How to Hedge For Black Swan Events
Aug 3, 2022
As COVID-19 continues to hamper our lives, many investors are becoming wearier about the risks they face every day. The ongoing pandemic has made today's events incredibly volatile, most events having a negative impact on many types of investments. In fact, this uncertainty has caused many market analysts to brace themselves for the worst financial crisis since the one back in 2008. As such, many refer to the COVID-19 pandemic as "The Black Swan'' of 2020.
What's a Black Swan event? What causes a Black Swan event? How do I safely trade during a Black Swan event? If these are the questions that popped up in your mind when you saw the term "Black Swan," you're in the right place.
Today, let's delve deeper into a Black Swan event to help you understand more about what it is and how you can successfully trade in such an event:
What Exactly Is A Black Swan Event?
A Black Swan event, also known as a "Black Swan," is something that is uncertain yet has the potential to be extremely impactful on the markets, especially the financial markets. In fact, the term "Black Swan" is taken from a philosophical concept that was first introduced by the philosopher and writer Nassim Nicholas Taleb. According to Taleb, a "Black Swan" is an event that is rare, unpredictable, and has a great impact on society.
A true Black Swan event is something that is impossible to predict, yet if it happens, it will have devastating consequences on the market.
What Coined The Name Black Swan?
In his book, The Black Swan: The Impact of the Highly Improbable, Taleb explained that his favourite metaphor was that of the black swan, which he compared to the financial markets.
This is because the black swan is a bird that is entirely placed outside the realm of the known, but at the same time, it does exist. For this reason, it is impossible to predict the appearance of a black swan due to one's limited knowledge, but if one does and can appear, it will have the ability to upset the balance of the market completely.
In short, it's the unpredictable and massive effect that can cause a market crisis. This is why the Black Swan Theory, or the idea of a Black Swan, is so popular and easily applicable in the financial markets.
Again, a Black Swan event is something that is unforeseen, but when it happens, it can cause a major market crash.
How Can Black Swan Events Impact The Financial Markets?
Because of the unpredictability of a Black Swan event, the financial markets can be heavily affected. Because the markets can't predict how Black Swans will impact the market, investors can be caught off-guard if they are not able to react quickly or make the right decisions.
For example, the Great Recession of 2008 is considered a Black Swan event. Even though there were many events that caused the financial crash, including the bursting of the housing bubble, the federal government's failure to address problems in the financial institutions, and the Federal Reserve Bank's unpopular decision to dramatically lower interest rates, many investors were caught off-guard by how much the market crashed.
Many investors were left without jobs, and many companies were forced to close their doors or file for bankruptcy. In the end, the initial trigger of the Great Recession of 2008 was something that no one could have predicted, which is what makes for a Black Swan event.
What Causes A Black Swan Event?
In addition to the unpredictability of a Black Swan event, there are many possible causes of Black Swan events that can make your financial markets unstable and vulnerable to a crash.
The following are some possible causes of Black Swan events:
Exchange Rates Policies: Many of the Black Swan events that have occurred in the financial markets have been caused by exchange rates policies. For example, during the Asian Financial Crisis of 1997, the devaluation of the Thai baht triggered a chain reaction that led to the devaluation of other Asian currencies like the Malaysian ringgit and the Indonesian rupiah.
Market and Instability: Another major cause of Black Swan events is market instability. For example, during the Great Depression, the Great Depression was caused by massive stock market crashes, a lack of confidence in the financial markets, and a lack of a systematic plan to address the markets' problems.
Market Regulatory Changes: It's also possible that Market regulatory changes can trigger Black Swan events. For example, after the Great Recession of 2008, there was a significant reduction in risk management and capital requirements. This was due to the regulatory changes made to the financial market after the Great Recession of 2008.
A Black Swan event can be triggered by many factors and can make the financial markets unstable.
What Black Swan Events Occurred So Far?
It's important to know how exactly Black Swan events have affected the financial market over the years so that you can better predict and prepare for the possible Black Swan events that will occur in the future, although incredibly challenging.
Here are some of the most devastating Black Swan events that occurred in the past:
The Black Friday Crash of 1929: In the fall of 1929, the stock market began to grow highly volatile, which made investors hesitant to invest in the market. This led to a massive sell-off of stocks. On October 24, 1929, known as Black Thursday, when the stock market was down, investors began to panic and then sold their stocks at a fast rate, causing a chain reaction where the stock market would fall more and more. Soon enough, the stock market crashed and lost $30 billion in value in a single day. Moreover, the stock market continued to fall significantly in the next few years, especially after the 1930 recession.
