Nassim Nicholas Taleb is a trader and a philosopher. His books about the way people think about probability have been obscenely influential, and trading strategies based off of his ideas are becoming an indelible part of the market.

His strategies center around the idea of the “black swan,” an event that’s incredibly unlikely to happen according to the models but has significant power on the market when it does. He made a great deal of money from betting on these events over the last few decades, leveraging what he saw as the mis-pricing of options in order to generate massive returns.

Finding a Black Swan
Taleb defines a black swan event with three attributes: (1) It’s wholly unpredictable given current models, (2) its effect is powerful, and (3) it is incorporated into models after it happens. You can have a better chance of calculating the likelihood of these events than other traders, but Taleb is emphatic on one point, you cannot predict the black swan and you shouldn’t be trying to.

Betting on a black swan isn’t about trying to predict what’s going to happen next year, it’s about finding bets that are mis-priced because nobody has calculated the odds of them properly. Taleb made his money on options that covered all sorts of low probability thresholds that were eventually crossed, most notably during the 1987 stock market crash.

These events may only happen on average once every hundred years, but if you have a hundred of them, you start to average one a year. The payoff is, at the same time, incredibly high because of the extremely low probability. Balancing a portfolio around this idea can be incredibly lucrative, but it’s not for the lighthearted.

You need a strong background in valuing options in order to make this strategy work but, most importantly, you need to know how to build a portfolio. If you’re investing your own money on long term chances, you may run out of cash before anything has a chance of paying off.

Building a black swan portfolio
There’s no case in which an investor should rely entirely on long-odds high-payoff investments to make his money for him, especially when the odds are so long that they’re impossible to calculate. You need to build a portfolio that can offer a steadier stream of income while you wait for the big bets to pay off, assuming they will, or at least one that ensures you don’t lose all your money.

In order to accomplish this, Taleb advises a portfolio in which 80-90% of the money is put in something extremely safe, with Treasuries being the generic instrument, while the rest of the money is invested in out-of-the-money options that carry ridiculous levels of risk.

This portfolio, which he titled the barbell, means that there is a guaranteed floor. You can’t lose your safe money. At the same time there’s huge upside from that once-in-a-hundred year event. If you aren’t familiar with options, however, or you’re not disciplined in your creation of a portfolio, trying to follow this strategy may be enough to wipe you out completely.

Don’t rely on the black swan
It’s been close to thirty years since Taleb discovered the power of so called out-of-the-money options, and many traders have invested in strategies that mirror his in the intervening years. That has risen the price of options covering the kinds of trades he made his name off of.

He was gifted with the 1987 stock market crash as a demonstration of the power of this idea, but he does not believe that strategy would automatically an ordinary investor, simply because there isn’t enough information to price the risks, and therefore, the mean time to happen, properly.

The bottom line is that this strategy takes a lot of work and involves a lot of risk if mismanaged. The original idea was to hold a tiny portion of your money in options for the long term while keeping the rest in something with a lot of safety.

Many investors go for broke investing in what they believe is a Taleb inspired portfolio, forgetting that he was working for an investment bank, and playing with their money, when he invented the strategy.

There’s still money to be made in this area, and there’s still plenty of mispricing of options going on every single day. You have to know when to buy them, however, how to price them, and know how to build a portfolio around them. If not, your returns are going to look downright bad, and you may spend forever waiting for the black swan.

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A black swan event is a term coined by Nassim Nicholas Taleb and it works as a metaphor that describes an event that comes as a surprise and has major consequences. These kind of events are rare and  its occurrence deviates beyond what is normally expected of a situation and can create substantial damage and chaos. Black Swans without any doubt are extremely difficult to predict, even in a time of sophisticated trading real time, risk management and predictive capital market algorithms.

The Black Swan term sums up what is happening in the hedging volatility of markets after the currency move by the Swiss National Bank and it displays something holistic we perceive at this moment in the world’s fragile and sensitive economy.

This disruptive and influential theory was developed and highlighted by Nassim Nicholas Taleb, a finance professor and former Wall Street trader, in the book with the same name of 2011. This influential concept was drafted, introduced it before in Taleb other 2001 book Fooled By Randomness, which concerned financial events and the power of random events and things that changes the normal trajectory of things.

