Nassim Taleb is back.  Citing a disgust for the lack of effective action on the growing global economic and financial crisis, he’d essentially gone into hiding over the last two years.  (I don’t recall seeing Taleb on TV since May 2010 when he discussed the “flash crash.”)  In fact, his website, Fooled by Randomness, championed this fact (check out the caveat he puts next to his email address at the bottom of the page).

The attached video shows Taleb discussing why he supports Ron Paul for the 2012 Republican Presidential candidate.  He lists four main reasons why: 

1) Paul’s position on reducing government spending in order to decrease the deficit and, in turn, the national debt.

2) Paul’s desire to audit and possibly abolish the Federal Reserve Bank.

3) Paul’s position on America's rampant militarism and defense spending.

4) Paul’s belief that America is resilient and can recover if we commit to rebuilding what was once a vibrant economy.

Followers of this website know that along with Nassim Taleb, Peter Schiff is the other market and investing guru that I follow closely and have a deep respect for -- and so you wouldn’t be too surprised how happy I was to hear that he was given an opportunity to testify before Congress on the current economic conditions.  The testimony occurred back on September 13, and you can watch part 1 and part 2 of his testimony on YouTube.

Basically, Schiff sticks right to the same message that he’s been touting for years, and that he used as a platform for his unsuccessful Senate run in 2010.  The major points you’ll hear in the testimony:

-- The government is a net destroyer of jobs.  For every job we see created in the tangible sense, we have no way of estimating how many jobs were destroyed or stopped from being created due to the burden of higher government spending, debt, taxes, regulation and overall intrusion into the economy.

-- Stimulating the economy with more borrowed or printed money does not make for an economic recovery; rather, it lays the foundation for greater economic pain down the road, by acting as a “sedative” that delays the necessary corrective forces in the market, thus exacerbating them when they finally run their course.

-- Speaking as a businessman (Schiff owns and runs Euro Pacific Capital), he emphasizes the fact that he has been discouraged from hiring new workers due to the high-tax, high-regulation environment our economy is subjected to.  Schiff goes so far as to point out that he has now resorted to opening new offices/branches overseas (he mentions Singapore and the Caribbean) in order to escape the tax and regulatory burden here in the States.  Effectively, these are jobs the government has driven out of the country through various misguided laws and policies.

Of course, these are just a few high points from the testimony.  If you enjoy following Schiff, or want to hear an alternative argument as to how to truly stimulate the economy as opposed to the ones consistently put forth by the government, then I recommend you take a look at the video clips contained in this post.

I thought that title might get your attention.  Sounds pretty outlandish doesn’t it?  Well, this post is about the individual who experienced a 67,000% gain in a matter of days back during the 1987 stock market crash.

His name is Nassim Taleb, and I’ve written about him and his philosophies extensively on this blog.  I’ve read quite a bit of material by Taleb, in particular his best selling books like The Black Swan: The Impact of the Highly Improbable and Fooled by Randomness, but not until recently had I come across Taleb speaking in depth on his actual options trading strategies.  This article from The Forex Village contains some rare insight by Taleb on how he approached options trading.

Of all the information in the article, I think one of the biggest takeaways is Taleb’s point about how far out-of-the-money (OTM) options are likely not to be priced accurately.  Human beings created the option pricing formula.  Human beings have a very difficult time perceiving the likelihood of rare (and often catastrophic) events.  Thus, the option pricing formula does not perform so well when assigning values to far OTM options, since these options are attempting to capture the possibility of extremely rare events.  Ultimately, this undervaluing creates the potential for massive gains, like the one Taleb had in 1987.  

Simply put, the sizable gains that far OTM options can yield are staggering.  Going back to Taleb’s 67,000% gain (which resulted from him holding options on eurodollars and the deutschemark), it helps to put it in real terms:

Say you had a portfolio that totaled $1 million in value.  You decided to allocate 10% of that, or $100,000, to the kinds of far OTM options that Taleb held in 1987.  Where you began with $100,000, after the smoke cleared you’d be holding $67,000,000 ($100,000 * 670).  (Of course, this assumes you invest the entire amount at once and it hits that same month.)

That’s $67,000,000 -- off of a $100,000 investment.  This is far from typical in terms of the kind of result you can expect -- but that doesn’t matter.  It doesn’t have to be typical.  It only has to happen once.

It took a while to get around to writing this post.  I've been beating myself up, languishing in my recent error with respect to the stock market.  Simply put, I missed out on a gargantuan profit during the intense market volatility last week.  I missed a 1380% gain.

