A black swan event can have a devastating impact on the markets and is next to impossible to predict. So how should you deal with black swans when trading?
What is black swan theory?
Black swan theory is the idea that events can arise completely unheralded – are unpredictable based on our current monitoring – which are then incorrectly classed as predictable after the fact. It is used to describe the effect that unforeseen events have on human history.
Essentially, black swan theory dictates that there are some events that we are completely unable to foresee which will change the world. Some of these events might have a positive impact, others negative.
The theory was proposed by Nassim Nicholas Telib, first in his 2001 Fooled by Randomness and then in more depth in his 2007 work The Black Swan – which was published just before the global financial crash. It is so named because for centuries it was believed that real-life black swans could not exist, until Dutch explorers discovered them in Western Australia.
Learn more about the history of market crashes.
Black swan event meaning
A black swan event is an occurrence that is rare, unpredictable and causes major disruption. Telib defined black swan events according to three criteria:
- They are outliers that sit outside the realm of expected possibility – so are a complete surprise
- They have an extreme impact
- Afterwards, people try to rationalise the event as predictable if we were paying attention to the correct data
Often, after a black swan event, our monitoring systems adapt to take the event into account, ensuring that we won’t be as surprised by such an occurrence again. However, that still leaves us open to a completely different black swan event.
Black swan events on the stock market
On the stock market, black swan events are classified as crashes that exceed six standard deviations – massive market crashes that are extremely rare and catastrophic when they arise. As with Telib’s theory, some argue that black swan crashes in the stock market are much more common than we think.
What is a grey swan event?
A grey swan event is similar to a black swan but is slightly more predictable. Grey swans are still usually a shock, but not as completely out of the blue as black swans. Some analysts also refer to white swans – major events that are bound to occur.
Telib doesn’t mention white or grey swan events in his books. But after his theory became fashionable, the terms arose to describe occurrences that don’t quite match the criteria of black swans.
Trading black swan events
By their very nature, it is extremely difficult to trade black swan events. After all, by definition, they arrive completely out of nowhere with entirely unpredictable consequences across forex, shares, indices and commodities.
But it is not advisable to ignore black swans either. In his book, Telib – himself an ex-Wall Street trader – argues that we should prepare for black swans to land at any time. We may not know what is coming next, but we can be fairly sure that a potentially catastrophic event could arise at any time.
For a trader, that means having a comprehensive risk management strategy in place, including always using a stop loss order. Black swans tend to cause massive volatility, so trading with guaranteed stop losses can be a useful way of protecting yourself against potential slippage.
Some traders may exit their positions as soon as a black swan begins to take over, preferring to stay out of the markets until normality resumes. However, it can be tricky to know when an event is a black swan as it plays out.
Diversification has also been touted as an effective way to protect against black swans – albeit not without controversy. After the 2008 crash, the asset allocation models used by many major funds were unable to protect against the effects of the crash. Once again, the unpredictable nature of these events makes creating a bulletproof diversification strategy difficult.
That doesn’t mean you should ignore diversification entirely, though. But relying solely on diversifying to protect against black swans probably won’t work.
Black swan event examples
Let’s take a look at a few examples of black swans over the years, to see how they can play out in practice.
Rise of the internet
The rise of the internet is used as a classic example of a black swan by Telib in his 2007 book. Why? Because without the benefit of hindsight, predicting the extent of the disruption caused to finance, science, history and technology from the adoption of the internet was next to impossible.
The rise of personal computing and smartphones can also be viewed as black swan events. Today we largely view the outcomes of these events as positive – not all black swans are complete catastrophes.
Telib also cited 9/11 as an example of a black swan. After the attack, many questioned whether it could have been predicted or prevented, but according to black swan theory, it couldn’t. The fallout from the atrocity was massive, dictating much of the political course of the next decade – and is still being felt today.
Some have noted echoes of 9/11 in the 2023 Hamas terrorist attack on Israel, itself a recent example of a black swan.
2008 global financial crash
Arguably one of the clearest examples of a black swan arrived shortly after Telib’s book on the topic and did much to propagate the theory.
In hindsight, many have claimed that the crash was inevitable and predictable – but very few were able to foresee when the crash would land, and how catastrophic the fallout would be, including the collapse of Lehmann Brothers in September 2008.
The crash caused more than $10 trillion in losses to global investors, the worst financial crash since the 1929 Wall Street crash. Telib himself argued that the global financial crash showed that broken systems should be allowed to fail, as it strengthens them against future black swans.
The COVID-19 pandemic killed millions and shut down much of the global economy in 2019 – with almost nobody able to predict the effects of the pandemic just weeks before global quarantines were imposed.
Some argue that COVID-19 should be classified as a grey swan. Pandemics have been a part of human history for millennia, and recent examples such as SARS offered evidence that a virus could sweep the world. Telib himself even argued that it is a white swan, since a pandemic was bound to occur at some point.
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