INTERVIEW
Love And Options
Nassim N. Taleb
by John Sweeney
Nassim N. Taleb is a quantitative trader operating at the intersection of theory and practice. Currently president and head trader at Empirica Capital LLC, a hedge fund operator in Greenwich, CT, and adjunct professor of mathematics at the Courant Institute of New York University (NYU), Taleb has held senior derivative trading positions at Union Bank of Switzerland, CS-First Boston, BNP-Paribas, Credit Agricole-Indosuez, and Bankers Trust; he was also a floor trader on the Chicago Mercantile Exchange.
In 1997, Taleb stirred the incredulity of institutional heads and financial system regulators by pointing out the logical holes in the rapidly developing consensus that value at risk (VAR) was the best single measurement of an institution's exposure to untoward events. He pointed out that, by definition, we do not know the distribution of future unusual events or even know how often they occur within the parametric distributions used by institutional financial engineers. He advocated taking positions based on available information and understanding rather than by what fell out of encoded differential equations.
Since that time, academics have started to explore mechanisms by which inefficient pricing and unusual events occur, and confidence in "engineered" measures has fallen in favor of more pragmatic, "know your business" rules for protecting institutions' trading. For his part, Taleb took to exploiting the unusual opportunities available in equity options by establishing a private, closed, hedge fund operator, which is where STOCKS & COMMODITIES Interim Editor John Sweeney spoke to him in June 2000.
ILLUSTRATION BY CARL GREEN
How did you get started in trading?
I first studied some statistics and econometrics, but I had no particular interest in quantitative methods. Then I went to business school, where I suddenly and irreversibly fell in love with options. I didn't really fall in love with the markets per se. I just fell in love with options.
Why did you find options so attractive?
Because they are nonlinear in their payoffs. They seem to require a lot of complex mathematics, but in reality, we can figure them far more effectively with a diligent use of guts. With some imagination, you can mentally play with their payoff and develop intuition for how they work. After school, I decided to get a job as an option trader and I have done nothing else since, except finish a doctoral thesis -- of course related to the math of option pricing.
Where did you go first?
Bankers Trust. I was lucky to get in at an exciting time in derivatives trading, just as things were starting to happen. I had the privilege of doing my own theoretical research, as no applicable theory was available then.
What did you observe?
I noticed that options had a tendency of sucking in very intelligent people and blowing them up. The smarter the person, the more spectacular the blowup. Situations resemble each other; people who had been successful in the past and thought they had it all down pat were carried out feet first.
Why was that?
Those people were, and are, attracted by the idea of making money without having to work. The first thing they do is to sell options because they think the future is going to resemble the present. They will make steady money for a while and build up larger and larger positions, and one day they walk into the office and find it is all gone. They explain to themselves that it was a simple accident that hurt an otherwise profitable strategy.
We'll get back to that. Were there mispricings when you started out?
I was involved in currency options at the beginning and then moved to commodities and fixed-income options. Options were extremely cheap then. Japanese institutions sold them and wrote down the premium as profit. But many professional traders sold them too and marked them down as mental profits. Some classes of options were cheap in relation to others, while some became cheap in absolute terms. Out-of-the-moneyÝ options were most mispriced. People thought that they were expensive and therefore they were a good sale, because the uninformed bought them like lottery tickets.
That's dangerous!
Absolutely. A lottery ticket has negative odds, while out-of-the-money options appeared to have hugely positive odds, the way they were priced. I bought them up when professional traders were selling them with abandon. That is how I learned that people looked for theoretical excuses to indulge. And selling options, particularly out-of-the-money options, feels great.
What did you do after that?
I graduated to more complex instruments, like second-generation derivatives. I continued to study the mathematics of probability while trading options. I went from practice to theory, rather than from theory to practice, the way bank research departments do. My career resembled a career in applied research more than it did a career of a pure trader or pure researcher. It was like someone learning from his craft. I'd go back and forth between trading and option mathematics.
Are you one of those traders who looks at the markets as a metaphor for life?
Trading is about dealing with randomness in an effective way. You have to be a hyperrealistic, no-nonsense type of person. This will have some irreversible effects on your intellectual makeup. You do not take what you see around you for granted, which may bother some people. You also start hunting for fools.
We humans have a lot of mental biases in dealing with randomness. You experience those in your life and in your trading. There is a war going on in me between the gullible part of me with genetic biases in my understanding of probability and the part of me that is the obsessively skeptical trader. You do not need to correct the biases in your private life; to do so would make you antisocial. But not doing so as a trader would be deadly. So you need to separate the two.
We depend more and more on uncertainty. Increasingly, our daily lives are full of randomness as our environment is becoming more and more complex. You have to deal with information, probabilities, and decision-making under uncertainty.
Options have a tendency of sucking in very intelligent people and blowing them up. The smarter the person, the more spectacular the blowup. -- Nassim N. Taleb
Excerpted from an article originally published in the September 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.