Yes, you read that right.  I could have multiplied my initial investment by 13.8.  Theoretically, I could have turned $1,000 into $13,800.

I’m repeating it this way more so for my own benefit, so I can stew in the knowledge that I abandoned the very system that I tout here on this blog in order to secure a short term gain instead.  Let me explain what I mean.

The week of July 25, I decided I wanted to buy the September puts on SPY in order to protect against the upcoming debt ceiling default that loomed over the US on or about August 2.  SPY was right around 130, and so I bought the Sep 119 puts against it.  When I bought them, the contract was selling for $0.65.

That Friday, July 29, those options had roughly doubled, and hence, I’d doubled my money.  I thought about whether I should keep the options in place despite this 200% move, since after all, black swan protection protocol dictates that I maintain my position throughout whatever black swan event might occur, and thus be able to capture the sizable move that would ensue.  After some contemplation, I decided 200% was enough -- I didn’t want to get greedy, and I figured the debt ceiling debate would be peaceably concluded over the weekend, in time to calm the markets the following week.

Just the opposite happened.  For whatever reason -- and it probably was a combination of poor US economic data, Europe’s financial unrest, and the threat (then reality) of the S&P credit downgrade -- the markets did the exact opposite.  Over the next two calendar weeks, we saw three large triple digit down days.  And that’s when my SPY puts went through the roof.

I remember looking on Monday, August 8, the first trading day after the credit downgrade, at the price of those options I’d held.  I honestly can’t recall the exact price at the time, nor do I know just how high it got that day, but suffice it to say that at some point I took the contract price and calculated how much I would have gained had I held on till that moment -- and it was 1380%.  The option I’d bought at $0.65/contract was now over $9 a contract.

What went wrong?  The bottom line is I didn’t implement a true black swan protection protocol.  I was simply trading options, nothing more than that.  In fact, I’d written here before about how I was going to start trying my hand at turning my options over for quick profits, rather than only maintaining the more defensive protocol of keeping them until expiration.  While it wasn’t wrong per se for me to choose this approach, it highlighted the benefits of always having that protocol in place for insurance purposes, regardless of what other trading strategies I might employ.

Truth be told, it’s difficult to employ the protocol month in and month out while losing money nearly every time, waiting for that one instance where the approach pays off.  And quite frankly, it may not make monetary sense either, when you look at all of the expired options you lost money on, versus the amount you make on one big move like last week.  In the end, you might still have a net loss for the year, even after catching a 1380% jump like I could have. 

In order to avoid that fate, you essentially have to go to the farther end of the “tail” so to speak -- the “tail” being the very far, flat end of the traditional bell curve, which represents the likelihood of a given event -- with your options purchases.  By this I mean, the further out of the money your options purchase is, the cheaper the contract will be, which equates to less money wagered and (most likely), lost.  However, when extreme volatility hits like it did earlier this month, even your far out of the money options will likely experience a significant bounce, absorbing your previous losses and netting you gains.  So what’s the downside to this approach?  Those far out of the money options won’t jump as much on smaller market movements, and so they’ll almost invariably expire worthless in every case.  Conversely, the closer in the money you are, the more chance you have of getting at least some kind of movement at some point in time...but you have to be willing to spend more for those options.

I’ll close by saying that if you want to institute a true black swan protocol, first make up your mind that the expense is just another line item in your budget -- call it “market insurance.”  Like all other insurances you pay for, consider it a sunk cost that buys you peace of mind.  Then select options as far out of the money as you can tolerate, and buy them robotically.  Then in the meantime, you can more actively trade options closer to the money if you’re so inclined.

If you’re currently using black swan protocols, I’d love to hear feedback from you on your approach and how it’s working out for you.

Before you read this post, read this article here.

So the question is, did you end up like the turkey over these last two weeks or so?

It's really incredible when you step back a moment and look at what the market has done since late July.  Consider the following:

-- Starting July 22 (a Friday) through today (August 11), the Dow Jones has gone down 11 of the 15 trading days in that time frame.

-- The Dow has declined 12.5% since July 21's point (12,724) to today (11,143).  Whether the market can hang on to today's sizable gains (+412) remains to be seen in this volatile environment, so we could easily head lower than 11,143.

-- In the last 15 trading days, we've seen three days of triple digit declines: Aug 4 (-513), Aug 8 (-635), and Aug 10 (-520).  Experiencing even one of these kinds of days would be considered a rare event, much less three in a span of five trading days.