The Pearl Harbor Attack: On December 7, 1941, the Japanese military launched a surprise attack on Pearl Harbor. This attack would directly lead to the United States entering World War II. As a result of the Japanese attack on Pearl Harbor, the United States entered World War II, which caused a major market crash in the United States. More specifically, the stock market saw a 21.7% crash in the month after Pearl Harbor, and the trading volume decreased by an estimated 89%.
The Great Recession of 2008: The Great Recession of 2008 began in 2007 and was not directly caused by a single event. Instead, the Great Recession of 2008 was caused by a confluence of factors, which included the bursting of the housing bubble, the federal government's failure to address the problems in the financial institutions, and the Federal Reserve Bank's unpopular decision to dramatically lower interest rates.
The Dot-Com Bubble of 2000: The dot-com bubble began to grow when companies were given easy access to capital and high valuations, which led to a major increase in the number of companies that would go public. This rapid increase in the number of companies going public led to the dot-com bubble.
The Terrorist Attack of September 2001: In September 2001, terrorists from the al-Qaeda terrorist network hijacked four planes and attacked the World Trade Center in New York City. This attack caused the destruction of the World Trade Center, which would severely damage the economy in the U.S. Both the World Trade Center and the Pentagon have been damaged, and the George Washington Bridge was damaged due to the two planes that crashed into it.
In summary, there have been many major Black Swan events that have occurred in the past. By being familiar with these events, you'll be better prepared to trade in an uncertain market.
How Do I Prepare For A Black Swan Event?
Since it is impossible to predict a Black Swan event, one of the best ways to prepare for one is to do a lot of research. For example, the best way to prepare for a Black Swan event is to research how the markets react to similar events.
For example, Black Swan events have occurred in the past because of major crises like the 9/11 terrorist attack or the Asian Financial Crisis of 1997. Since there are different types of Black Swan events, it's best to research the events that you believe may cause a Black Swan event, how the market reacted, and what happened to the economy when it happened.
Another good way to prepare for a Black Swan event is to know the major financial markets you are invested in. For example, if you plan to get a job related to finance, you'll want to invest in the financial markets. In order to do this, it's best to first educate yourself on the major markets and how they operate.
This is because one of the best ways to combat a Black Swan event is to know how the markets will react, just as we mentioned earlier. For example, if a Black Swan event triggers a stock market crash, you'll want to know how the stock market will react and whether you should sell your stocks immediately.
The last way to prepare for a Black Swan event is to invest in the financial market. By investing in the financial market, you will be able to make more money to act as a cushion should a Black Swan event occur, which leads to a sudden market crash.
By investing in the financial markets, you will also be able to spot Black Swan events that may affect the markets. Additionally, you can start to educate yourself so that you can protect yourself from these events in the future.
How Do I Trade During A Black Swan Event?
If you still want to trade during a Black Swan event, there are a few tips you can follow to limit the risk you face and maximise success.
For example, one of the things you must never do during such an event is to go all-in on a specific investment. This is because your investments may end up being worthless in the event of a Black Swan event, which will result in a significant loss.
Instead, it's best to diversify your investments to minimise the risk of Black Swan events. For example, if you plan to invest in stocks, it's best to diversify your investments by investing in bonds, commodities, and foreign currencies. This will help to protect your assets in the event of a Black Swan event.
Another tip you can follow is to hedge your portfolio. This is by investing in the markets that you believe will do well if there is a Black Swan event. For example, if you believe a terrorist attack will cause the Black Swan event, you could short the market of the country in which the attack is most likely to occur.
You could also invest in foreign stocks that you believe will do well in the event of a Black Swan event. For example, if you believe that the cause of a Black Swan event is a terrorist attack, then you can invest in foreign stocks that you believe will do well in the event of a terrorist attack.
Our final tip for you is to look for stable blue-chip companies. This is because a Black Swan event will significantly affect the financial markets, but blue-chip companies will be significantly less affected by the market crash since they're well established and do their part to survive the event.
For example, suppose a Black Swan event occurs because of a terrorist attack. In that case, it's best to invest in blue-chip companies that are unlikely to be affected in the event of a terrorist attack, such as Johnson & Johnson, Nike, McDonald's, General Electric, and Procter & Gamble. Though their stocks may not rise or even experience a drop, you can rely on their ability to survive the event.
It's important to remember that Black Swan events are unpredictable, which makes it challenging to prepare for them. However, by doing a thorough research and setting up a stable portfolio, you can improve your chances of succeeding during Black Swan events.
In addition to the above tips, it's best to be careful when you invest during a Black Swan event. Although it may be tempting to put all your money into a stock that you believe will do well during a Black Swan event, it's best to diversify your investments and keep a sizable stake in cash in case a Black Swan event occurs!
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