No, we’re not talking about birds here. Although the idea and theory of black swan events stem from falsifiability, we’re dealing with trading and finance here.
You see, people once thought, “All swans are white.” However, explorers found black swans in Australia, a true observation… making the initial claim false. But what does this have to do with trading and finance?
Well, this observation brought about Nassim Nicholas Taleb’s application of philosophy and sociology to the trading world. Consequently, he coined the term “black swan event.”
The theory of black swan events brought about a new way of thinking about risk and how it impacts the financial markets.
Now, not all extreme moves may be categorized as black swan events. For example, Brexit and the moves in the British pound and euro were not considered black swans.
You see, there are specific characteristics of a black swan event.
That said, let’s take a look at what classifies an event as a black swan, and how to potentially trade them.
Black Swan Event Explained
A black swan, or tail event, has three characteristics:
- The event is an outlier. In other words, the impact of the event is outside the realm historical moves and is unexpected.
- Since the event is an outlier, it typically carries an extreme impact.
- Lastly, even though these events are considered outliers, traders often develop theories and explanations for the outlier after the fact.
However, that doesn’t help us when we’re trading right?
You see, to potentially profit during a black swan event, traders are positioned for an extreme move. So coming up with a theory after the fact is the same as playing Monday morning quarterback. That said, let’s take a look at how to profit from outliers.
Strategy for Outliers
Now, remember… outliers are rare and unexpected. You could continue to use this strategy and not make money for years… but all it takes is one extreme event, and you could potentially change your life.
However, what happens if that’s not your goal? And you just want to trade options and multiply your money consistently? Well, check out this webinar to see how you could time your trades, and generate monster profits off of small moves.
Remember the normal distribution?
Well, if you don’t know what the standard normal bell curve is, that’s fine. Just know that when there is a tail event, all of the observed percentage returns are either on the far right-hand or left-hand side of the chart above.
What happens if you think there will be an outlier in volatility products, and wanted to use options to express your opinion?
Tail Event Strategy Example
Well, the tail strategy could be helpful. Here’s how the strategy would look like in the Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB).
This is a true bet on a tail event. The math checks out here.
That in mind, to make the trade mathematically sound, the strategy involves selling at-the-money (ATM) straddles, coupled with buying deep out-of-the-money (OTM) calls and puts. The key to this strategy is buying a ratio of OTM calls and puts. For example, if you sell 1 ATM straddle, you may look to purchase 5 deep OTM calls and puts – which is what’s shown in the strategy from earlier.
Take note, if you really want to use this strategy, you’ll need to know your time horizon… and if there is no tail event before your options expire, you would need to roll that strategy over. That’s the drawback of this strategy. But that doesn’t stop traders to try to play for a bear market with this strategy.
Now, there is a more efficient way to take part in a tail event, if you can pick a direction. That in mind, let’s look at some historical events and how you could’ve used the “money pattern” to profit… if you were trading during these events.
More Efficient Way to Trade Black Swans?
For example, here’s a look at the SPDR S&P 500 ETF (SPY) between 2002 and 2007. This was a remarkable run for the market. Doubling in just a few years from its dotcom bubble lows.
Here’s a look at the daily chart of SPY.
Now, at this time… the market was resilient, and the housing market was hot. It seems like everyone was getting homes, banks were packaging these loans and creating investment products. That spelled trouble. These banks, traders, and investors were buying and selling these products, but didn’t understand the math behind it.
Here’s a look at the hourly chart of SPY.
Now, I’m not saying you could predict extreme events with this… but what I have discovered is the fact the “money pattern” is useful for directional bets. Moreover, it’s what I’ve been using to consistently multiply my money – and I think you can learn my approach in 30 days.
Instead of using capital to purchase and sell different legs of the strategy… you could just purchase one type of option contract. The best part about this pattern is the fact that it works in any market environment. Unlike using a traditional tail strategy, you would not have to sit around and wait for it to work. All you need to do is get the money pattern alert, look for an entry and where you would stop out. Additionally, you would need to find a target. For me, I only look for 100%+ winners. You can pretty much set it and forget it.
If you’re still confused about options trading, check out this guide – outlining everything from hedging (on page 13) and my strategy to spot directional trades (page 37).
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