Nassim Nicholas Taleb (Scholar Investor) – Bloomberg Interview (Oct 2017)

Chapters

Abstract

John Doe’s Trading Odyssey: A Tale of Innovation, Intensity, and Insight in Financial Markets

In an era of burgeoning financial markets, Talebemerged as a dynamic figure, navigating the complex terrain of investment strategies, market conditions, and historic market crashes. His journey, marked by a transition from short-term fixed income to the artisanal world of equity options, epitomizes the evolution of trading practices in the late 20th century. Most notably, his experiences during the 1987 stock market crash offer profound insights into the emotional and strategic landscape of high-stakes trading, underscoring the flaws in traditional financial models, the implications of moral hazard, and the unanticipated intensity of market crises. Doe’s narrative, blending personal reflection with critical analysis, reveals the underpinnings of financial markets, the hidden narratives of Black Monday, and the invaluable lessons learned from one of the most tumultuous periods in financial history.

Investment Strategy and Market Conditions

John Doe’s initial foray into the financial world was marked by a focus on short-term fixed income, a strategy influenced by the affordability and popularity of these options. He established a large portfolio in this area, effectively positioning himself as short volatility. He was vulnerable to small market movements, potentially leading to losses, but he stood to gain significantly from substantial market shifts. This strategy allowed him to accumulate options in the tails, offering the potential for significant gains in extreme market conditions.

At the time, the equity options market was relatively small, with low liquidity and depth, unlike the robust fixed income options market. Due to the large number of outstanding bonds, fixed income options were the primary focus of trading activity. Trading equity options was not considered as valuable as fixed income options, leading to limited interest among traders. However, as he transitioned to equity options, Doe embraced the artisanal nature and independence of this field, adapting to the limited liquidity and depth of the stock options market. This shift illustrated the broader market landscape where fixed income options were dominant, but equity options were beginning to gain traction.

The 1987 Stock Market Crash: A Crucible of Insight

The 1987 stock market crash served as a pivotal moment in Doe’s career, where his intense focus mirrored the heightened concentration found in high-pressure scenarios, akin to Roman legions in battle. This period revealed the flaws in established financial models like the Black Scholes option model, particularly in their failure to predict extreme market events. Early on October 19, 1987, Doe noticed unusual market activity, with prices plummeting and volatility spiking. He recalls someone mentioning the rarity of such extreme events, known as “six sigmas.” As the market crash unfolded, Doe realized that traditional financial models and theories, such as the Black-Scholes option model, were inadequate in explaining the extreme market behavior. He felt vindicated in his belief that these models were flawed.

Doe’s experiences during the crash, from the emotional turmoil to the strategic vindication, underscored the importance of anticipating large market movements and recognizing the moral hazard embedded in the financial system. He discusses the concept of moral hazard in the financial system, which began in the early 1980s with the nationalization of Continental Illinois and the subsequent bailouts of financial institutions. He criticized the Fed’s actions during the crash, particularly the decision to provide unlimited liquidity, which he believed perpetuated moral hazard and eventually led to the 2008 financial crisis.

Trading Dynamics and Compensation

Doe’s trading intensity during this era was characterized by a fast-paced environment and strategic agility. Doe vividly recalls trading on Black Monday, using 15 phones and 200 screens to communicate with various markets. He mentions a memorable incident involving Richard Dennis, a famous trader who went bankrupt that day due to a trend in Eurodollars. His role at First Boston, albeit within a communist-like system of profit sharing, highlighted the nuances of compensation in trading, where nominal positions and substantial payoffs defined success.

Doe recalls the panic that ensued after Black Monday, emphasizing that during the event, traders were solely focused on the task and did not fully grasp the extent of their injuries or losses until afterward. He discusses the concept of nominal positions, which refers to the accumulation of tiny options. He mentions that his P&L at the time would be considered substantial in today’s terms, but compensation was significantly lower back then.

The collapse of Richard Dennis’ fund and the volatility in currency markets further illustrated the complex dynamics Doe navigated, capitalizing on opportunities in less obvious markets like Eurodollars and yen. He highlights the significant volatility in currency markets during Black Monday, particularly in lesser-known currencies like Eurodollars and yen. He notes that the big payoffs were not in the main currencies but in those where the movement was unexpected.

Lessons from Black Monday

Black Monday was not just a day of market turmoil for Doe; it was an epiphany that shaped his future strategies. The unexpected nature of financial markets, the high volatility, and the inadequacy of regular models in predicting black swan events became apparent. Doe suggests that the focus on the stock market during Black Monday overshadows the significant action that took place in the fixed income and currency markets. He attributes this to the fact that these markets are dominated by professionals who are less likely to discuss their experiences publicly.

This crisis illuminated the ergodic problem in financial markets, where a single catastrophic event can erase accumulated gains, emphasizing the necessity of robust risk management strategies. Doe reflects on the systemic issues in risk management post-Black Monday. The tendency to focus on past deviations led to an underestimation of extreme events. The emergence of extreme value theory addressed these limitations, but the problem of socialized losses and moral hazard persisted, as exemplified by traders receiving bonuses despite incurring significant losses. This period highlighted the flawed nature of regular models during extraordinary events and the societal inclination to accept these models despite their limitations.

Conclusion

John Doe’s journey through the financial markets of the late 20th century offers a multifaceted perspective on trading, strategy, and risk management. His experiences during the 1987 stock market crash serve as a testament to the emotional depth and strategic acumen required in high-stakes trading. As an emblem of innovation and resilience, Doe’s account sheds light on the intricate dynamics of financial markets, offering invaluable lessons for understanding market behavior and the critical role of regulators in safeguarding against future crises.

Notes by: Simurgh