Many people went into July 22 thinking they had a "conservative" or "moderate risk" portfolio.  After 12.5% (or higher) losses, many of those same individuals now realize they had high risk portfolios all along.  The problem is, no one told them that when their portfolios were constructed.

Worse yet, a good number of these individuals were planning on living off of these investments within the next couple years.  Undoubtedly, those plans have now been delayed, perhaps for some time as the economy and markets struggle to find their footing.

Isn't it funny how the market can take 12.5%+ from your portfolio in a matter of a few days, but it never seems to put 12.5% into your portfolio in a matter of a few days?  Of course, I'm sure you've heard it a million times before, but it bears repeating: once you lose 12.5% you have to make back an even greater percentage just to get back to even.  This often equates to needing a couple of years to earn back what's lost in a couple of days.  To me, that sounds like a very high risk proposition.

This is exactly why Nassim Taleb, author of the "The Black Swan: The Impact of the Highly Improbable" advocates a "barbell strategy" approach for the individual investor's portfolio.  In short, instead of trying to construct a medium risk or conservative portfolio, one should split their assets into an 80/20 allocation: 80% in extremely safe (relatively speaking) instruments like CDs, money markets, or cash; and 20% in very high risk investments such as options (or other securities that have a high payoff potential).  Of course, this 80/20 mix can be tailored for what fits you best, but the general principle remains the same.

Again, think of the markets the way the turkey should think of Thanksgiving.  Given that premise, if you have any flexibility at all, take a closer look at how you can construct a portfolio that is more robust to these market fluctuations and perhaps even benefits from them.  Click on the Black Swan or Nassim Taleb categories in the right hand column to read more about this subject.

It was a year ago today that we experienced what has come to be known as the “flash crash.”  On May 6, 2010, the Dow Jones Industrial Average plummeted nearly 1,000 points in a matter of 10 minutes or so.  The event was harrowing and left market participants, experts, and various pundits searching for answers: how could the impossible have occurred?

If you recall, accusations flew over the weeks after the crash.  Most pointed to electronic trading mechanisms that went haywire and simultaneously sold off billions of dollars worth of positions, thus fleetingly tanking the market.  Some said it was rigged by large institutions in order to see what would happen and thus prepare better for a repeat scenario.  Still others actually pointed to a single hedge fund, Universa (advised from a distance by The Black Swan author Nassim Taleb), as the reason for the crash, when it bought a sudden and massive position in deep out of the money options.  The hypothesis was that such a bearish position caused a psychological backlash in the market and induced a selling panic.  (Never mind that this accusation coincided with repeated critique on Taleb’s part of the US government’s and Federal Reserve’s economic and monetary policies.)

After all that hypothesizing, what did we learn about the causes?  Nothing.  Scarily, we are no smarter today about it than we were a year ago.

So today, we watch as the market continues to climb upward, in spite of a host of economic realities that suggest the market should be heading the other direction.  Consider the following:

-- The unemployment rate moves higher, even as jobs are added, because the job creation cannot keep up with the demand for work.  There simply aren’t enough jobs for all the people who want to work.

-- The European debt situation (the “PIIGS” crisis) festers, with little in the way of long term solutions firmly in place.  

-- The US credit rating is poised for a downgrade by S&P within the next couple of years.  A loss in confidence by our creditors will mean higher interest rates, shrinking loan access, and a sharp decline in our standard of living. 

-- Charts depicting housing prices in the US clearly show a double dip forming, with waves of resetting mortgages coming due in the next three years.

-- Talk persists about changing the reserve currency from US dollars to something more viable, a nightmarish scenario that would send the value of the dollar plummeting and cause almost certain hyperinflation and destruction of our currency.

So the point of this post is to simply remind the reader that, no matter how outlandish or unbelievable any of the above items sound, anything is possible, as was demonstrated to us a year ago today.  No one would ever have thought the May 6, 2010 flash crash could have happened -- a scenario like that would have been labeled “impossible,” right before it actually happened.  And the conditions for a more virulent flash crash, or even a more protracted and sustained crash, are ripening.  There has never been a better time to scrutinize your portfolio, review your risk exposure, and make any necessary adjustments now before it’s too late.  I urge you to take the time to do this in the coming weeks.

While I don’t devote much time on this blog to political subjects, occasionally they become relevant since they’re interwoven with economics, and thus addressing them becomes unavoidable.  And so I wanted to turn my attention to the events in the Middle East, in the context of the black swan conjecture.

