Black Swan Events
The term “black swan event” was popularized by financial thinker Nassim Nicholas Taleb through his book, Fooled by Randomness. It refers to an unforeseen or rare event that has a significant impact on financial markets. In the context of trading, black swan events can lead to extraordinary profits or devastating losses, usually catching investors off guard due to the unpredictable nature of these events. They have always and will always pop their ugly face on occasion.
The history of the term comes from the notion that black swans did not exist; they were only white. The old-world presumption was that black swans were simply impossible… until Dutch explorers lead by Willem de Vlamingh became the first Europeans to actually see black swans in Western Australia! The term subsequently metamorphosed to connote the idea that a perceived impossibility might later be disproved.
In the realm of financial markets, black swans are:
1. Outlier events, as nothing in the past can convincingly point to its possibility
2. Events that carry extreme impact, could be both positive or negative, and
3. Such that in spite of its outlier status, human nature makes us concoct explanations for them after the fact, making it explainable and predictable.
Examples include the housing market crash of 2008. Oddly enough, it occurred shortly after the 2007 publication of Taleb’s follow-up publication, The Black Swan. It ticked off all the boxes in his description. The tech bubble of 2001 is another example, as America was enjoying rapid economic growth and increases in private wealth before the economy catastrophically collapsed. More recently, the COVID-19 pandemic disrupted markets and economies around the world.
While I have not seen mention of the recent market meltdown thought of as a black swan event, a 28-point drop in the S&P 500 is about as close to it in the options world as “damn” is to swearing. More than a few of us were caught in the downdraft, with the only saving grace being a rise back up in the coming days. This event serves as reminder of the volatility of the markets and their vulnerabilities.
The way to protect oneself is to invest in any one trade only enough that you can afford to comfortably lose. It seems counterintuitive as we aim to make huge profits from options trading, but keep in mind, should the market collapse, you should never be in a position that will adversely affect your lifestyle. In my e-book Triumphs and Tragedies, I talk of one gentleman who had his retirement savings heavily invested in call options. When SPY suffered a similar fate, he contacted me from his hospital bed for my opinion. “Is it possible for my calls to recover?” he asked. After a brief analysis, I replied, “It’s possible but not probable. SPY will have to rise $10 tomorrow, and I don’t see how that will happen.” I hope this poor gentleman recovered, but I never heard from him again.
These events happen from time to time. Their unpredictability makes it all the more difficult to anticipate; hence the need to practice safe money management at all times. Even if I have a million dollars hanging out of my back pocket, I would still take the vigilance of careful position sizing. This is especially true with flippant leadership at the helm. When a president makes powerful, world-embracing decisions on a whim, there will be ramifications reverberating throughout the financial world.
Another way to protect oneself is to always buy time, or at least, understand the risks of soon-to-expire options. With time comes the ability for markets to recover. Pay the extra premium and consider it insurance against black swan events. You will get all that extra premium back when you sell anyway, so it shouldn’t matter.
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Although they may sting, black swan events don’t have to be game changers. We can help you steer through them to relative safety. Join Jon and me, with over 45 years combined market experience!
Great trading
Hugh
