Podcast – Episode 005 – Who’s Afraid Of The Black Swan
Podcast Summary
Today’s episode comes about because of an email I got this week. Let me read it for you. It goes, “I’m very interested in joining your website, but I have some concerns you may be able to help with. I have friends who used to trade credit spread options, but had some very bad losses due to a black swan event a couple of years ago. If you advise us to place a trade, risking say 70 percent of account, and an event happens over the weekend, the market could gap and we lose 70 percent almost overnight. This is the only thing that stops me from signing up and learning how to trade options. Am I missing something here? Thanks. John”.
For those of you who’ve never heard of it, and I’m surprised if you have never heard of it because it’s very common nowadays to say that, throw this word around. “The black swan”. Basically what it is, it’s an unpredictable event. Something that we can’t account for. It could be man made. It could be natural. These are things that are not taken into event normally because they are so out of the realm of possibility that you wouldn’t even think about it. Or at least that’s what the guy says who came up with this theory.
Now notice, it is still a theory. It hasn’t been scientifically proven or anything like that. But it is something we should be aware of, and maybe even take into consideration while we’re trading. A good example of a black swan event is 9/11, the attack on the trade towers, and all the other attacks that happened with the planes. Now nobody had ever, well they did kind of, they had some kind of inkling that something like that could happen. But for the general population, nobody ever considered that terrorists would take over airplanes and drive them into buildings. Never considered it.
Resources
Podcast Transcript
Who’s afraid of the big black swan? The big black swan? The big black swan? Who’s afraid of the big black swan? I hope not you.
Welcome to another episode of the Option Genius Podcast, ladies and gentleman. Today’s episode comes about because of an email I got this week. Let me read it for you. It goes, “I’m very interested in joining your website, but I have some concerns you may be able to help with. I have friends who used to trade credit spread options, but had some very bad losses due to a black swan event a couple of years ago. If you advise us to place a trade, risking say 70 percent of account, and an event happens over the weekend, the market could gap and we lose 70 percent almost overnight. This is the only thing that stops me from signing up and learning how to trade options. Am I missing something here? Thanks. John”.
Well first of all John, thank-you for your email. Appreciate it. It’s always wonderful to hear from people who are thinking of signing up. But the first thing I want to mention is that you should probably not be putting 70 percent of your account in one trade. Not a really good plan there. Not good diversification. That is not something that I would ever advise. I don’t know where you got that notion. Diversification is good. Having your money in multiple trades is good. Having 70 percent in one trade? Maybe not the best idea. Especially if you wouldn’t know how to handle it if a black swan event did occur.
Now the second is this reference to the black swan. For those of you who’ve never heard of it, and I’m surprised if you have never heard of it because it’s very common nowadays to say that, throw this word around. “The black swan”. Basically what it is, it’s an unpredictable event. Something that we can’t account for. It could be manmade. It could be natural. These are things that are not taken into event normally because they are so out of the realm of possibility that you wouldn’t even think about it. Or at least that’s what the guy says who came up with this theory.
Now notice, it is still a theory. It hasn’t been scientifically proven or anything like that. But it is something we should be aware of, and maybe even take into consideration while we’re trading. A good example of a black swan event is 9/11, the attack on the trade towers, and all the other attacks that happened with the planes. Now nobody had ever, well they did kind of, they had some kind of inkling that something like that could happen. But for the general population, nobody ever considered that terrorists would take over airplanes and drive them into buildings. Never considered it.
Another black swan event could be what we just had recently, where you have several major category four and category five hurricanes making landfall in the same month. We had Harvey. We had Irma. We had Jose. We had Maria. We had, what was the other one? The one that hit Mexico. Then you had two major earthquakes in Mexico. These are all natural disasters, one after another after another. This is a black swan event because people did not think that this would happen. Possible? Yes. 0.00001 percent chance of possibility it could happen. Will it happen? No. Does it normally happen? No. You don’t really plan on it.
This concept of the black swan was developed by a guy named Nassim Taleb. He’s written a couple books on it, gotten a lot of awards, gotten a lot of prestigious write-ups in different magazines. Now he makes money from his books and whatnot, and from his lecturing. He travels around the world, lectures about this thing. Now what he does is, he advises hedge funds on how to profit from the black swan. The major strategy that they have is to buy put options and to buy call options on the VIX. Far dated, totally out of their money, really out of their money options. Buying some on the VIX and buying put options on the overall indexes. That’s their strategy if something goes to pot and something really bad happens. The moon crashes into the Earth and whatnot. Stock market’s probably going to tank. But if something like that happens I don’t think we’re going to be worried about the stock market really that much, right? That’s what he does.
