It seems every time the market gets choppy, news sources and conversations discussing Black Swan events begin. Very simply, a black swan is a black colored bird (I’m not sure what investing’s infatuation for animal metaphors is). Slightly less simply, a Black Swan event in finance is an outlier move in the stock market.
What is a Black Swan Event?
A Black Swan event, or Black Swan theory, is a term popularized by the writer Nassim Nicholas Taleb. He wrote a book titled, “Black Swan: The Impact of the Highly Improbable” that explains Black Swan events as having three qualities, “rarity, extreme impact, and retrospective (though not prospective) predictability.”
What Nassim Taleb is referencing are events like the invention of the steam engine or computers, effects of natural disasters like the Fukushima crisis, financial crashes such as 1987 Black Monday, 2000 dotcom bubble, and 2008 mortgage crisis, and cultural phenomena like the success of Harry Potter.
He says that these types of events do not occur often, are not predictable ahead of time (though explainable after the fact), and cause large amounts of change (I have to admit I still do not understand Harry Potter... maybe it’s because I stick to the classics like “Option and Volatility Pricing” by Sheldon Natenberg).
When we think of Black Swan events in finance, we think of outsized (+ or – 3 standard deviation) moves up or down in an underlying or market. What makes Taleb’s theory interesting is that he distinguishes Black Swan events as unpredictable and rare (unknown unknowns) from normal more common predictable financial risk (known unknowns).
Known unknowns are things like Apple selling two million fewer iPhones at launch than analysts had originally thought.
Unknown unknowns are things like Elon Musk (TSLA, SCTY, & SpaceX) holding a press conference explaining that he is an immortal alien desperately trying to advance earth’s infrastructure and technology towards intergalactic space travel to rejoin his friends 1500 light years away on a recently discovered alien superstructure.
For “known unknowns”, we generally know what to expect and what to look out for in an Apple earnings call. We have an understanding of what information we do not know yet.
For Black Swan events or “unknown unknowns”, we are blindsided by a rare event, that we were unable to predict, that will have large future result (Harry Potter or intergalactic space travel).
An important distinction for Black Swan events is that they are very much in the eyes of the beholder. So basically, in our hypothetical Elon Musk example, to us earthlings, Elon Musk’s announcement of being an alien and intergalactic space travel would be a Black Swan event, but to ‘Elon Musk the Alien’ the event would predictable and not rare and hence not a Black Swan event.
Using dough and tastytrade to Think about Black Swan Events
At dough and tastytrade, we account for potential Black Swan risk by trading small, managing our delta exposure, trading high probability of profit strategies, and being short high implied volatility rank (IVR) premium.
- Trading Small
- Manage delta exposure
- High probability of profit strategies
- Short high IVR premium
Because Black Swan events are inherently rare and unpredictable, we do not place trades predicated on hitting the Black Swan lottery. In a previous “You Gotta Be Kidding Me” tastytrade segment, Tom and Tony break down how difficult it would be to make money investing in a Black Swan fund. Consistently purchasing low probability long options would create a drag on our overall portfolio that would require near impeccable timing and optimal circumstances to be profitable.
Instead we primarily sell options, looking to balance high probability of profit trades with high return on capital (ROC). We look to place trades around the one standard deviation mark (pictured to the right) to collect significant premium for the level of risk we take.
If you have watched tastytrade before, you have probably heard Tom Sosnoff say that he does not sell “that junk”, referencing selling really far out of the money (OTM) options. Far out of the money options, carry high levels of notional risk with little potential reward. Selling extremely far out of the money options exposes us to Black Swan risk with little reward that could bring down our account if we trade too large and the market moves outside of three standard deviations.
For more information on Black Swan risk with premium selling strategies, check out the linked “Game Changers” tastytrade segment where Tom, Tony, and Chris go over how premium selling strategies and different management approaches would have fared during the 2008 crisis and the linked video on Karen the Supertrader.
Black Swan Events Recap
- Black Swan events are rare, unpredictable, and have large impacts.
- Because Black Swan events are unpredictable, we try to protect ourselves by trading small, managing our delta, trading high probability of profit strategies, and being short high IVR premium.
Still have questions about Black Swan events? Email us at email@example.com