning, or take a meeting in a Paris night club, sipping champagne and surrounded by scantily clad women, and once he asked Taleb what would happen to his positions if a plane crashed into his building. Taleb was young then and brushed him aside. It seemed absurd. But nothing, Taleb soon realized, is absurd. Taleb likes to invoke Popper: No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion. Because L.T.C.M. had never seen a black swan in Russia, it thought no Russian black swans existed.

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. He`s never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market`s moving in one direction or another. That would require Taleb to assume that he understands the market, and he knows that he does not. He does not have Warren Buffett`s confidence. So he buys options on both sides ” on the possibility of the market`s moving both up and down. And he does not bet on minor fluctuations in the market. Why bother? If everyone else is vastly underestimating the possibility of rare events, then an option on G.M. at, say, forty dollars is going to be undervalued. So Taleb buys out-of-the-money options by the truckload. He buys them for hundreds of different stocks, and if they expire worthless he simply buys more. Taleb does not even invest in stocks ” not for Empirica and not for his own personal account. Buying a stock, unlike buying an option, is a gamble that the future will represent an improved version of the past. And who knows whether that will be true? So all Taleb`s personal wealth ” and the hundreds of millions of dollars that Empirica has in reserve ” is in Treasury bills. Few on Wall Street have taken the practice of buying options to such extremes. But if anything completely out of the ordinary happens to the stock market ” if some random event sends a jolt through Wall Street and pushes G.M. to, say, twenty dollars ” Nassim Taleb will not end up in a dowdy apartment in Athens. He will be very rich.