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Black Swans, Rare Diseases and Other Common Events

In 16th century London, the phrase “Black Swan” was a metaphor used to connote something fictional: something that did or could not exist. In 1697, explorer Willem de Vlamingh discovered actual black swans in Western Australia. In a flash, one metaphor died, and the Black Swan rose, phoenix like, with an entirely new meaning. The term “Black Swan” is now commonly used to mean an unpredictable or random event that creates an extreme or disruptive impact. Such events can be negative like a natural disaster or the 9/11 attacks, or positive, like the discovery of a radical new technology. In either case, they pose a difficult problem for traders and investors.

Whether you are an options trader or a long term investor, your best ally is the ability to make educated predictions about the future movement of an equity. Technical and fundamental analysis both rely on the idea that the past can give clues to the future. The trends that show up on the chart, the patterns that are revealed through dissecting a company’s balance sheet are the tools of our trade. Black Swans fly through our careful analysis and tear things to shreds.

Because such events are both rare and unpredictable, it is easy to ignore them. It is tempting to act as if all the world’s activity can be contained within two standard deviations of the norm and outliers do not exist. After all, how can you plan for something entirely unforeseeable? Unfortunately, hiding your head in the sand is not a great strategy. The truth is that although any individual Black Swan is completely unpredictable, disruptive events happen all the time. The idea that some Black Swan will occasionally effect an equity in your portfolio or the entire market or the entire world should be taken as a given. How many “once in a life time” events have all of us already seen during our trading lives? Think of it this way, epidemiologists define a rare disease as one that affects 5 or fewer people in 10,000 – pretty good odds. However, 1 in 10 people in the United States suffer from some rare disease.

Moreover, then there are what I like to call, “personal Black Swans.” These are events that can disrupt your life and curtail your ability to trade. In April of 2013, my husband passed away suddenly and completely unexpectedly. For many months, the stock market was the last thing on my mind. But although no one wants to think about money at a time like that, I still had a family to take care of, bills to pay, and a future to plan for. I was lucky that my portfolio was well hedged and not so tied up in complicated trades that I couldn’t step away for a while. It made me realize that in addition to all the precautions we take when trading, we also need a plan for times when we cannot trade. How vulnerable would your portfolio be if something happened to take you out of the picture for a while? Are there people depending on that money? Do many of your trades need to be followed tick by tick?

So what can we do? We can structure portfolios that can survive Swan Attacks in any form. It comes down to basic portfolio management. For me that means that although I do not let fear paralyze my trading, I always keep an eye on the worst case scenario. By keeping my allocation to any single equity small or by the use of protective puts, I can make sure that my portfolio can survive the overnight collapse of any single equity (I’ve lived through the tech bubble of 2000, so I know that can happen). Protecting against a severe and sudden market collapse is harder, but that is where the allocation to cash is useful. Keeping funds in reserve not only gives me a great cushion of safety but frees up the capital to buy in at lower prices once things eventually turn around. If everything falls at once, as it tends to do during times of extreme panic, I know I have the funds to keep going. Finally, I have made plans so that if I cannot trade for some reason, a person I trust has access to my account and knows what to do. I have made sure that most of the portfolio is in trades that can be easily unwound if necessary. These are things that no one wants to think about, but in the end, being prepared gives me a good deal of comfort, and that comfort makes me a better trader overall.

Jodie Lane
OptionsANIMAL Instructor

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Jodie Lane

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