A black swan event has three salient features a) it is a surprise for the observer b) it has a major effect and c) it is rationalized and made obvious after the event with the benefit of hindsight. The black swan event was a term coined by Nassim Taleb in the book “The Black Swan.”
For example, the attacks of Sept. 11, 2001, were a black swan event for most of the world. They were a major surprise, had major economic and financial impact on the U.S. and were “explained” in hindsight as something which was waiting to happen.
Not all black swans are as dire as 9/11. There are positive black swans too. For example, discovering penicillin was a positive black swan for Alexander Fleming.
A New Way of Looking at Options
I was of the opinion that buying calls is a very risky strategy and is akin to gambling. I thought that selling puts of stocks you want to own is a good and safe strategy. For example, McDonald (NYSE:MCD)’s is at its 52-week low. I still find the stock to be a bit expensive. I can justify paying $75 for the stock but it sells for $85. So, it makes sense for me to sell a January 2014 $80 put for $5.80.
Taleb offers a different viewpoint. He says that selling puts is like picking up coins in front of a bulldozer. The upside is limited but the downside is quite large. In the above case, the best we can hope for is the upside of $5.80. The downside on the other hand is comparatively quite large at $75. We know that McDonald’s is not going to $0 anytime soon but the worst case is still $75.
On the other hand, consider the following scenario. You can buy a January 2014 $10 call option of Dell (NASDAQ:DELL) for $1.17. The downside is $1.17, in case Dell stays below $11.17 until January 2014. But the upside is unlimited. If Dell recovered to its 52-week high, then you might expect to make $7.19 ($18.36 to $10-$1.17). So an investment of $117 can end up returning $836 in the next 12 months. This is a return of 715%.
Notice the asymmetry. If you make six such bets (worth 6 x $117 = $702) and you lose all but one, making $836, you still end up with a return of 19% for the year.
Buying puts, similarly, can be a way to collect positive black swans.
The example of Dell call options is not strictly a black swan event according to our definition. I hope the idea is clear nevertheless.
Taleb calls this “dumbbell investing.” You put 85% of your money in an ultra-safe investment (Treasuries for example). The rest of the money can be spent on making deals like buying Dell call options.
You put the 85% money in safe investment because even if you lose the 15% of your investment, you are still alive to make deals in the future. The idea is to keep collecting “positive black swans” and be alive to see another day.
Something very important to discuss is the emotional pain associated with this strategy. You might win a few but you will lose most of your bets. Furthermore, each day your portfolio will most probably decline in value.
The return of your portfolio is based on using a black swan event. These events do not occur that frequently. When they do occur you will win quite big. Probably enough to retire on. But in the meantime you have to go through the stress associated with seeing your portfolio in the red, day in day out.
This strategy is not for everyone. You need to be able to handle the stress. You need to wait and you need to believe in your strategy for a really really long time.
I can say for sure that even if I see the positives associated with the dumbbell philosophy, it is not for me.
I would rather just buy a few Dell call options at the moment and increase my chances of benefiting from positive surprises.