In his book The Black Swan, philosopher Nassim Taleb describes a memorable trading situation, namely, where a previously unseen and unencountered scenario wipes out a position with no warning. Taleb compares this event to what a turkey experiences close to Thanksgiving.  From the turkey’s viewpoint, each passing day provides one more data point confirming the positive outlook of his or her existence. Until of course the final moment of reckoning.

Closely related to the turkey trade is the trade where the turkey knows exactly what will happen in advance, but does not know when.  This is far more common than the case where an event occurs completely out of the blue.  The infamous volatility explosion of February 2018 may have caught many risk managers, PhDs and ambitious retail traders completely by surprise, but there were endless warnings in the alternative press of the upcoming “vol-mageddon”, not to mention the prescient analysis presented in this blog in 2016.  Looking at the historical record, the dot com bust was widely predicted in mainstream news sources for years leading up to the event, as were wipeouts in “fad” stocks such as Krispy Kreme Donuts, Krocs (a maker of plastic foot ware) Bitcoin ca 2017 and other issues going through a meltup-meltdown cycle. Younger traders sometimes call this trade ‘YOLO’ (short for You Only Live Once) and recommend buying calls in huge quantities in these speculative issues.

One shortcoming in Taleb’s analysis is that although he vividly describes a very real and dangerous trading scenario, he does not offer suggestions on how to scan markets for a trade in the Thanksgiving Turkey scenario or what the best risk controls to manage the position might be.

The unstated implication is that it is best to avoid the scenario entirely but this can leave significant profits on the table.

Terry Shakan from Sparta Trading (a major VIX market making firm) described one way to trade the Thanksgiving scenario with limited risk.  It assumes an unknown period of high returns followed by a single, extinguishing “wipe out” event.

The strategy involves two key ideas:

Enter a uniform, defined-risk position size on a periodic basis

Take profits, but do not compound the returns

In Terry’s case, he set up a small trading desk that did nothing but short retail volatility instruments in a small but consistent position size, week after week.  The profits were set aside to cover future expected losses, but were never reinvested. The position size remained constant and did not increase or decrease. In Terry’s case, the expected losses never happened because he retired before the wipeout event in February 2018.

The same strategy applies to more recent Thanksgiving Turkey scenarios, namely, the explosive short squeeze moves in Volkswagen (2008) and Tesla and Beyond Meat (2020).

Once the squeeze begins, two things are certain:

  • It will continue for an unknown period of time
  • It will collapse by an uncertain amount

Option spreads offer an ideal way to profit from this scenario.  

The simplest way is to purchase short term expiration debit spreads with a 1-1 payout. A long call vertical with wingsize 2.50 expiring in one week selling for 1.25 is an example of a 1-1 payout.  The maximum profit is 1.25, the maximum loss is also 1.25.

In the melt up phase, the return of this strategy will be 100% per week for the duration of the meltup, followed by a 100% loss when the meltup reverses. +100% +100% -100% would be the payout stream for a short squeeze lasting three weeks.  Latecomers to the squeeze will get +100 -100% payouts in week two or a single -100% return if they put the trade on one week before the squeeze ends.

Compare this to holders of common stock.  The stock needs to melt up at a rate of 100% per week to match the return of the vertical spreads.  And if the squeeze lasts for a minimum of one week, the vertical strategy is guaranteed to break even no matter what happens in the future, as long as the position size remains constant.  

The same strategy works on the collapse after the short squeeze ends.  It is trickier to trade on the way down because of the violent relief rallies.

Your author successfully traded this strategy in both TSLA and BYND.

Here are the results of five TSLA vertical spread  trades vs purchasing shares of the underlying.

The trades were opened intraday starting Jan 09 2020 after an immediate $20- or greater spike. They were closed out early if the stock reversed so some of the trades were less than 100% wins and had a decline from max value.

+100% +71% +48% +80% +100%, for a 399% total return

Buy and hold until today (Feb 18, 2020) 48% total return

Buy and sell at all time high, if you were clairvoyant, 78% total return.

The key idea in this trade is to cut it off after the first 100% loss and not restart it. This is really hard to do.  In the middle of the the dot com meltup, Mark Cuban was the only big figure to lock in his gains at the peak.

In some melt-up scenarios (e.g. SPCE melt-up in Feb 2020) there is no liquidity in the verticals and you have to use long calls or puts. In this case I like to liquidate the calls/puts when they hit the next strike and immediately roll up/down. This takes profits and reinvests at a higher leverage strike. Some traders prefer a fixed ratio, e.g. sell 1 contract on every five point move in the stock. Get out if there is even a slight decline from high.

Making money is easy. Keeping lots of it requires discipline. Especially after a big win. During Thanksgiving Turkey Scenarios there will be lots of winners gloating about how their ‘special’ strategy made 10000% gains. But for some reason the big gains tend to be followed by total radio silence. The traders got overconfident, greedy, and their accounts were liquidated and distributed to smarter people and robots. Josef Stalin called this phenomenon ‘Deliriousness Due To Success’.