Lesson Overview

How to Avoid "Black Swan" Events

Scared of another market crash or flash crash? Want to learn how to avoid Black Swan market events? Once I can get you to recognize and accept the truth about black swan events, your confidence and courage as a trader will explode!

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In this video, we're going to talk about avoiding "black swan" market events. So, "Black Swans" are the quick unexpected, unavoidable, and often significant moves in the stock market.

Though most of the time it's when stocks fall, there can be bullish "Black Swans" if a stock price rises quickly. I think most people assume that, you know, most of the time with Black Swans, that actually happens to the downside, which is true, most of the time it does.

But, it doesn't mean that you can't have a bullish Black Swan event where a stock price rises very quickly in a matter of a couple days or weeks. In fact, right now with the time we're doing this video, gold is in one of those situations which has just been rallying very, very quickly.

Now, I think it's important to understand, apparently, that there is this constant cycle with most investors. You may have been in this before or you may be in this right now, but understanding what that cycle is, as far as fear and greed, buy and sell, is really important.

I think this picture here kind of describes it really well is that we all go through this greed cycle where we buy, we're confident and then we go through this fear cycle where we sell and we're confused and scared and then we just kind of keep repeating this process.

So, our goal here at Option Alpha is to help you get out of this trap and understand what really happens in market dynamics and how you can basically trade around this so that you can make some money.

Now, as the description suggests, they are "unexpected and unavoidable" so how can we anticipate them? Well, the reality is we can't, so stop trying to anticipate when they're going to happen.

Just realize that they are going to happen. So, in this manner, we've also done a little bit of research and went back all the way to 1928 which is about as far as we could get some, you know, good stock market data.

We basically kind of brought some numbers to light as to how many times the market has fallen by certain percentages. And again, it's not to prove that it will happen, or it won't happen again.

It's just to bring some context in to how often some of these, you know, moves happen. So, 90 times stocks fell at least 10% going back to 1928. That's about once every 11 months. So, once a year, you can pretty much assume that stocks are going to fall about 10% in a given year.

41 times they fell at least 15% so that's once every 2 years. 21 times stocks fell at least 20%. That's at least once every 4 years. 9 times they fell at least 30% which is once every 10 years. So every decade you can basically assume that a third of the market value is going to be wiped away.

And then only 3 times in history has the stock market fallen by at least 50% which means that a handful of times we will have really, really bad Black Swan events.

Again, you have to accept these facts as truth because they will happen again. It's not a matter or if, it's when. Once I can get you to recognize and accept this truth, your confidence and your courage as a trader will explode and hopefully, we can get you to that point here in this video.

So, Mark Twain famously said, "Courage is the resistance to fear, mastery of fear, not the absence of fear." I think that's really important because it's not that we can't be fearful, it's just that we have to recognize that things like this happen and we can do only what we can do as traders to control it and to basically live through the event.

So, the analogy that I often use, and if you went through Track 2 you saw this as well but it's worth repeating a million times, is getting into a car and driving. So, you can get into your car and control only so many things as you drive down the road.

You can control your speed, you can buckle up your seatbelt, you can keep your eyes on the road, not pay attention to your text messages, your cellphone, or the radio, or whatever the case is.

Two hands on the wheel, drive in between the lines, there's a number of things that you can control while driving down the road. And that's the analogy for investing.

You can control what things you trade in and how big your position size is and how much money you put at risk and when you take money off the table and when you close out positions or use stop-losses. There's so many things you can control.

But what you can't control, especially when driving, is you can't control the idiot that decided to drive drunk, or drive under the influence of some other drug and is barreling down the road at 90 miles per hour, head on.

You've done everything you can possibly do to protect yourself, but you can't control that person. Like you can't control the markets and Black Swan events because they are going to happen. Right? It's not a matter of if, it's just when it's going to happen.

Now, it doesn't mean that you're going to get hit by a drunk driver, so please don't add all these kind of crazy comments to this video. Just trying to prove a point that there's only so many things you can control.

So, now that we know we can't avoid "Black Swan" events, which is what everyone tries to do, what we need to do is to focus on how to stay alive through them to keep trading. As you might have guessed, there are basically two things you have to do so that you can live through these "Black Swan" events.

And, they're right here. Number 1, you've got to keep your allocation per trade at 1 to 5 percent. And Number 2, you have to maintain an overall neutral portfolio as much as possible.

So, the first thing is, of course, we got to keep our risk in line. Meaning our maximum risk per trade or our allocation has to be between 1 and 5 percent. There's a reason why we choose 1 and 5 percent. I'll get to that here in a second.

But this is the table that you can use to make sure that, you know look, if you're trading a $20,000 portfolio that you have to keep your maximum risk per trade at $400 if you want to allocate 2% per trade, okay? It's a requirement. This is not a maybe you should do this, maybe you shouldn't.

