Your point is taken, but how about another reason that Empirica could fail.The strategy may well be simply wrong.Taleb is right that a lot of people underestimate the probability of a large move.But they are not necessarily the ones making the prices in the options. He is alsoimplicitly very confident that he can value these teeny options better than everyone else,or at least the niederhoffers of the world that are selling them to him.this all ignores the costs in these options which are considerable.If he really had " a robust way to estimate value", then his returns should probably be a lot better.

No trader tells himself, I'm going to figure out exactly what strategy will sell the best, and start a hedge fund. Rather, traders brainstorm what strategy they think will perform the best, arising from the constraints of their limited experience. Then, of those traders, the one whose strategy sells the best, starts a hedge fund. Environmental factors are channeled through both traders, and clients, in their decisions! >>My experience is the opposite. Everyone sits around wondering what kind of strategy will sell. Moreover, the strategy is one small part of the marketing effort, like the color of the box of a new breakfast cereal. LTCM had a ton of money to play with due to their 100 to 1 leverage, not its success in getting equity investors. And its success in getting equity investors had everything to do with contacts, maybe a little to do with names and almost nothing to do with strategy.There are two senses in which LTCM failed. It lost a ton of money between May and August 1998. That had nothing to do with being too big, or trusting VaR too much or liquidity. The fund picked the losing side of bets. If LCTM had been given the credit to stay independent, as it wished, it would have have still been finished. It would have reported huge losses for the year, lost most of its equity investors and all of its lenders. I get tired of LTCM apologists overlooking the string of losses, which prove to me that its successes in prior years were mostly luck.The second sense in which LTCM failed is the banks took it over in September 1998. I grant you that was the result of growing too fast, having too much leverage, seeing liquidity dry up when it needed to trade to survive and putting too much trust in models. A conservatively managed LTCM would have survived the year, but no one would have cared. It would not have been open for business in 1999.

Everyone sits around wondering what kind of strategy will sell. >>This is frighteningly true - and I lay the blame firmly at the door of the prime brokerage marketing teams. I have lost count of the number of wannabe funds that have had interesting (if somewhat wild) potential strategies, but have been blended into an anaemic "15-20% target return, lower than market vol, net market exposure plus/minus 20%" format post a visit to their new prime broker. Because that's what is selling at the moment, and it is selling because that has been an attractive strategy over the past couple of years. Investors are once again chasing the last battle.Which brings me to Empirica, or rather Empirica-esque strategies. Investors are tired of backing the guy who's short the tails - they've learnt the hard way that this looks good for a while until it all goes horribly pear-shaped. So now they're trying to invest with the guys who are long the tail, on the grounds that this would have been a sensible investment previously - voila, we're chasing the last battle again. It never fails to amaze me the way that 99.99% of investors (especially at the institutional level) drive with both eyes on the rear mirror.My fear is that investors will once again get burnt as the rush for Empirica-type exposure gains momentum - what I don't know is whether they will lose their money in one big LTCM style event, or whether they will bleed away and finally learn that they paid too much for their tail insurance.Phew, I don't usually go off like that - must be MP's influence

yuka, interesting post, and mainly true. the out of the money puts are rich, for a reason.hari

<< My fear is that investors will once again get burnt as the rush for Empirica-type exposure gains momentum - what I don't know is whether they will lose their money in one big LTCM style event, or whether they will bleed away and finally learn that they paid too much for their tail insurance.q]depends largely on what sort of leverage they are employing. if you pay for your options up front, yourdownside is capped and you will bleed slowly. If you are trading on margin then an implied volatility move against youcan blow out a long player as easily as a short. Two myths1. you can't go broke being long options. I know several people who have.2. market makers are short options. In fact most of the ones I know are typically long the wings. (a major reason why wings are expensive looking. this is exactly the same reason that bookies don't give fair odds on outsiders at the track).

I must say, remarkable post Yuka, as well candid. Admittedly, we don't see much of this here. << I also get tired of people who overlook how the performance of strategies is not absolute, but dependent on popularity, evolution, and correlated factors. It was not luck that the strategy did and didn't work when it did and didn't work. Of course nothing in the universe is "luck" in this sense. But I am just wondering whether it is possible to trace and manage the factors which manifest themselves. >>I wholeheartedly agree on this point, people are overlooking the performance of the strategies and delving into its popularity, evolution, and cutting-edge technology, just to name few. However, an absolute function contains the strategy, as well the decision-making procedure, all together. In other words, the classical view of an objective strategy (i. e. returns, complexity, etc.) as it is and independent of the choice of how it is observed, in my humble opinion, this observation should be no longer valid. We cannot make a meaningful forecast of the ROI directly, using such and such strategies. But, indirect forecasting through various measurements are fairly possible, and can be predicted probabilistically. By the words "indirect forecasting", I mean focusing on the evolution and surviving of the people who run the process rather than focus on the ROI, the strategy, etc. The story of Richard Dennis and the turtles is probably an excellent illustration of a living contrarian. , Dennis preferred to invest his own funds according to his contrary principles such as, picking those who had the proper perception of decision-making process in dynamic environments. Furthermore, there are many potential traders out there with vast amount of zeal and enthusiasm, however, lack the mental expertise to deal with proper decisions in dynamics markets environment. Long ago, I once responded here that I ultimately prefer to invest in people, and not in complex software and neither black-box strategies solely limited by the developer/producer. Again, this is my personal preference thoug<< I perfected that old mind-reading strategy by studying inexperienced rock climbers from the top of a cliff. >> I know exactly what you had in mind MP, but sadly enough, another SM had argued: "it is not for mortals" (And in this sense, Martingale might remark: "off topic")

I must say, remarkable post Yuka, as well candid. Admittedly, we don't see much of this here. <img src="i/expressions/face-icon-small-wink.gif" border="0"> >>Thanks David. I was maybe a little harsh on prime brokerage - if there are any PBs on the site, sorry guys - you do a good job reflecting the demands of institutional investors (but don't get me stated on them )

<<A conservatively managed LTCM would have survived the year, but no one would have cared. It would not have been open for business in 1999. >>Although Scholes (Oakhill) and Hawkins McEntee (?) and Meriwether himself (JWM) seem to have been able to raise some more...

Scholes (Oakhill) and Hawkins McEntee (?) and Meriwether himself (JWM) seem to have been able to raise some more... >>Yeah, better to have failed spectacularly than never to have been trusted in the first place. Plus, LTCM sold a lot of people on the story that their trades won, the banks just took them over before LTCM could collect the winnings.But I don't mean to say that the people involved with LTCM were stupid. They were among the smartest investors around. But smart or dumb, the market can humble you. No one should get 100 to 1 leverage.