I had finished reading Nassim Taleb’s new titled book The Black Swan: The Impact of the Highly Improbable. It was a very nice read. Although I’d say if you are familiar with Taleb’s work this book may be a bit repetitive. I’d try to give here the main points of the book and how it is applied to trading.
Black Swans
Taleb discusses in this book the failing of people to predict rare events. Events that defy prediction. The concept of the Black Swan is in example of how the human mind works. It was thought that all swans are white. The absence of evidence became evidence of absence. Just because you haven’t seen black swans, it doesn’t mean they don’t exist. Later on it was discovered that black swans do exist. In terms of trading, this could mean that just because the stock market was up for 10 years in a row it wouldn’t crash in some certain day unexpectedly. Problems arise when you assume these rare events are negligible or you disregard them all together.
Mediocristan VS Extremistan
Taleb makes the distinction between a Mediocristan world vs an Extremistan world. In a Mediocristan world, the height and weight of people follows the bell curve. It is safe to assume that we won’t expect anytime soon a person who is 10 feet tall. No surprises there. This also applies to weight. Weight also follows a bell curve among a sample of people. The problem arises with non-physical quantities in which our intuition is no longer valid. This could be the wealth of a person (think Bill Gates) or sales of a blockbuster. These no longer follow the bell curve.
This could be due to the fact that in the old days, for our survival, such intuition was not needed to our survival. In the Extremistan world, the bell curve is no longer valid and we generally do no predict those events.
Overestimating
We overestimate black swans that are talked (lottery) and under estimated the ones that are not. Environment kills more than terrorists, yet we over estimate the probability of a terrorist attack. After 9/11 which was a rare event and had low probability, it was talked that another terrorist attack like that could occur with high probability. Thinking of trading, this could mean that after a crash, people would be afraid that another crash would soon come making put options very costly.
What Can We Learn From The Past
Consider a turkey that is being fed each day. Each day corroborates the turkey’s assumption that it will be fed tomorrow. Until some the day that he is killed by the hand which fed him. In terms of trading, this means that past prices can fool us and we can’t assume that history will teach us anything about the future.
Taleb’s obsession with black swans and forecasting comes from his childhood. He grew up in Lebanon and when the civil war (which no one predicted, hence a black swan) went on for a decade. Experts assumed it would only last a few days.
Taleb is also influenced heavily by Richard Feynman in my view. Feynman was smart enough to say “I don’t know”. It’s hard to say an expert on anything say that. This is where Taleb disdain for Economists and Political experts. Instead of saying “I don’t know” they try to give failed predictions of the future.
Experts vs Street Smarts
Taleb thinks that when it comes to prediction, the guy from the street is better than the so called expert. He gives an example of an expert in statistics and a guy named Fat Tony. He gives them the following question: Let’s suppose I have a fair coin and I toss it 90 times and it all came heads. What is the probability it would come tails in the next toss? The expert says that this is a trivial question and there is a 50% chance because the coin is fair and it doesn’t matter what happened in the past. Fat tony on the other hand says that the chance is closer to 3%.
Taleb argues that the expert thinks inside the box while fat Tony thinks out of the box. Fat Tony thinks that there is no way the coin is fair and the probabilities are not 50%. This comes back to Taleb’s argument of the use in finance of the bell curve when in fact these are not the right probabilities to use.
Backward process
If you catch the financial news, you always see that people seek for reasons. If the stock market was up 20 points, it was because interest rates are expected to fall etc.. The markets are very complex systems. Attributing a move in the market to one factor is pretentious at best. This is called a backward process. Let’s suppose we are looking at an ice cube melting and we are trying to guess the shape it would melt to. This is a forward process. Now consider a puddle of watter and try to guess how the ice cube looked like. There are infinite possibilities.
Final Words
Taleb’s main argument is that we live in an Extremistan world, in which rare events shape our lives(internet, laser). Most of the returns in the S&P over the last century come from a few days. His advice is to try to be exposed to “positive” black swans and be prepared for “negative”. This does not mean you have to predict the black swans(because you can’t). You can only be prepared as much as you can. All in all, I recommend this book if you are open minded and free to explore new ideas. Finance students would probably find this book irritating.
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. It is NOT your regular stock investement book.
as a good introductory book. It has a touch of everything and it has a clear writing. If options are still new to you, you may find a more subtle introduction to options with no math in any number of books of your choice or even from the web.
If you want it too hard then you may also consider purchasing 
which has a lot of fun examples.
is good and has the easiest proofs I could find. The background in measure theory and analysis is found in a book I cannot bookmark but is found in most Israeli Universities and is EXCELLENT. The book by the open university called measure theory. It is EXTREMELY GOOD and has all you need in measure theory. If you can’t have this book, it’s a shame. The next in measure theory I recommend would be 
. Cheap and good and also straight to the point.
. Very good and clear.
