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Trading black swans

The somewhat esoteric term ‘black swan’ simply refers to an event that has not been expected by the market. A black swan event is difficult to predict because of its apparently random nature – although with hindsight it often seems hard to understand that markets did not foresee a certain event.

Typical black swan events include both World Wars, the 9/11 attacks and the housing crisis in the USA. Natural disasters, such as droughts, earthquakes, and floods can also have significant effects on markets and since they are nearly impossible to predict they can often be described as black swan events.

Although it is therefore possible to project the likelihood of certain events with a fair amount of accuracy (e.g. election results based on opinion polls) other events such as the Japanese earthquake and tsunami remain unpredictable for now.

Nassim Nicholas Taleb argues in his book The Black Swan: The Impact of the Highly Improbable that black swans will remain inherently unpredictable no matter how complex our statistical models become. Trying to predict future black swans by studying the events that led to past black swans is futile, he says, because there are simply too many variables involved and they will never repeat themselves in exactly the same manner.

For investors, governments and traders it is, however, not good enough to say that, because Black Swans are unpredictable, we should simply ignore them. There have to be contingency plans in place to deal with disastrous events – even though we are not sure when they will in fact happen and if they happen how severe they will be.

You also have to take into account that not all swan events are negative and that what is a negative black swan event for one person might be a positive ‘white swan’ event for another. A sudden, unexpected surge in the value of the euro against the dollar after a huge oil discovery in Europe would, for example, be a white swan event for Europeans but a negative black swan event for Americans.

This is also true for traders. Swan events can be both positive and negative. The positive ones should be exploited as far as possible and the impact of the negative ones should be limited as far as possible.

Diversification is one of the best ways to protect your portfolio against negative black swans. Rarely does an event occur that has a negative influence on all sectors of the economy. A well-balanced portfolio therefore has a much better chance to weather bad news than one consisting of only one or two investment instruments.

There is of course also a danger in over-diversifying: if you own ten stocks and one of them suddenly triples in price, it will have a significant effect on your profit ratio. If you own a hundred stocks the overall benefit will be much smaller.

Take Profit levels

A positive, or white swan, event can often be exploited by setting up a Take Profit level, in other words, setting up a level at which the trade should be closed the moment you have made a certain amount of profit.

An example of this can be seen in the chart below. If you went long on gold at 1517 (point A), when it emerged from the Ichimoku cloud, and decided that you would be happy if it reached 1817, you would have set up a Take Profit level at point B (1817).

Click to expand image

If you were greedy and set up the Take Profit level at point C or higher, you might have stayed in the trade long after the profit potential had evaporated, losing money in the process.

Stop Loss levels

If you, for example, trade using a spread betting account, a Stop Loss is one of the best ways to protect your investment against sudden price movements. If you had Stop Losses on all your trades before gold lost more than $150 on 22-23 September 2011, you would have been protected against these sudden losses.

Let’s assume you had a Stop Loss at point D (1740.00). You would have been out of the trade by the end of 22 September, and you would have missed the massive price drop that occurred the next day. You should note however that Stop Losses are not guaranteed and may be subject to slippage (positive or negative) and market gaps in volatile market conditions.

The golden rule for the trader here is not to try to predict the future, but to make sure you are ready for it, regardless of what happens.

Published: 19 October 2011

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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