The coronavirus pandemic reminded even the most resolute of optimists that things can go horribly wrong when you least expect it. But that reality has made some fund managers quite wealthy. In this intriguing look at “black swan” investing, journalist Scott Patterson offers valuable insights into this pessimistic brand of trading. Black-swan traders don’t try to forecast crashes or predict crises; they just assume that one is always lurking around the corner. Then, when disaster does strikes, the traders reap huge rewards. Patterson provides readers an engaging overview of the broad theory and telling details about this niche in investing for calamity.
- The coronavirus pandemic underscored the appeal of “black swan” investing strategies.
- Market crashes and political chaos are growing more common.
- Mark Spitznagel learned trading discipline at a commodities exchange.
- Like Spitznagel, Nassim Taleb cut his teeth as a trader.
- Taleb cultivated a contrarian profile.
- Before the pandemic, Universa Investments struggled to land investors.
- The pandemic proved that an always-pessimistic portfolio offers downside risk protection.
- Taleb saw bitcoin as useless in protecting against black swans.
The coronavirus pandemic underscored the appeal of “black swan” investing strategies.
In investing jargon, a black swan is an unexpected event that creates volatility. The concept was popularized by Nassim Taleb, a trader, mathematician and author who wrote a hit book about the topic. Taleb’s main thrusts were that unknown threats lurk at all times and that investors should be prepared. Such an event occurred in early 2020: In January, a nasty new contagion in China grabbed headlines. By March, the pandemic had spread, creating a bona fide black swan. That was good news for Universa, a Miami investment firm that operates the Black Swan Protection Protocol Fund. The fund, run by Mark Spitznagel, had done well in the 2008 financial crisis and in subsequent periods of volatility, such as the Flash Crash of 2010. By the end of March 2020, Universa’s fund reported a gain of 4,144% in three months – a $50 million bet had ballooned to $3 billion.
“The returns were so astronomical some experts were skeptical. Some said the returns were impossible.”
The massive win drew disbelief across Wall Street. Rivals said Universa’s returns simply couldn’t have been that high. But Spitznagel argued that the returns proved the value of his Black Swan Protection Protocol as an insurance policy. The fund’s strategy was to constantly buy put options that would lose small amounts of money at most times but that would generate outsized profits in case of a crash. Universa didn’t try to time the market or forecast crashes. Instead, it was always in a position to make money in a market downturn. Of course, the coronavirus market bust quickly reversed itself, as the Federal Reserve and large governments pumped liquidity into markets. To Spitznagel, that sort of response simply sets the stage for future black swans.
Market crashes and political chaos are growing more common.
An era of instant communication and porous borders creates a treacherous breeding ground for everything from conspiracy theories to contagions. An infection in a resident of Wuhan, China, shocked the world and led to millions of deaths. A cellphone video of a man being murdered by a police officer in Minneapolis, Minnesota, sparked global protests about racial justice. After the 2020 election, the baseless arguments of Donald Trump mushroomed into an assault on the foundations of US democracy. Russian president Vladimir Putin brought the world to the brink of global war.
“As globalization expands, connectivity accelerates. Complexity breeds complexity, and speed breeds speed. Social networks spread news – and conspiracy theories – like a virus.”
The age of rapid communication and global trade creates new levels of risk. The pandemic-era disruptions to the supply chain illustrated the fallout from seemingly far-off risks. And those aren’t the only threats facing the world. Climate change, for instance, is leading to ever more dangerous bouts of extreme weather – hotter heat waves, longer droughts, more damaging wildfires, and more intense hurricanes and typhoons. The climate chaos is affecting the calculus of both property owners and property insurers. Political extremism is also on the rise, as evidenced by the US electorate’s vast and dramatic mood swings. The left-leaning Barack Obama was replaced by the norm-smashing Trump, who was defeated by a candidate running as the anti-Trump. A British historian says the world now exists in “polycrisis,” a state characterized by uncertainty, instability and dangerous feedback loops that serve only to magnify and propel the chaos.
Mark Spitznagel learned trading discipline at a commodities exchange.
