In 2007 Nassim Taleb wrote “The Black Swan”, a book that examined the influence of highly improbable and unpredictable events that have massive impacts. In essence Taleb theorized that we can’t foresee or imagine what worldly events will shake the world and the stock market.
For example, because we CAN imagine our current market worries such as the Trade War, Impeachment and Recession, none of these fears would qualify as a Black Swan. And while these issues may cause temporary market shakiness, none of these events are likely seismic enough to send the market spiraling lower by 20% or more.
Instead, the unforeseen, such as terrorists hijacking airplanes and flying them into the Twin Towers in New York, are Black Swans, and the types of events that can shake the market and send shockwaves through history.
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So what is the next black swan that we need to prepare for?
According to Taleb, the answer is: We can’t know!
However, I couldn’t help but think several weeks ago, days before the U.S.-China trade talks were set to take place in Washington, D.C., that Houston Rockets General Manager Daryl Morey’s tweet supporting protests in Hong Kong could have been a “small” black swan.
At that time, before Morey’s tweet, the protests in Hong Kong were a third-page-of-the-newspaper story for most Americans.
However, Morey’s somewhat-out-of-nowhere tweet supporting the protests was met with strong dissatisfaction in China. And very quickly Tencent (TCEHY), the NBA’s exclusive digital partner in China, announced it would suspend business relations with the Rockets, and Sportwear brand Li-Ning suspended business ties with the NBA.
Very quickly this third-page story became a lead for the evening news as the Rockets and the NBA appeared to be more interested in saving their business interests with China than honoring Morey’s right to free speech.
If you had hopes that the already flammable U.S. relations with China were going to simmer down ahead of the trade negotiations, Morey’s tweet seemingly threw gasoline on that fire.
However, as we now know, the story has slowly faded from the public’s interest, and the U.S. and China were able to reach a “Phase 1” deal on trade on October 11.
But stepping back, if this Morey issue had put a nail in the coffin of the trade talks, or somehow inflamed the Hong Kong protests, we might be looking back weeks/months later wondering if this was an unforeseeable “Black Swan” event that had long-term ramifications.
How Do I Hedge against a Black Swan?
Because we never know when the next Black Swan will pop up (and in reality they are very rare), hedging against such an unforeseeable event is very challenging.
How we manage this in my Cabot Options Trader and Cabot Options Trader Pro advisories is that we typically hold one bearish position against our portfolio of bullish positions.
So while I continue to be bullish on the market, and own call positions in Target (TGT), Medtronic (MDT), salesforce.com (CRM) and many others, we do also own put options on the S&P 500 ETF (SPY). And when we buy hedges such as these SPY puts, we know that this trade is simply an insurance policy that we hope to lose money on as the rest of the portfolio’s holdings rise in value.
That said, because Cabot Options Trader is a trading service, we do also trade/scalp our puts when they become profitable very quickly, or if I think a sell-off is overdone. For example, here is my sale alert on selling half of our SPY puts for a profit of 20% just a week after buying:
“Sell HALF of Existing Position: Sell Half your S&P 500 ETF (SPY) March 298 Puts for $14.10 or more.
“The S&P 500 is trading lower again today. And while we would prefer the market to trade higher as we are holding several bullish positions, the portfolio is not so overwhelmingly long that we can’t take a quick scalp of 20% on half of our SPY puts.
“To execute this trade, you need to:
“Sell to Close Half your SPY March 298 Puts
“We will hold the balance of this position to protect our bullish portfolio.”
As the trade alert above shows, when I recommend entering or exiting a trade I give specific instructions on how to execute each trade so that my subscribers can trade with full confidence.
Will I recommend a new put buy so that Cabot Options Traders have even more protection against the next Black Swan? Only time will tell. Though in reality, as Taleb theorized in 2007, because we can’t foresee or imagine the next Black Swan, there’s never a way to prepare for it.
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