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Comment by lordnacho | Hacker News Reader

Hedge fund guy here. I actually met NNT, fun character. Irreverent as always.

He was talking exactly about this strategy when he came in. The thing is, trading often presents you with a tough choice:

- Do something that on most days makes a bit of money, but sometimes creates big losses.

- Do something that on most days loses a bit of money, but sometimes gives you a big payday.

Your problem is then what to do. If you've decided that you want to wait for the big payday, how are you going to stay in business until your ticket comes in? How do you keep your investors faithful until then? This is the actual skill in this trade, btw.

If you're wondering about taking the other side, the trope is that you get an even bigger job after you get fired for losing a huge amount of money in an "unforeseen event".

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NNT is very entertaining. He's also blown up two hedge funds. Ever notice that running a fund is an asymmetric option? The management makes money either way at least until the investors leave, but there's no clawback if the fund blows up. So, I enjoy NNT. I respect his wit and intelligence. I'll even use his insights to steer my thinking. But he's not where I want my money going. And with his books and his trips to Washington perhaps he's gotten that bigger job.

A less successful example of this type would be Hugh Hendry, who after the implosion of his Eclectica fund is now seeking listeners willing to pay via Patreon for his weekly podcast recordings.

What were the hedge funds, what happened? I’m a fan of NNT, but I want to get a more complete picture of whether his “stuff” works or not, and good info is hard to come by.

I'd also like to know.

> Your problem is then what to do. If you've decided that you want to wait for the big payday, how are you going to stay in business until your ticket comes in? How do you keep your investors faithful until then? This is the actual skill in this trade, btw.

I’ve been to one of the Wilmott-Taleb seminars in London. Taleb answered that question this way:

1. You buy way out of the money calls or puts which will eventually get you your big payday. Most sellers of these sort of options use Black-Scholes or similar model to price them, underestimating the frequency and/or magnitude of payout, and thus mis-pricing them.

2. Simultaneously you sell in-or-near-the-money puts or calls, which are more mathematically tractable, model-able, and thus manageable. Results in small and predictable income and payouts which you can manage to keep the fund afloat until #1 pays off.

3. Make sure your fund LP’s understand that this is essentially an insurance policy. People are accustomed to paying regular small payments for insurance against big unexpected events, and tend to accept that model for the fund too.

As you say, the skill in this trade is in discovering options for #1 that are indeed mis-modeled and mis-priced, and in #2 managing that in/near-the-money portofolio as optimally as possible to cover or minimize the steady bleed from #1. It’s not easy.

Suppose you are right. If the near-the-money options are correctly modeled, how will you make money on them?

> If the near-the-money options are correctly modeled, how will you make money on them?

In a hand-wavy sense, they're the hedge.

A mis-priced option isn't completely mis-priced: some of the modeling is correct enough. The trick to making money is to buy the mis-priced option, but then sell back the "part" of it that is correctly priced.

That leaves you holding only the part where you think you have an edge, and in turns this is what makes the "insurance" model somewhat viable.

I don’t know, no one asked that followup question, everyone just accepted it. There’s probably more to it he didn’t elaborate on.

I assume it depends partly on asymmetry of information between a more sophisticated option seller (like Universa) and buyers (especially retail). Maybe also the ability of the seller to sell a diverse heterogenous mix of options and construct the mix to achieve a small positive net revenue. Options sellers tend to blow up eventually when they sell way out-of-the-money options, and this strat avoids that at least.

Anyone can be permanently bearish (it works both ways - the permanent market cheerleaders are just as bad in reverse) and then go on CNBC and tell everyone they correctly called every recession or bear market.

Typically these people have called 176 of the last 8 recessions.

There are plenty of fund managers out there that make some when its a bull market and make some in a bear market, they dont tend to go on tv and talk their book though.

Interestingly, it just occurred to me that VC is the exact opposite of this. Many VCs have called 176 of the last 8 unicorns. You can still make bank doing this though.