As a teen in the 1980s, Mark Spitznagel identified with the Family Ties TV character Alex Keaton, a conservative son of liberal parents. Spitznagel was enthralled by his visit to the Chicago Board of Trade (CBOT), and he began working for the corn trader Everett Klipp. A star trader, Klipp taught Spitznagel his counterintuitive strategy: “You have to love to lose money and hate to make money.” Klipp’s approach was all about discipline – as soon as a trade started to lose money, a trader had to sell. If traders bailed as soon as a trade went the wrong way, they’d never lose a significant sum. Everyone thought they could predict the market, but Klipp resisted that temptation.
“He [Spitznagel] never held onto a position after it took a small loss, which meant he was never at risk of losing everything.”
Spitznagel became a trader on the CBOT at age 22, trading his own money and focusing on Treasury bonds. He was on the floor for the bond crash of 1994, spurred after Federal Reserve chair Alan Greenspan jacked up interest rates aggressively. In the ensuing chaos, California’s Orange County went into bankruptcy. Spitznagel survived, thanks to the teachings of Klipp. While star traders went broke by doubling down on losing bets, Spitznagel stuck with the program and never held on to a losing position. As machines replaced humans in the trading pits, Spitznagel switched his focus to a hedging strategy. His positions performed well, first during the Asian crisis of 1997 and again in the 1998 blowup of Long Term Capital Management.
Like Spitznagel, Nassim Taleb cut his teeth as a trader.
Taleb grew up in war-torn Beirut and then moved to the United States. After studying at the Wharton School at the University of Pennsylvania, he became a Wall Street trader. In 1985, his small position in currency options soared from $500 to $2 million. While working as a trader on Black Monday in October 1987, Taleb held a number of out-of-the-money positions in eurodollars. As the Fed moved to rescue markets the day after the crash, Taleb’s positions soared in value. Contracts that had cost him just $2 or $3 each were now worth as much as $500. A few years later, Taleb was diagnosed with throat cancer – even though he was young and had never smoked. These improbable experiences led him to ruminate on the risks and rewards of unlikely events.
“Taleb was impressed that a meathead pit trader would be interested in mathematical finance and thought he’d be an ideal partner at his new fund.”
In the early 1990s, Taleb had a stint on the Chicago Mercantile Exchange, and he was struck by the sheer animal behavior he witnessed there – the fear, the greed, the angry trader who choked Taleb with both hands for unwittingly standing in the wrong spot in the trading pit. Along the way, Taleb earned a doctorate in mathematics from the University of Paris-Dauphine, and he grew skeptical of Wall Street’s theories of financial engineering. In the late 1990s, Taleb was launching a fund in Greenwich, Connecticut, when he met Spitznagel. The two hit it off and decided to go into business together. Their new venture mostly stuck to Spitznagel’s discipline, which meant it lost small amounts of money most of the time but then performed extravagantly during volatile episodes. Spitznagel compared the fund to a pianist who could barely play Chopsticks suddenly firing off Rachmaninoff. Their firm, Empirica Capital, could have hugely profited after the September 11, 2001, attacks, but clients were reluctant to gain from a crisis that had hit so close to home.
Taleb cultivated a contrarian profile.
Taleb’s 2001 book Fooled by Randomness gained media attention, and he appeared on CNBC and other outlets. About that time, Taleb met Benoit Mandelbrot, a French mathematician who was drawing connections between fractal geometry and markets. Author Malcolm Gladwell profiled Taleb in the New Yorker. But even as Taleb’s media profile was rising, Empirica was losing money in a market devoid of volatility. Taleb took the poor performance to heart, despite Spitznagel’s attempts to placate him. Taleb couldn’t stomach the daily losses, and in 2004 he told Spitznagel he needed to leave the firm. After departing, Taleb went on to write The Black Swan. Spitznagel, meanwhile, launched Universa, but he found little interest from investors, most of whom were wedded to Modern Portfolio Theory and had no use for a contrarian strategy. Investors had largely migrated away from stock picking and fancy strategies, opting instead to buy index investments.
“Tail risk? Options? Black Swans? Blank stares. It was as if they were speaking a foreign language.”
