Try This Hedge Fund Strategy On For Size

Unlike most investors in October, Nassim Nicholas Taleb, author of best-selling book, "The Black Swan," had an incredible October. While it seemed like the stock market plunged last month, Taleb's hedge fund soared to new heights.

The Black Swan is a book about the impact of extreme events on the world and the financial markets. Taleb helped launch a hedge fund, Universa Investments L.P., which is loosely based many of the book's themes, including how to achieve large returns despite a sharp market downturn.

The Wall Street Journal reported funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October. The funds are also managed by Mark Spitznagel, who previously as a pit trader on the CBOT.

Mr. Taleb told the WSJ that investors often ignore the risk of extreme moves in the market. The name of the book, "Black Swan," alludes to the belief, that all swans are white -- a notion that was proven wrong when explorers discovered rare, black swans. Therefore, a black-swan event is something that is highly unexpected.

This is how Universa's strategy works: It buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn and because these put options are so out of the money, they are extremely cheap. However, they can become extremely valuable in a market decline of 20% or more in a one-month period.

Here's an example of one of Universa's trades it executed. At the end of September, when the S&P 500 was trading around 1200, Universa bought put options that would pay off if the index fell to 850 by late October. Since such a descent was considered highly improbable, such options only cost 90 cents. However, on Oct 10, those options cost $60 as the S&P 500 plunged. Universa sold most of its position in the high-$50 range.

Universal also employs this strategy with individual equities as well. For example, the fund purchased a puts on Goldman Sachs Group (NYSE: GS) in July. The fund also bought puts on American International Group (NYSE: AIG), paying $1.29 apiece for the contracts. The puts were priced to pay off if AIG dipped below $25 a share by September. Universa eventually sold them for about $21 apiece. Nice return!

This strategy can have many years of lackluster returns as dramatic downturns in the financial markets have historically been rare events. "We're discovering the fragility of the financial system," Mr. Taleb told the WSJ, and he expects market volatility to continue as more hedge funds run into trouble.

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