Musings on Entrepreneurship and Innovation
Sunday, July 02, 2006My Life as an Options Trader
I haven't had a real job since I left the banking business more than 15 years ago. Since then, it's been a rare week that a well-meaning friend hasn't asked me whether my (then current) business venture was "making money." Nassim Nicholas Taleb has provided me with a good reply:
The best description of my lifelong business in the market is "skewed bets," that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) give me some form of advantage.
My EIP partners and I are in the business of losing money almost every day - possibly for years - in order to have a reasoned chance to win big.
Visibly, the statistic that 90% of all option positions lost money is meaningless (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%. If we make 50 times our bet on average when the option is in the money, then I can safely make the statement that buying options is another way to go to the palazzo rather than the poorhouse.
In other words, we view the uncertainty that defines the large-scale adoption of consumer products as a source of opportunity:
- "In the U.S. packaged goods industry, for instance, companies introduce 30,000 products every year, but 70% to 90% of them don't stay on the market for more than 12 months...According to one study, 47% of first movers have failed, meaning that approximately half the companies that pioneered new product categories later pulled of of those businesses." Eager Sellers and Stony Buyers
- "A review of of academic studies and U.S. census data found that on average about 75% of new businesses, products, or services fail and are discontinued within two to five years." Jump Start Your Business Brain
Like Taleb, we believe that most people behave as though market outcomes are distributed normally rather than according to a power law or other scale-free distribution. As a consequence, they tend to underestimate uncertainty, which translates into over-valued long positions and under-valued call options. [1] Our strategy is straightforward enough:
- Cultivate a portfolio of real call options, the right, but not the obligation, to invest in consumer product inventions that have mass market potential.
- Improve the chances of success at the lowest possible cost.
- Beware of "optimizing" the product. That is, avoid the temptation to take a long position in a "sure bet." The world is more uncertain than we'd like to think.
Like many strategies, it's easy to describe, but hard to execute. Per Taleb:
It requires some strength of character to accept the expectation of bleeding a little, losing pennies on a steady basis even if the strategy is bound to be profitable over longer periods. I noted that very few option traders can maintain what I call a "long volatility" position, namely a position that will most likely lose a small quantity of money at expiration, but is expected to make money in the long run because of occasional spurts. I discovered very few people who accepted losing $1 for most expirations and making $10 once in a while, even if the game were fair (i.e., they made the $10 more than 9.1% of the time).
Taleb's recipe for success:
My lesson...is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.
Given the fact that each of us at EIP hold an MBA, Taleb might be skeptical of our chances for success:
MBAs tend to blow up in financial markets, as they are trained to simplify matters a couple of steps beyond their requirement.
Optimistically, I'm hoping that we have made sufficient progress in our attempts to re-learn how to learn.
[1] Who makes more, on average: entrepreneurs or VCs? Who owns common stock (a long position), and who owns convertible preferred stock (an option)?
