Long time readers and speculators know that I’m a huge fan of Nassim Taleb’s work (the former-trader-turned-risk-philosopher).

The insight from his three books – Fooled By Randomness, Black Swan, and Antifragile – have all been key in my own asymmetry-focused (low risk – high reward) investment strategy. (Which I’ve recently written about – read here).

But – in summary: I focus on using favorable optionality (another word for asymmetry) to minimize my downside risks – all while keeping the potential upside (i.e. keeping the good while ditching the bad).

Or – in practical trading terms: I focus on buying mis-priced, long dated, out of the money, options.

As I’ve learned from Taleb – using these types of options are my way of experimenting in the markets.

Meaning – with just small amounts of money, I can buy call options (those that increase in value when prices rise) or put options (those that increase in value when prices fall) to test a market thesis.

For example: I’ve written articles over the past few months highlighting why I believe the Hong Kong economy and markets are very fragile. And that I bought long dated, out of money, put options on a Hong Kong ETF ($EWH) to potentially profit from any downside volatility.

Worst case scenario? I’m wrong and Hong Kong flourishes. Thus the put options expire worthless – and I only lose the small upfront premiums I paid.

And the best-case scenario? I’m right (or a random ‘black swan’ occurs) and Hong Kong’s economy or markets sink. Thus sending the put options soaring in value. Hopefully making a significant profit.

This optionality-focused strategy gives me the kind of trial-and-error that let’s me see what works without causing me serious harm (only risk small losses).

(For those of you who aren’t familiar with my recent writings about ‘optionality’ – read here).

Now – I’m aware that many believe buying long dated, out of money, options are ‘pure luck’ or ‘simply gambling’ (‘lottery tickets’). Thus not worth the upfront money paid out in premiums. (At-least this is what modern portfolio theorists believe).

And while I absolutely agree that luck and randomness play huge roles. I do believe that speculators can use cycle theory to increase their edge.

Or – said another way – understanding the market cycle increases the speculators optionality. . .

For instance – using the market cycle – I can take advantage of the market’s extreme points (tops or bottoms).

Putting it simply – when the market’s expensive and sentiment is high (aka peak levels) – I can most likely buy long dated, out of money put options at their cheapest.

And when markets are cheap and sentiment is low (aka bottom levels) – I can most likely buy long dated, out of money call options at their cheapest. . .

(I don’t want to do the opposite of this when they’re both expensive – i.e. buy puts after a crash or calls after a rally).

Thus – eventually – when the market cycle turns (which it will), the low cost, long dated options will hopefully outperform.

Here’s another way of looking at this:

Imagine living in an area where there hasn’t been a flood in a long time. And the weather’s been great in recent memory.

Thus – most people in the area will feel a false sense of security – believing that the future will be similar to the recent past. (This is a human bias called the ‘recency effect’ – the tendency to weigh recent events more than earlier events. And it happens in markets much more often than many realize).

Because of this – many homeowners will stop paying for their flood insurance – believing it’s unnecessary now.

And even insurance firms will begin believing that the chance of a flood is unlikely – thus lowering the premiums they charge consumers.

This gives the optionality-focused homeowner a great opportunity to buy a cheaper insurance policy. (They’d rather sleep well at night knowing that they’re paying small amounts for protection against a flood).

Then suddenly – a few months later – a massive storm hits from out of nowhere. And a great flood occurs.

Those that didn’t have flood insurance panic. And the insurance firms sharply raise the premiums they charge to try and collect greater income. (Since now they must pay out significant amounts in obligations – aka flood damages).

So – in summary – markets (and the world) are complex systems that are full of turbulence and randomness (much more so than what’s actually priced in; especially during extremes – like tops or bottoms).

But – still – cycles occur like clockwork.

This gives speculators an edge when positioning themselves – or if they’re simply testing a thesis. (Especially in commodity cycles – I’ve written more on this here).

(Remember – to beat the market consistently, a speculator must compound every edge they have). 

Now – it’s not simple determining where things stand in the current cycle (a top can move higher – and a bottom can slide lower). But it certainly helps when the market mis-prices options during extremes.

Thus – awareness of cycles, being contrarian (fighting human biases), positioning for optionality, and using a little imagination – a speculator can make a fortune by risking small amounts. . .

Stay tuned (part-two of this topic coming soon).

PS – a great book on the market cycle is Howard Marks’ Mastering The Market Cycle: Getting The Odds On Your Side. It’s a must-read in the ‘CYCLES’ section of my comprehensive reading list.

PSS – the $EWH put options I referenced earlier in this article are up over 120% since writing about them. And I’m still holding.