One obvious challenge was the benchmarking used by investors and fund managers. Chief investment officers didn’t really care if their portfolios lost 10% in a market correction – so long as their competitors and the index against which they were measured lost a similar amount. Despite skepticism of the model, when Taleb’s book The Black Swan was published in early 2007, it quickly became a runaway bestseller. When the stock market crash began in earnest in 2008, Universa suddenly became extremely profitable. The Black Swan Protection Protocol was built to profit if stocks plunged more than 20% in a month, and that was exactly what happened. In those early months of the crash, Universa made $1 billion, and money flooded into the fund. Universa outperformed the market by a wide margin, making a 115% gain in 2008, compared to a 39% decline for the S&P 500. Other contrarians, like John Paulson and Michael Burry, did well in the crash, but their profits came from specific bets against the housing market, rather than Universa’s larger bet against the overall market. In other words, Universa could replicate its gains in the future, no matter what would cause the next market meltdown.
Before the pandemic, Universa Investments struggled to land investors.
As stocks recovered after the Great Recession, Universa again struggled to woo investors. In 2017, Universa landed a $1.5 billion investment from the California Public Employees Retirement System (CalPERS), the nation’s largest pension fund. In February 2018, a crash known as Volmageddon hit, and Universa profited handsomely. CalPERS ramped up its investment to $5 billion, and the public pension talked about putting even more into Universa. But then, in 2019, a CalPERS executive who had been a proponent of the Universa strategy resigned, and CalPERS began unwinding its holdings with Universa. CalPERS was the fund’s largest client, and it closed out its investment with Universa just before the coronavirus first appeared in Wuhan, China.
“Volatility was near record lows, aided by the Fed’s seemingly bottomless punch bowl stimulus.”
As the pandemic took hold in China, Taleb quickly grew worried, but most investors remained sanguine. In February 2020, the VIX index of investor angst flirted with an all-time low. Universa did manage to recruit a couple of new clients who were troubled about the reports from China. Universa was able to snap up S&P 500 puts and VIX call options on the cheap. After all, no one thought there’d be a need for lockdowns and border closures when stocks were rising to record heights.
The pandemic proved that an always-pessimistic portfolio offered downside risk protection.
Spitznagel went on Bloomberg Television on February 24, 2020, and the anchor asked if the coronavirus contagion was a black swan. Spitznagel answered that he wasn’t sure, and he summed up the strategy of Universa as providing protection against threats that rarely materialize. “There usually aren’t monsters hiding under the bed. And sometimes there are,” he said.
“CalPERS had likely given up $2 billion to $3 billion in gains by dumping Universa with historically bad timing.”
The short bout of COVID-induced volatility made Spitznagel a hot commodity. While massive stimulus quickly reversed the coronavirus market crash, Universa had shown on a grand stage that its hedging strategy worked. Forbes estimated Spitznagel’s wealth at $250 million. The Wall Street Journal labeled him a “hedge fund star.” Perhaps most tellingly, CalPERS’s ill-timed decision to pull its money from Universa just before the crash led to internal bickering at the fund. By the end of 2021, Spitznagel’s assets under management had soared to $16 billion, up from $4 billion before the pandemic.
Taleb saw bitcoin as useless in protecting against black swans.
In 2021, Taleb made a splash on Wall Street with his argument that bitcoin was worthless. While the cryptocurrency reached an all-time high of $67,801 in late 2021, it crashed in 2022 as the Federal Reserve began an aggressive campaign of interest rate hikes. The crypto craze peaked with the 2022 Super Bowl, which featured ads for FTX Trading and other crypto exchanges. Taleb argued that, in contrast to gold and other precious metals, bitcoin had no intrinsic worth; to maintain its value, bitcoin needed the constant attention of bitcoin miners. What’s more, Taleb noted, bitcoin had fallen harder than the overall market during the crash of March 2020. FTX, meanwhile, soon collapsed.
“It was hard to keep grinning when you feared Black Swans lurked in the shadows.”
