Bullish or Bearish?

Nassim Nicholas Taleb is a famous writer and statistician as well as a former financial trader and hedge fund manager. Many of his books are bestsellers which are praised by well-known figures in the business world (e.g. Gladwell, 2002), and one of them was even picked by the Sunday Times as “one of the best twelve books since the Second World War” (Appleyard, 2009). In the first book, Fooled by Randomness (Taleb, 2005), Taleb shared a story which shaped his entire philosophy of investing.

When Taleb was working for a large investment house in New York, he was occasionally subjected to the harrying weekly “discussion meeting” which gathered most professionals of the New York trading room. He was not fond of such gatherings as it was mostly a forum for salespeople and “strategists” who make pronouncements based on rhetoric rather than testable facts. He thought the whole thing was a “pure intellectual pollution” as he was simply not interested in the views of most others in the room.

Taleb was once asked in one of those meetings to express his views on the stock market. He said he believed that the market would go slightly up over the next week with a high probability of 70%. Clearly, that was a very strong opinion, but then a strategist interjected, “But, Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market would go down. What made you change your mind?” 

Taleb answered, “I did not change my mind! I have a lot of faith in my bet! As a matter of fact, I now feel like selling even more!”

The other employees in the room seemed utterly confused. “Are you bullish, or are you bearish?” the strategist asked Taleb. 

Taleb replied that he could not understand the words “bullish” and “bearish” outside of their purely zoological consideration. His opinion was that the market was more likely to go up, but that it was preferable to short it, because even though the market has a higher chance to go up, it would not go up too much, but in the event of going down, it could go down a lot. 

Suddenly, the few traders in the room understood his opinion and started voicing similar opinions, i.e. even though the market is more likely to go up, it is preferable to short it because the larger potential reward. It was not the kind of thing which those salespeople and strategists had ever thought about. And strangely enough, after this brilliant lecture on probabilistic thinking, Taleb was not forced to come back to the meeting again.

Let us assume Taleb was right, and the market over the next week had a 70% probability of going up and 30% probability of going down. However, also let us say you can only make $1,000 if it goes up, but $10,000 if it goes down. What would you do if you are a trader? 

Let us do some calculation. If the probability of going up is 70% and the average gain is $1,000, then the expectancy of going long will be: 70% x $1,000 = $700. 

Similarly, on the other hand, if the probability of going up is 30% and the average gain is $10,000, then the expectancy of going short will be: 30% x $10,000 = $3,000

In which case, probabilistically, the favour of going short far outweighs that of going long by: $30,000/$7,000 = 4.29 times. It is much preferable to go short.

Do you consider yourself “bullish” or “bearish” in this case? We are often flooded with meaningless concepts like “bullish” and “bearish” which refer to the general likelihood of higher or lower prices in the financial markets. However, without considering the actual magnitude of gain in either direction, those terms are often hollow words with no application, especially if you are a trader who has to make a living out of a largely random world.

REFERENCE:
Appleyard, B. (2009, Jul 19). Books that Helped to Change the World. The Sunday Times.
Gladwell, M. (2002, Apr 22). Blowing Up. Retrieved on 1 Sep 2016 from: http://gladwell.com/blowing-up/
Taleb, N. N. (2005). Fooled by Randomness: The hidden role of chance in life and in the markets. New York, NY: Random House.