Black Swans

What Does Black Swan Mean?
A Black Swan is an event or occurrence that varies from what is generally expected of a situation and which is be extremely difficult to predict.

Black Swan Events were described by Nassim Nicholas Taleb in his 2007 book, The Black Swan. He is a finance professor and former Wall Street trader.

He used “The Black Swan Theory” to explain the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations.

Characteristics of a Black Swan Event

1. The event is a surprise (to the observer).
2. The event has a major impact.
3. After the fact, the event is rationalized by hindsight, as if it had been expected.

Ten Principles for a Black Swan Robust World

Taleb enumerates ten principles for building systems that are robust to Black Swan Events:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.
Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks and hence the most fragile become the biggest.

2. No socialisation of losses and privatisation of gains.
Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant or your financial risks.
Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity.
Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning.
Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.
Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains.
Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs.
Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself.

You can read more about Nassim Nicholas Taleb here.

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Options Trading Strategies

The simmering Sino-US relationships, paroxysms in European bond market and the domestic budget of this fiscal around the corner are the contributors of high volatility in NIFTY.

The latest fuel to burn the superficial bonhomie between the two super powers is the America’s decision to sell Taiwan $6 billion-worth of weaponry. This is playing an active role in bringing the confidence indexes to their all time lows.

Late last month the yield on 10-year government bonds issued by Greece vaulted to 7.1%, which is the highest since the country became EU member. This yield is 400bps more than that on German bunds, which are considered to be the safest investment in EU. The panic abated on 3-Feb, when the European Commission endorsed the Greek government’s plan to cut the deficit to 3% of GDP by 2012. The storm in Greece has compelled many sleepers like Portugal and Spain to wake-up and start preparing for the similar crises in domestic bonds.

Latest updates from Central Statistical Organization (CSO) has although updated the growth estimate to 7.2%, many are skeptical about the numbers because of the negative growth in the agriculture, thanks to the monsoon this year.

Traders of imminent I-banks have started getting the margin calls in their vanilla strategies. ABC Bank didn’t have any prior experience and exposure to the options. They want to enter in options trading and want to profit from the present condition of the Indian market.

All the six traders of the ABC Bank have different opinions on the importance and the outcome of the scenario. Depending on the view of the traders, we have to advice the best strategy for the novice traders of the ABC bank.

Case I:

Trader1: I think despite the bad numbers in agriculture by CSO, the good part is that overall Indian economy will grow at much higher rate (7.2%) than previously expected. I think the budget should be investor-friendly. If I talk about Sino-US relationships, it’s not breaking news. It had been going since 4^th Nov, ’09 the day Obama entered white-house.

You: Tell us something about EU bond market and your overall view in Indian context.

Trader1: According to me, EU bond market squall can be another crisis in the offing if not nipped in a week or so. This may affect Indian stock and bond market. Overall I would say I am conservatively bullish and conservatively bearish, but Congress’ investor-friendly budget as expected would lead the show.

You: From your feedback, the best strategy for you would be buy a call option, but as you are bearish because of EU bonds, I would suggest selling a call option at higher strike price. This strategy is also called Bull Spread.

Case II:

Trader2: My expectations are exactly opposite to what Trader1 thinks on the importance of the events.

You: This means that you think the probability of the EU bonds affecting Indian markets would be more than the impact of budget. For this outlook best suited strategy would be to sell call option at lower strike price and to buy a call option. Bear Spread

Case III:

Trader3: I am interested in short term options and for that period only possible outcome is the budget, which has equal chances of being a good or bad news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty.

You: Buy a call and buy a put at same strike price. Straddle

Case IV:

Trader4: My expectations are same as Trader3, but I don’t want to spend too much money upfront. Moreover the range boundaries which Nifty is going to break are higher than those expected by Trader3.

You: Buy call and put of different strike prices depending on your range boundaries. Strangle

Case V:

Trader5: I am interested in short term options and for that period only possible outcome is the budget, which has more chances of being good news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty. Overall Nifty is going to break the range boundary. There are 90% chances that the broken boundary is going to be the upper one.

You: If you are so much confident about the broken boundary to be the upper boundary, go for Strap strategy. Strap involves buying 2 call options and 1 put option at same strike price.

Case VI:

Trader6: Every year we get a new budget, few years back there were tensions between Middle East and US, now it’s between China and US, few months ago Dubai-world made a new about sovereign debt default, now it’s Greece or any country for that matter. All these so called big news are not going to be very significant unless our market obeys strong market efficient hypothesis. There’s so much of the positive and negative information that it cancels out in the end, only thing that remains is the irrationality and the psychology of the investor. So I think Nifty is going to trade between a range unlike a biotech company about to launch a new drug. So my expectations are that the market would be range bound and don’t want to spend too much upfront.