As I write this, Libya is in turmoil as its long-standing dictator’s regime prepares to be toppled, only a matter of days since Egypt’s ruler was deposed.  Thirteen other Middle Eastern nations are experiencing some kind of protest from its citizens towards its government.

If you’re a regular follower of this site, you know I subscribe to the black swan conjecture, which I’ve written articles about previously (you can read a couple here and here).  In short, a black swan event meets the following criteria:

1. the event is deemed unlikely to occur, and comes as a surprise when it actually does occur
2. it is highly impactful
3. it is retrospectively distorted (in other words, it’s viewed as something that could/should have been predicted)

The Middle East uprisings fit the black swan criteria almost to a “t.”  The first two points are fairly obvious; on the third point, I’ve heard pundits claiming that in each country’s case, the seeds of discontent were clear and the uprising was inevitable.  I’m not so sure we should be so sure of ourselves about that.

If I had told you a couple of months ago that Moammar Gadhafi and Hosni Mubarak would be removed from power a couple of weeks apart, and that 15 Middle Eastern nations would be rising up in protest against their governments to demand reforms and changes in leadership, you’d likely have dismissed the notion as impossible.  Let’s face it, witnessing even one Middle East uprising would be considered notable -- but 15 simultaneously?

What this is telling us is that anything is possible.

On an individual level, the Middle East events happening right now will very likely affect your portfolio in some form or another.  Oil rose above $100 a barrel today, and gold and silver saw big gains as well.  These movements suggest a defensive posture on the part of investors.  While we shouldn’t directly attribute all of these developments to each other, it’s safe to say that there’s a reactive element in the markets right now to the unrest.  But we simply cannot predict what the next effect will be.

So from the economic standpoint, the lesson here is simple: we have to make every effort to build robustness against black swan events into our financial situations.  Portfolios should be constructed to absorb the effects of a significant market crash, and perhaps even benefit from such a crash.  If you’re approaching retirement, your exposure to these potential black swans should be minimized, to say the least.  On the other hand, if you have the time horizon and risk appetite for it, you could get very aggressive with your black swan protection protocols and attempt to profit significantly off of a market plunge.  Regardless of the specific approach, envision a large scale market disruption (a la 2008) and ask yourself pointedly if your portfolio could withstand such an event in its current state.

I’ll continue to follow the situation in the Middle East and post any thoughts I might have on its implications, so check back here often for those updates.

So the market has continued shooting to the moon, devastating my monthly options purchases and rendering them nearly worthless well before expiration.  Most people would be discouraged by this result; however, I continue to remind myself of Nassim Taleb's analogy of the two traders in "Fooled by Randomness," and this helps me get through the mounting losses.

I wanted to use this post to provide a quick update on my tactical approach to buying the monthly put options against the S&P 500 index.  Recall that late last year I wrote about hedging the hedge by taking a portion of the options purchased and using those to try and flip a quick profit, which could then be pocketed or reinvested into more options purchases.  I plan on employing that approach as more of a routine aspect of my current options-buying methodology.  I see the advantage in potentially allowing me to accumulate more options over time through the reinvestment of any short term profits.

My lone hesitation for using this approach stems almost entirely from the emotional component -- or more simply, knowing when to sell.  Anyone who has traded in the markets knows that knowing when to sell is 1,000 times harder than knowing when (or what) to buy.  I've been in situations in the past several months where I witnessed my options positions jump by 50, 75, or even 100+% in a single day...and froze, holding the position under the assumption that it had more room to run.

And don't get me wrong -- it's okay to hold fast in that situation, since the whole point of these options is to have insurance for the fat-tail events, the catastrophic market plunges that are sure to occur again.  But if part of the trading approach is intended to incorporate short-term profits, as I plan to endeavor upon, then knowing when to sell -- and having the fortitude to actually do so -- is important as well.

So here's how I envision this working: say I purchase 10 Mar SPY 120 puts in the next couple weeks.  Of these 10, I'd allocate five of them toward pure insurance (for a potential market plunge) and the other five would be used to trade on a short term basis.  Assuming I buy the 10 on Tuesday, March 1, and they appreciate 125% on Wednesday, I'd sell the five options and keep the remaining ones.  Then, on an up day in the market, if these options (or those with a more aggressive/higher strike price) depreciated to an attractive level I'd buy more of them and repeat the process.  On the other hand, if the market rose consistently day-to-day after buying all 10 options, I'd likely just hold them through expiration and treat all 10 as insurance against a black swan event.

I'll post an occasional significant update on my trading activities like this one here on the blog, but check my Portfolio page for more frequent and concise updates.