Cygnophobia and Robustness

Thu, Dec 11, 2008 | Jared Woodard

Books, Volatility

What is fear of swans called? We’ve searched and although it doesn’t seem to exist – so far – can we suggest ‘cygnophobia’, from the latin cygnus for swan?

-WikiAnswers

People love them some Taleb, and for good reason.  Both The Black Swan and Fooled by Randomness are good reads, with interesting and provocative ideas scattered liberally throughout.  But ever since the notion of the “black swan” (an unpredictable and counterfactually inexplicable event with some dramatic impact) has been taken up among traders, a misconception has prevailed.  The misconception is that shorting volatility is prohibitively dangerous, if seductive, and therefore that being long volatility is the only rational approach.  This view is certainly bolstered by the fact that Taleb’s Universa fund reportedly pursued a strategy over many years of buying cheap OTM puts in anticipation of some market-crushing black swan(s).  Doubters and haters jeered for years and the real estate and commodity bubbles kept inflating, and now, conversely, the media having been tripping over each other to get Taleb’s take on everything.

But the misconception really is just that – a misunderstanding of the implications of Taleb’s own claims and concepts.  What matters isn’t whether you’re long or short volatility, or long or short the market, or long/short long/short funds or neutral market-neutral funds, or etc.  What matters is robustness, how vulnerable you are to the unknown, to fat tail or high sigma or “black swan” outcomes. An investor whose retirement account lost 30% in 2008 because their mutual funds got plowed along with the market was somewhat vulnerable and non-robust, but it’s not as though they could (or should) have done otherwise, even according to Taleb.  On the other hand, a bank blowing up or a municipality that can’t even give its bonds away because neither of them can survive in a hostile credit environment are examples of agents who are very vulnerable and not at all robust.

In a lecture in 2007 to the RSA, Taleb clarified this point:

So this is why when people are trying to sell volatility, those [of you who are] option traders you understand that you’ve got to sell volatility, but not sell black swans. So this is so like my paradigm, in other words, don’t be shy of volatility. And I’ll explain the story of banks by saying [that] the banks have one attribute, this is why you should worry about banks but not hedge funds. Because banks … I don’t know how many of you are bankers, but in my days when I was a banker, so they would find the most dull people they could find and they make you even duller, so to look conservative and safe and effectively they’re sitting on time bombs, the banks. Whereas hedge funds seem volatile but effectively, they don’t have the risk of banks. So it’s an
argument in favour … if you happen to be a regulator go favour this intermediate whatever you want to call it, by having more hedge funds because you have a more diverse ideology and less concentrated architecture of banks where everyone ends up trading with JP Morgan in the end. [link]

To put this in terms of option trading: you can sell volatility a hundred different ways, all of them risk-defined and entirely robust to any possible outcome, including the inconceivable ones.  For instance: imagine Singapore invades Alaska tomorrow (they have secret aircraft carriers or whatever) and nationalizes all the oil and kills all the polar bears.  (Oh, wait.)  Markets panic and the S&P 500 gets cut by two thirds overnight.  If you’re short some put verticals, sure, those trades are going to incur their maximum possible losses, but you’ll survive. Or you can sell black swans.  Let’s say the Singaporean invasion occurs, and instead you’re loaded up with naked short puts.  In that case, you might be on the hook for multiples of your current account balance.

For individual traders, the point here is that volatility is your friend.  Paradoxically enough, during the “great moderation” in volatility of the early-to-mid 2000s, people couldn’t get enough information about short vega strategies.  A thousand buy-write flowers bloomed.  Now that there is actually some really meaty volatility premium to work with, we regularly get emails from readers who are “getting out of the market for awhile” not because they blew up an account but merely because they “can’t handle the volatility.”  In short, individual traders have become cygnophobic.  Bizarre, right?  If you’re a volatility trader, the thing to do when the market environment changes isn’t to throw up your hands and refuse to adapt, but to learn some new tricks, or at least tighten up your old ones.

Government regulations, margin requirements, and liquid exchanges go a long way toward protecting most of us from ourselves, as individuals.  Not so for institutions.  And maybe that’s a good way to think about the idiocy of deregulation: allowing banks to be leveraged 30:1 for the purpose of holding illiquid debt was apparently just a fancy way of ensconcing the ludic fallacy as the primary operative principle of American finance.

Tags: , , , , , ,


0 Comments For This Post

3 Trackbacks For This Post

  1. Thursday links: scary predictions « Abnormal Returns Says:

    [...] The real implication of the concept of black swans.  (Condor Options) [...]

  2. Nightly (Vaue) Investment Links #46 | Simoleon Sense Says:

    [...] The Consequence Of Black Swans On This Environment-Condor [...]

  3. » Czy w Europie b?d? rozdawa? darmowe obiady? Trystero: O tym si? nie pisze. Says:

    [...] http://www.condoroptions.com/index.php/volatility/cygnophobia-and-robustness/ Tags: sytuacja makroekonomiczna, UE [...]

Subscription Access

Get Our Free Newsletter

Weekly emails with Options market updates and analysis.

About

Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

Categories

Open All | Close All