VC's put "early investor in Google and Uber" on their bio, not "passed on Series A Facebook because MySpace has already won the social media war, then begged to be in the last funding round before the float".

yeah you don't actually have to get that many right when the winners return 750x

But if you do get the 749th right - you can live off that reputation for a long time.

You're not wrong but... If you can get a 400:8 (50:1) returns, then betting on 176 recessions and winning 8 puts you well ahead of other traders.

I'm less familiar with put and call options , compared to common shares and selling short; But one of the challenges to sell short, compared to buying long, is that your upside is limited and liability unlimited. Whereas the inverse for common stock, upside is unlimited and liability is limited. If you place 176 bets and win big 8, I think will be more successful buying long , like the venture capital model.

People say this, but of course if you invest via a hedge fund (or other similar corporate structure), your total downside is just whatever you invest. The fund maybe run up 1tn, or 1000tn in loses somehow, but that just means a lot of disappointed creditors meeting limited liability...

If you buy an option (the right but not obligation to either buy or sell at a certain price), then your liability is limited to what you pay for it.

There are options for limiting your losses, eg a bear put spread - buy put options at strike price X and sell put options at Y where Y < X.

There's always a third choice:

- Do nothing on most days, hold cash, earn a little interest, maybe play bridge to keep yourself entertained, and bet big only when you're sure you'll win big.

Call it the Buffett approach. The main downside to it is that on most days you have nothing to do.

Yeah it’s called if you don’t have a strong view, you are just gambling. Bet big when you see it, but this takes experience as sometimes you think you see it but it’s really noise, or you have 5 big blind spots you didn’t consider

Bosses dont pay you to go home early and play tennis (they should), they pay you to make money and you cant make money unless you sit there and gamble.

At pro trading firms they likely have edge in data speed and execution speed. Something common man won’t have

I would look at Universa's record, it is horrible.

I know a few guys who make money doing this but it does require more than Universa appear to be doing. Practically, I have found short-selling funds are even better...but, for reasons you mention, the economics of running these funds mean that very few exist.

> the trope is that you get an even bigger job after you get fired for losing a huge amount of money in an "unforeseen event".

Levine talks about this in Money Stuff in the sense of 'oh, they trusted you to lose a quadrillion dollars? You must be good'.

Isn't there also a massive counterparty risk, since you're trying to claim money when everyone else has lost money?

It's a risk, not something that you couldn't deal with. You have to have a sensible prime broker mainly. Any of the big ones will have systems in place to protect them well in advance of you putting on this huge put option. The only guys who would blow up from this were merged earlier this year.

This is assuming the entire trade is just S&P500 puts of course. A proper doom merchant might put it on in a bunch of ways, with various swaps against counterparties in different assets. It's really just OTC risk you'd care about but again if your PB isn't incompetent you will know where you can do this.

For publicly traded options there isn't much counterparty risk unless the financial system completely melts down. Counterparty risk is more of an issue with other derivatives traded off market. That risk can sometimes be partially hedged, for example by purchasing credit default swaps on the counterparty.

I've also read that lots of traders make money before taxes and fees. They can use skill to determine things.

But "picking pennies up in front of a steamroller" has it's downsides, too.

And you can be absolutely correct about what is going to happen, but off on the date and get wiped out.

> I actually met NNT, fun character.

Me, too. I hosted him at Google and now I have a signed copy of The Black Swan

https://www.youtube.com/watch?v=S3REdLZ8Xis

Anyone who talks about "permanent bears" does not get the concept.

A fixed allocation to a one-size-fits-all tail risk fund doesn't work. It won't have positive returns over the long run. And its diversification benefit will not be enough to overcome the drag on performance.

A tail risk strategy that is tailored to the portfolio, point in time, in an opportunistic way (e.g., when vol is cheap) can potentially work. But you need a strat like that to be part of the portfolio construction process.

I dont believe that is what they are doing.

- Do something that on most days loses a bit* of money, but sometimes gives you a big payday.

Welcome to Startup Land

* (or a lot)

Excellently put

Taleb explained both phenomena and many others in "Antifragility" and "Skin in the game". Worth reading.

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