You: Buy two calls at different strike prices and sell two calls at intermediate strike prices. Butterfly spread.

Download the the excel file:

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Options Trading Strategies

The simmering Sino-US relationships, paroxysms in European bond market and the domestic budget of this fiscal around the corner are the contributors of high volatility in NIFTY.

The latest fuel to burn the superficial bonhomie between the two super powers is the America’s decision to sell Taiwan $6 billion-worth of weaponry. This is playing an active role in bringing the confidence indexes to their all time lows.

Late last month the yield on 10-year government bonds issued by Greece vaulted to 7.1%, which is the highest since the country became EU member. This yield is 400bps more than that on German bunds, which are considered to be the safest investment in EU. The panic abated on 3-Feb, when the European Commission endorsed the Greek government’s plan to cut the deficit to 3% of GDP by 2012. The storm in Greece has compelled many sleepers like Portugal and Spain to wake-up and start preparing for the similar crises in domestic bonds.

Latest updates from Central Statistical Organization (CSO) has although updated the growth estimate to 7.2%, many are skeptical about the numbers because of the negative growth in the agriculture, thanks to the monsoon this year.

Traders of imminent I-banks have started getting the margin calls in their vanilla strategies. ABC Bank didn’t have any prior experience and exposure to the options. They want to enter in options trading and want to profit from the present condition of the Indian market.

All the six traders of the ABC Bank have different opinions on the importance and the outcome of the scenario. Depending on the view of the traders, we have to advice the best strategy for the novice traders of the ABC bank.

Case I:

Trader1: I think despite the bad numbers in agriculture by CSO, the good part is that overall Indian economy will grow at much higher rate (7.2%) than previously expected. I think the budget should be investor-friendly. If I talk about Sino-US relationships, it’s not breaking news. It had been going since 4^th Nov, ’09 the day Obama entered white-house.

You: Tell us something about EU bond market and your overall view in Indian context.

Trader1: According to me, EU bond market squall can be another crisis in the offing if not nipped in a week or so. This may affect Indian stock and bond market. Overall I would say I am conservatively bullish and conservatively bearish, but Congress’ investor-friendly budget as expected would lead the show.

You: From your feedback, the best strategy for you would be buy a call option, but as you are bearish because of EU bonds, I would suggest selling a call option at higher strike price. This strategy is also called Bull Spread.

Case II:

Trader2: My expectations are exactly opposite to what Trader1 thinks on the importance of the events.

You: This means that you think the probability of the EU bonds affecting Indian markets would be more than the impact of budget. For this outlook best suited strategy would be to sell call option at lower strike price and to buy a call option. Bear Spread

Case III:

Trader3: I am interested in short term options and for that period only possible outcome is the budget, which has equal chances of being a good or bad news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty.

You: Buy a call and buy a put at same strike price. Straddle

Case IV:

Trader4: My expectations are same as Trader3, but I don’t want to spend too much money upfront. Moreover the range boundaries which Nifty is going to break are higher than those expected by Trader3.

You: Buy call and put of different strike prices depending on your range boundaries. Strangle

Case V:

Trader5: I am interested in short term options and for that period only possible outcome is the budget, which has more chances of being good news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty. Overall Nifty is going to break the range boundary. There are 90% chances that the broken boundary is going to be the upper one.

You: If you are so much confident about the broken boundary to be the upper boundary, go for Strap strategy. Strap involves buying 2 call options and 1 put option at same strike price.

Case VI:

Trader6: Every year we get a new budget, few years back there were tensions between Middle East and US, now it’s between China and US, few months ago Dubai-world made a new about sovereign debt default, now it’s Greece or any country for that matter. All these so called big news are not going to be very significant unless our market obeys strong market efficient hypothesis. There’s so much of the positive and negative information that it cancels out in the end, only thing that remains is the irrationality and the psychology of the investor. So I think Nifty is going to trade between a range unlike a biotech company about to launch a new drug. So my expectations are that the market would be range bound and don’t want to spend too much upfront.

You: Buy two calls at different strike prices and sell two calls at intermediate strike prices. Butterfly spread.

Download the the excel file:

Related posts:

1. What are Exotic Options / Vanilla Options ? (20.719) What are Exotic Options/ Vanilla Options ?...
2. Effective Asset allocation Techniques (5.946) Effective Asset allocation Techniques...

• See more related articles and free preparation stuff at: The Finance Blog - CFA PRM FRM Certifications