The pillars of the Black Swan concept can be summarised in these 3 points in Taleb’s words:

1. “The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology.
2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).
3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs.”

Unlike the earlier concepts and philosophical “black swan problem“, the Taleb “black swan theory” refers specially to unexpected events of large magnitude and consequence and their dominant role in history. This theory has become special relevant in the capital markets and trading world where the theory became a Bible for traders and part of the implicit DNA of trading.

Aerial Photo of Davos – the host Alpine City of the World Economic Forum Annual Meetings

Such special and unexpected events, that happen very fast in hawkard circumstance, considered extreme points of no return, or outliers, collectively play vastly larger roles than expected regular occurrences and shift actions and special the players. More technically, in another paper, Taleb describes in the scientific monograph Lectures on Probability and Risk in the Real World: Fat Tails, a more sophisticated mathematically explanation that highlights and translated the black swan problem as “stemming from the use of degenerate metaprobability”.

So yesterday move of the global markets after the Swiss National Bank’s sysmic shock move to stop intervening in its foreign exchange market, has been one of the biggest Black Swans of the last years for traders. Special only after three days the Swiss National Bank, Vice President Jean-Pierre Danthine had defined the Swiss Franc cap a “pillar” of monetary policy.

In these circumstances people and special traders, markets, brokers and investors don’t behave normally special when central banks don’t. This has created a butterfly effect in the global markets with riddle effects still difficult to predict.

This move all comes in the follow up of the European Central Bank big introduction of quantitative easing when it meets Jan. 22 2015. Switzerland is making its home work and somehow surrendering before a critical and polmic wave of post-QE money fleeing the euro that threatens to make a mockery of its currency policy. It’s also in the follow up of the lower oil prices that brings global deflation ever closer.

This move has been affecting the world markets, disrupting even big retail trading players of the industry such as FXCM with its Shares Trading down 85% in Pre-Market Trading and a Massive $225 Million Client Negative Balance Hit Due to CHF Volatility ). IG Group another massive world trading house disclaimed  losses up to £30 Million, Tip of Industry CHF Volatility Losses. And the most radical case Alpari Uk entered in admnistration following up client losses. LCG Group also faced up to $2.5 Million Losses.

To add a more positive note Gain actually generated profit with this black swan Forex Industry black Thursday. Other retail trading players such as Saxo Bank and Mahih FX, CMC Markets, City Index continued with their businesses and trading operations despite the CHF Convulsion. Also IC Markets and Darwinex persisted despite Minimal Losses and Setbacks.

This exceptional market turmoil following up from the Swiss move has created and trickered a series of events and dsiruption and has extended its impact worldwise. Swiss stocks such as Swatch and Nestle fell sharly and in the same path Asian shares dropped with U.S. index futures, while Japanese and Australian government bond yields had record plunges.

This action by the Swiss National Bank taking will put in question the effective strenghts or weakness of the euro polemic currency adventure that started some 15 years ago.

Adding to the chaos coming from Swiss central bank unexpected moves there is the Russian ruble and its weakening economy that continues to lose buying power, and a lot of the big Oligark money that has been flowing into Switzerland from that country. The challenge now is how this will affect more the sensible and fragile Russian economy completely fragilised by the lower and lower prices of cheap oil.

No doubt this move by the Swiss National Bank is a black swan game changer. And its repercussion will probable continue as the ECB continues its path to a massive action that will intensify new actions and potential disruptions. The US economy probably will be the balance in this complex and fragile system.Investors and traders have to be wise at the moment and eventually move their portfolios to solid commodities. This is the case of gold that will be growing its value. Example of that is the move in its the price that keeps its trajectory of 4 month highs. Gold in these occasions is the traditional safe haven out of paper money.

Interesting also that the Swiss Central Bank did this less than some weeks before the global Davos World Economic Forum Annual Meetings – that are host in the Swiss Alpine City.

Be safe and wise if you are trading these days! and beware of the black swans riddle effects in the hedging volatility of the global economy.

Market Place

MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.