In 2009 he was profiled in a GQ article as having made $20 Billion using his strategy. That sounds great, right? $20 Billion? Holy cow. Until somebody investigated it, and it came out that the $20 Billion was not how much he made, but it was how much the trade was worth. The gain on the trade was about $20 Million. Then somebody else pointed out that the fund itself was worth about $20 Billion, so they had $20 Billion in a fund. That big payday that they heavily advertised as proof of their theory, kind of really small, right? One percent? Jeez. Not very much.
Same thing happened again in 2015, where his fund made 20 percent in a single day when the Dow dropped 1000 points. That’s what their fund is made for, when those big days happen. Then they made not much else for the rest of the year. 20 percent in a year, that’s not bad. Nothing to really write home about. But it’s not bad.
Anyway, I’m done trashing this guy. We’re not here to debate about the merits of the theory. We just have to know that it can happen, and of course that we should be prepared for it if we can.
Here we have John who says that his friends were doing credit spreads and they lost money because of a black swan event where the market gapped overnight. Now it doesn’t have to be a black swan event. He didn’t give me more details on what it was or when it was so I can’t tell. But if you’re in a stock, and stock, the company could gap down. Or gap up. Any day, for whatever amount of reasons. It doesn’t have to be a black swan. I guess you could call it a black swan because there’s no category, but if the CEO dies in a plane accident, that could be a black swan. The stock might tank. If you take Apple, I don’t wish anything bad, but if the guy in charge of Apple, something bad happens to him? Things are going to happen. The stock’s going to tank. Warren Buffett for example. He’s in his 80’s. Just celebrated another birthday. Eventually he’s not going to be around. When that happens, is the stock going to tank? Who knows. But that could be the black swan event that happens to any stock.
You’re in this stock. You have a credit spread on. The market gaps or the stock gaps overnight and your trade loses money. That sounds pretty scary, right? A black swan of that nature could happen at any time. Maybe we just don’t trade at all. Wouldn’t that be the safest thing to do? If you’re in a trade and the trade could go bad and blow up on you at any time because of a black swan, then maybe we shouldn’t be trading. Maybe we should be putting our money in a mattress. That’s where, it can be safe there. Unless we have a fire and the house burns down, and the mattress, and the money in the mattress. Nowadays we have these Memory Foam mattresses. I don’t know where you’re going to put the money. But that could happen, so maybe not.
The same thing could happen when you’re out driving. Imagine that. You’re out driving. You’re out there minding your business. You’re on the freeway. Maybe you’re going home. All of a sudden a million ducks come out of nowhere. No, not a million ducks. A million swans come out of nowhere and they fly over your car. As they’re flying over your car they decide to use your car for target practice, and they take a huge dump on it. There are tons and tons of excrement that fall down on your car, and basically it’s so heavy that it squishes your car into a pancake with you inside. Wow. I mean, talk about a real black swan. Right? Then maybe we shouldn’t even drive then?
Or maybe we shouldn’t do anything. Maybe we should just stay at home, curl up in our bed, and eat ice cream all day. Hey, that sounds pretty good. Maybe we should do that, right? No. We don’t do that. We have to live our life. We have to go about our daily jobs. After 9/11 happened, what was the first thing that they said to do? George Bush came out and said it. He goes, “Go back to your daily life. I know you’re scared. I know things have happened. I know this is unexpected and people have died and there’s still all this rubble and everything all around you. But the only way to recover is to go about living your life. Go back to normal”. That’s what we have to do as a trader.
If you are a trader, you have to trade. That’s what you do. Not live your life on the sidelines. Not sit there and say, “Okay. I’m scared of this event happening. I’m scared to that happening. I’m scared of this happening. I’m just not going to do anything. I’m going to keep my money in cash”. Okay. Well if that’s you, then that’s what you do. But if you want to get ahead, if you want to actually make some money, then you have to take some risk. Part of the risk that you’re going to take is this. You can call it whatever you want. Some people call it market risk. You can call it black swan risk. It’s there. It could happen, anytime. But you take precautions.
If you’re afraid of the black swan, you could do simply what Nassim Taleb is doing. You take some of your money and you buy long dated out of the money put options on the index. Or you buy call options on the VIX. Don’t get mad though when those options lose money, because they’re going to lose money, because they are there for insurance. They are there as a hedge to protect you in case something bad happens. What you want is for them to lose money and expire, because you don’t want something bad to happen. Kind of like when you’re buying life insurance. You don’t want the life insurance to pay off, because that means you’re not around anymore. Same thing with the black swan. You buy these put options or call options on the VIX, and you let them expire hopefully.
