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Protecting Against a Worst-Case Scenario

If someone asked what could be the worst-case scenario for the market for 2014, what would your answer be?

We Know How to Handle Winter

Black Swans

Protecting Against a Worst-Case Scenario

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My family and I moved to the Southeast a couple of years ago to get away from the nasty Chicago winters that never seem to end. We were tired of the snow and wanted to go somewhere warm.

Our first year in the south we saw no snow. Then, just three weeks ago, we got hit by an inch of snow. Our city shut down! We laughed it off and made fun of our neighbors who had stocked up on a week’s worth of groceries and were glued to the television for breaking news on the “snow storm.”

So last week when it was predicted that we could get another two inches of snow, my wife and I once again laughed it off. She went into work 20 minutes from our home and I settled into my trading office at home. Then the snow started to fall. I called my wife to tell her that the snow had started and she said that she’d finish one last project and head home.

Within an hour we had several inches of accumulation, and by the end of the day we had 6 to 9 inches of snow on the ground. This was well above the forecasted snowfall and the roads were an utter disaster. A drive that should have taken my wife 20 minutes took nearly five hours as the roads became an absolute mess with cars ditched by the sides of the road. Luckily my wife made it home before the ice storm hit our area!

Why am I sharing this story today? You know it’s going to have something to do with investing.

Snowstorms are part of life. We’ve seen hundreds of them. The weather service can predict them with a certain level of accuracy. We know the chain of events when the snowfall starts: traffic slows down, we watch for black ice, kids may miss some school. Snow is a known aspect of our lives and for the most part, we know how to deal with it.

In investing, we also know of potential events that may sidetrack the market or individual stocks such as earnings misses, accounting issues and war—to name just a few.

It’s the unknown event that we rarely price in when investing.

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These types of unknown events have been famously labeled “Black Swans” by Nassim Taleb in his book Fooled by Randomness and his follow-up book The Black Swan.

Taleb basically characterizes a black swan as an event, positive or negative, that’s deemed extraordinarily improbable yet causes massive consequences.

The term Black Swan originates from the former Western belief that all swans are white. At that time in history, white swans were the only swans ever accounted for. However, in 1697 a Dutch explorer shattered this belief when he discovered black swans in Australia. This was an unexpected event that changed the way we thought.

So how can we identify the next Black Swan event? The theory is that we can’t. We don’t know what we don’t know.

History is filled with examples that satisfy the Black Swan criteria—both positive Black Swans and negative Black Swans.

A positive Black Swan could be the rise of the Internet and its impact on our lives.

Negative Black Swans would include the rise of Adolph Hitler and the subsequent World War, the totally “out of the box” way the United Sates was attacked on September 11, 2001, and the tsunami that destroyed the Fukushima Daiichi nuclear plant that released substantial amounts of radioactive materials into our seas in March of 2011.

So if we can’t begin to guess the next Black Swan, how can we possibly plan for it when it comes to investing? One way to protect ourselves against the negative Black Swan is to buy put protection.

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If you asked yourself what would be the worst-case scenario for the market for 2014, what would your answer be? Down 10% to 15% for the year because the U.S. economy slowed down or the emerging markets melted down? No, those aren’t Black Swans because we know these risks.

How about the market declines 20% OVERNIGHT?

Now let me stop and say that such Black Swan events are extraordinarily rare. However, there are ways of protecting yourself against a massive Black Swan downside move in the market.

If I were looking for protection against a large move in the markets, I would look to buy a put on the S&P 500. To do this, I could buy a put in the SPDR S&P 500 ETF Trust, which corresponds to the price and yield performance of the S&P 500. The symbol is SPY.

I could buy a put 10% below the current market price once a year every year. So today, I could buy the SPY December 165 Put for $5. If the SPY were to drop below 165, my puts would increase in value to somewhat offset the losses in my portfolio.

Think of this protection in terms of homeowners insurance. None of us thinks our house is going to burn down … yet we all have insurance against such an event.

I hope I haven’t scared you. However, I feel it’s appropriate to prepare for the downside risks of the unexpected. And that’s just a sample of risk-management advice that I give the readers of Cabot Options Trader every week.

For details, click here.

Your guide to successful options trading,

Jacob Mintz
Chief Analyst, Cabot Options Trader

Jacob Mintz is a professional options trader and editor of Cabot Options Trader. Using his proprietary options scans, Jacob creates and manages positions in equities based on unusual option activity and risk/reward.