Even as crypto cratered, stock investors were riding high. The Dow Jones Industrial Average had touched 36,000 for the first time. Still, geopolitical minefields lurked: Relations between the United States and China had soured, and Russia launched its ill-considered invasion of Ukraine. Putin’s war seemed to be yet another black swan – the world knew Putin was a strongman but had looked past his vicious wars in Syria and Chechnya until it could no longer ignore his true nature. Meanwhile, Taleb had met Ukraine president Volodymyr Zelenskyy before the war and remained unimpressed: In Taleb’s reckoning, the former TV star seemed overmatched. He had to acknowledge misreading the situation, which marked yet another episode of real-life events running counter to conventional wisdom.
About the Author
Scott Patterson has been a financial reporter for more than two decades, mostly at The Wall Street Journal. He is the author of The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It and Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System.
Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis by Scott Patterson is a gripping exploration of the world of Wall Street trading during times of financial turmoil. In this book, Patterson delves into the strategies and tactics employed by traders to profit from chaos and uncertainty in the markets.
Patterson begins by setting the stage, providing an overview of historical financial crises and their impact on the global economy. He then delves into the mindset of successful traders who thrive in these volatile environments, highlighting their ability to identify opportunities amidst chaos and make significant profits.
The book is structured around key events and crises, such as the 2008 financial crisis and the flash crash of 2010. Patterson takes readers behind the scenes, providing a detailed account of how traders navigated these turbulent times and capitalized on market disarray.
One of the notable strengths of Chaos Kings is the in-depth analysis of trading strategies used during crises. Patterson explores various approaches, from high-frequency trading algorithms to contrarian investing and risk arbitrage. He explains the rationale behind these strategies and provides insights into how traders adapt their tactics to exploit market inefficiencies.
Patterson also delves into the psychology of traders, examining the pressures they face and the psychological resilience required to succeed in high-stakes trading environments. He sheds light on the intense competition, the constant need for adaptation, and the emotional rollercoaster experienced by traders during periods of crisis.
Furthermore, the book touches upon the ethical implications of profiting from financial crises. Patterson raises thought-provoking questions about the role of Wall Street traders in exacerbating market volatility and the potential consequences for society as a whole.
Chaos Kings is a well-researched and engaging book that provides readers with a fascinating glimpse into the world of Wall Street trading during times of crisis. Patterson’s writing style is accessible and he effectively balances technical explanations with real-life stories and anecdotes, making the content relatable and compelling.
However, it is important to note that the book focuses primarily on the experiences and perspectives of traders, and may not provide a comprehensive analysis of the broader economic and societal impacts of financial crises.
In conclusion, Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis offers valuable insights into the strategies, mindset, and dynamics of Wall Street traders during turbulent times. It is a must-read for anyone interested in understanding the inner workings of the financial markets and the individuals who thrive in times of chaos.
- The book explores the strategies and tactics employed by Wall Street traders during financial crises.
- Provides detailed accounts of key events and market disarray, such as the 2008 financial crisis and the flash crash of 2010.
- Analyzes various trading strategies, from high-frequency trading algorithms to contrarian investing and risk arbitrage.
- Examines the psychology of traders and the pressures they face in high-stakes trading environments.
- Raises ethical questions about the role of traders in exacerbating market volatility.
- Well-researched and engaging, with a balanced mix of technical explanations and real-life stories.
- Offers valuable insights into the world of Wall Street trading during times of crisis.
Here are some of the pros and cons of the book:
- Well-written and informative
- Provides a fascinating look at the new world of risk
- Full of insights and analysis
- Some of the technical details may be too complex for some readers
- The book can be slow-paced at times
Overall, I highly recommend the book Chaos Kings to anyone who is interested in learning more about the new world of risk. The book is not for everyone, but it is a valuable resource for those who are willing to put in the effort to learn from it.
Here are some additional thoughts on the book:
- I appreciate that Patterson provides a clear and concise explanation of the new world of risk. This makes it easy to understand the concept and start thinking about how it affects you and your investments.
- I also appreciate that Patterson profiles some of the most successful Chaos Kings. This gives you a real-world example of how these strategies can be used to make money.
- I think the book is most helpful for people who are already invested in the stock market or who are considering investing. It can help you to understand the risks that you face and how you can better manage them.
If you are interested in learning more about the new world of risk, I highly recommend reading Chaos Kings.