But if you’re scared of that then you do that. You protect yourself. But it shouldn’t stop you from getting in the game, right? You have a choice. Either you live your life or you live in fear. Bad things can always happen to us. But we need to keep moving, keep forward. Set out goals and reach for them. It’s funny, because I get these black swan questions frequently. The term has become famous nowadays. Everybody uses it. “Black swan this. Black swan that”. You turn on CNBC, Fox Business, all that. Those things come up. But the people that use it the most, do you know who they are? They’re people who are looking for an excuse not to get in the game. They are looking for a reason not to move forward, not to pull the trigger, not to start trading. I never get this question from people who are already trading.
People who are already trading will ask me, “How do I protect against something? How do I protect against a loss? What can I do if this doesn’t work out in my favor?”. I never get a question like, “I’m putting on this trade but maybe I shouldn’t do it because of the black swan”. If somebody is a real trader, they live with that every day. They get over it. I only get these questions from people who are quote unquote learning. If that’s you, that’s fine. But if there is a black swan event that affects all the markets, what do you think it’s going to do to stocks? To bonds? To futures? Every other financial instrument? They will all be affected.
Be aware of the risk, but you can not stop trading. You can not stop investing. You can not stop trying to reach your goals. The black swan by definition is not predictable. It’s something that might happen. But on a flip side, it is something that might not happen. It might never happen. Then what? You’re sitting there in your retirement home at age 80 years old or 90 years old wishing that you had the balls to invest 30, 40 years ago? Sorry. It’s too late then. Today is the day to get started. Today is the day to get in the markets, to protect yourself.
I understand if you have a plan in saying, “I’m looking at these indicators. I think the market is overvalued and so I’m going to wait for a pullback”. That’s great if you’re that type of trader. But me? I’m an option seller. I am a trader and I need to make an income from my trading in order to survive. I find a way that I can trade on a monthly basis.
Now some months I don’t trade, obviously, because I am on vacation or whatnot. I don’t have to trade. But if you’re an option seller, you have all of the benefits already associated with that. You’re already far away from the money. You already have a high probability of profit. You already have a pretty good ROI. But if something bad does happen, we can get back in the next month and try to make it back. That’s why we have protections in place. That’s why we have our stop losses in place. That’s why we have our spreads in place. That’s would be a great reason to have spreads. Notice in this scenario, the only reason they lost money was because they put 70 percent of their money in one trade. That was what John said in the email. That doesn’t make a lot of sense, unless you were betting on a sure thing, which, there are no sure things.
Anyway, back to John. I hope I answered your question. First of all, like I said, 70 percent in one trade is way too much. Especially if you’re learning. Especially if you don’t know how to handle an adverse event like a black swan or a gap. Those don’t happen that much, but they do happen. You should be prepared for them. The only way to get prepared and to have that experience is to trade. If you’re afraid to be trading with real money, I get that. What you should be doing then is paper trading. It’s not the same thing. It doesn’t have the same emotional oomph to it. But if you can’t get yourself to open an account and put real money at risk, then do it with paper money and do it for a few months.
You don’t have to get rich overnight. That’s not the game we’re in. We’re in the game to make small base hits, not home runs. We want to hit singles and doubles. We’re not hitting grand slams. Month after month after month you get experience, and things will happen. It might not be a black swan event, but your stocks might go against you and you’ll have to figure out how to fix your trades. How to adjust your trades. That’s one of the reasons why you have a spread and you don’t want to sell naked. Because that could hurt you even more. But the thing in this scenario, and what he did not explain in the email, was what timeframe were they selling the options in?
Obviously I stress that weekly options are more risky than monthly options just because of that one reason. Because if something bad happens to your trade, there is very little time for recovery. If you had sold credit spreads and 9/11 happened, if you had done weekly trades you were going to lose your money because the market tanked. The market was closed actually for a few days. But if you had sold monthly, or if you had gone out 50 or 60 or 70 days or 90 days away from expiration, your trade had enough time to come back, because the market did come back. Once it opened the market rallied, and eventually it got back to where it was before 9/11.
I didn’t do the research on this so don’t quote me, but you had the time to get back, and your trade maybe not have been a complete total loss. That is another way to protect yourself.
Again, my take home for this episode is, the black swan might happen. Might not happen. Bad things will happen in the market. Those are the risks that we take into account. That’s why we protect ourself. That’s why you have diversification. That’s why you don’t put all your money in a single trade if you don’t have to and you don’t know how to do it. Be prepared, but don’t be afraid of the black swan. Go live your life. Do the things you want to do. Learn to trade. Don’t use it as an excuse. There’s no more excuses. Today is the day to get started. Remember, trade with the odds in your favor.