A winning strategy in a volitile market

Bloomberg:

Investors advised by ``Black Swan'' author Nassim Taleb have gained 50 percent or more this year as his strategies for navigating big swings in share prices paid off amid the worst stock market in seven decades.

Universa Investments LP, the Santa Monica, California-based firm where Taleb is an adviser, has about $1 billion in accounts managed to hedge clients against big moves in financial markets. Returns for the year through Oct. 10 ranged as high as 110 percent, according to investor documents. The Standard & Poor's 500 Index lost 39 percent in the same period.

``I am very sad to be vindicated,'' Taleb said today in an interview in London. ``I don't care about the money. We're proud we protected our investors.''

Taleb's book argues that history is littered with high- impact rare events known in quantitative finance as ``fat tails.'' As the founder of New York-based Empirica LLC, a hedge- fund firm he ran for six years before closing it in 2004, Taleb built a strategy based on options trading to bullet-proof investors from market blowups while profiting from big rallies.

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Taleb's strategy is based on buying out-of-the-money options -- puts and calls whose strike price is either lower or higher than the market price of the underlying security. A put option gives the buyer the right, though not the obligation, to sell a specific quantity of a particular security by a set date. A call option gives the right to buy a security.

The Black Swan Protection Protocol bought puts and calls on a portfolio of stocks and S&P 500 Index futures, along with some European shares. The Black Swan Protocol doesn't rely on commodities, currencies or insurance on bonds known as credit default swaps, Taleb said.

``We refused to touch credit default swaps,'' Taleb said. ``It would be like buying insurance on the Titanic from someone on the Titanic.''

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Buying both puts and calls in a volatile market can result in significant profit. If there is enough time left on the options it is sometimes possible for both to be profitable because of the swings of the market. His original strategy appears to be based on limiting losses in a market going in one direction, but lately he has been in that five to ten percent cycle of profitability.