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 included 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 lead 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 has 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.
One also has to take into account the fact 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 hundreds 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 Fig. 10.17(a). If you went long on Gold at 1 517 (point A), when it emerged from the Ichimoku Cloud, and decided that you would be happy if it reaches 1 817, you would have set up a take profit level at point B (1 817). If you were greedy and set up the take profit level at point C, you might have stayed in the trade long after the profit potential had evaporated, losing unnecessary money in the process.
Guaranteed Stop Losses: If you, for example, trade using a spread betting account, a guaranteed stop loss is one of the best ways to protect your investment against sudden price movements. If you had guaranteed stop losses on all your trades before Gold lost more than $150 on the 22nd and 23rd of September 2011 (See Figure 10.17(a)), you would have lost nothing more than the amount you were prepared to risk in the first place.
Let us assume you had a guaranteed stop loss at point D (1740.00), you would have been out of the trade by the end of the 22nd of September, and you would have missed the massive price drop that occurred the next day.
The golden rule for the trader here seems to be not to try to predict the future, but to make sure you are ready for it –regardless of what happens.
Spread betting and CFD trading both carry a high level of risk to your capital with the possibility of losing more than your initial investment. These products may not be suitable for all investors, and are only intended for people over 18. Please ensure that you are fully aware of the risks involved and, if necessary, seek independent financial advice.