In this business, everyone wants to be remembered for making ‘THE call’. It is what legends are made of. Make one good market call and you can be remembered for months if not years. However, in this world of quick information, changes and decisions, ‘what have you done for me lately’ is the theme followed closely. Get it wrong following a big winning call and you’ll be branded a ‘one timer’, even worse less reliable. How do you make ‘the call’? Clearly a contrarian player sees something the rest of us don’t see. The ‘black swan’ trade often referred to as it is a very rare bird has made for both pain and joy. The payoff if correct on the call and the timing has made some very wealthy.
Let’s take a look at the odds here of playing such an outlier. Generally speaking, the ‘black swan’ trade is based on an event or occurrence NOT being priced into the market that can cause a major shift in direction or trend. These are unexpected and priced as such, mostly a 5% chance or less of occurring within a particular timeframe. Hence, you would be paying up over and over again for the right to profit from an event that has very little chance of happening. You may LOSE 10 times in a row before being paid off on one of these bets.
As an options player, I weigh the odds of my plays each time and settle for the amount of risk appropriate for a particular trade. Do I try for home runs? Absolutely, but in the context of reality and believability and not in some potential dream of a pot ‘o gold. I accept the risk and make my plays accordingly.
Today, we hear of many ‘black swan’ trades. The bond market collapse is a frequent one (where the expectation is for US interest rates to go through the roof, crippling the treasury and bondholders), CDS are active for the sovereigns in Europe as a potential collapse of the eurozone and the currency is always swirling. Other trades include the fiscal cliff in the US, however that is going to play out. Some are betting on armageddon and a collapse of the entire stock market.
The last true ‘black swan’ payoff of course was the massive bets against mortgages and the financial crisis about 6-7 years ago, and that was not completely paid off (the thought was if the entire banking system collapsed who would be left to pay it off). John Paulson and others made a fortune from something they saw and others did not believe. THAT is the true nature of the ‘black swan’ trade – something apparent but not seen clearly. Could we have other events crack the markets? Of course. Nobody saw last year’s ‘black swan’ event – remember it? That was the Japan earthquake/tsunami, which raised volatility levels and uncertainty due to to unexpected consequences.
Nasim Taleb, who penned the book ‘Black Swan’ and has talked repeatedly about such events for years also invests/trades in these dark areas. Mostly, the black swans he is looking for are of the negative variety. An associate of mine who invests billions of capital for others reminds me that playing the odds as Taleb does is a losing proposition – you may win once or twice but how much capital would you have left by the time the event occurs? Very little, or perhaps none? Playing for the black swan trade to hit the proverbial ‘home run’ is like betting on the 99-1 shot each time at the racetrack. Can you withstand all the many losses before your horse comes in?