You have to do this and I guarantee if you don't do this, you're going to be set up for Murphy's Law which means that something bad's going to happen, just when you least expect it when you're not following the rules.

Now, if you think about it, this is why casinos have table limits. When you go to a casino in most of the case, expect for a higher roller's room or something like that, but most casinos have table limits because they don't want somebody coming in and placing a million dollar bet one time with a high probability of winning, right?

Or with a decent probability of, you know, one roll being that roll that nets them a million dollars. But you'll see casinos actually have table minimums and table maximums because they want to control how many times you played their game because they know the longer you play and more times you increase the number of plays then the house edge gets increased back to the casino.

So again, the longer you play, the more you stand to lose. Period, end of story. So, we need to apply that same concept as we trade in the markets as well, realizing that there could be somebody who walks in and takes a million dollars from us.

That's that Black Swan event for a casino. Somebody who walks in, places a million dollar bet on the table, red or black on a roulette table, and one time walks away with a millions dollars, never comes back again. For a casino, that's a Black Swan.

For us, we need to realize that there could be an event at any moment that takes a lot of our money away. That means we have to control us position size.

Again, for casinos, the more you play, the greater the edge becomes back to the house. So, if you think about it, and this is something that we've covered a millions times here, but basically after one spin in roulette on a casino wheel, your edge or the amount of time that you're behind to the casino is 51%.

So, your edge is about 49%. It's basically the best percent chance that you have of winning is only the first time that you actually spin that roulette wheel or that one bet.

Again, this is why casinos don't ever let people invest a lot of money on one bet. They have these table limits that keep them there for a long time because they know that after a 100 spins, the casino's ahead 64% of the time.

After 1,000 spins, casino's ahead 81% of the time and after 10,000 spins, the casino is ahead 100% of the time. And what that means in here, and this is why it's so important, is that even in that 10,000 spin, there could have been 2 or 3 really bad trades that the casino made.

Meaning they could have paid out a lot of money 2 or 3 times to a couple people but the vast majority of the time, they made money even including those 2 or 3 big payouts, those 2 or 3 big Black Swan events for the casino.

They're still ahead of the game because of the number of times that people have played and because they controlled how much money people invested.

So, what we've done at Option Alpha is actually primarily calculated out your odds or your probability of seeing consecutive losers based on different levels of expectation in placing trades.

So, if you place a trade let's say on a 60% chance of success level, the likelihood that you see one losing trade is one in three. The odds that you see two losing trades back to back or consecutively is one in seven.

The odds that you see 20 losing trades back to back, so one trade after another after another after another, 20 losing trades consecutively placing trades at a 60% chance of success level is 1 in 90.9 million. So the odds that that actually happen is so, so, so small.

This is why if you think really hard about why our position size allocation is 1 to 5 percent, it's because if we were to allocate all of our money at 5% per trade, that means we'd have at any one time, 20 positions on, okay?

This is, again, this is where we come up with our 1 to 5 percents, not just randomly picked. But if we were to allocate all of our money, 100% of our capital, 5% at a time for each trade, we could at most have 20 trades on.

If we're trading all of our positions at a 70% chance of success, which is where we trade here at Option Alpha, all of our positions are basically [inaudible 00:10:14] at a 70% chance of success.

That means that the odds that we go bankrupt and lose all the money that we have on every single trade that we've invested in is 1 in 28 trillion. Okay? We have almost no chance of going bankrupt even if we invested all of our money in high probability trades.

There's a very, very small chance that we actually lose all of our money if we just keep our position size and if we just focus on high probability trades. Again, so this is why we say to keep your position size between 1 and 5 percent. It's not randomly picked out of a hat.

Now the second part of that in avoiding or living through these Black Swan events is keeping your portfolio as neutral as possible. In our case, what we use is beta weighting or delta weighting.

It doesn't matter what you call it but it's basically making sure that the best combination of stocks that you're come up with, whatever that ends up being, whether you trade ETFs or stocks or it doesn't really matter.

But whatever you come up with are net-neutral to your benchmark index. What that means is that as long as you continue to maintain an overall neutral portfolio, the market moving erratically in one direction or another is not going to kill you.

Could it create a losing scenario where you lose on some trades for a month or a week or whatever the case is? Sure. Of course it could. But it doesn't mean that it's going to wipe you out and that's the only way that you really lose in this game is getting wiped out.

So we love to use a beta weighted portfolio and you've probably seen videos on this before. If you haven't, this is your first time going through it here at Option Alpha.

What we use is SPY as our benchmark index. We mainly beta weight everything that we have to SPY. We say, okay take all of our positions and if they were like one big SPY SPDR's position, what would it look like?

How much room would we have for the market to move? And for us it just makes it really simple and easy to see how our portfolio is going to react to the overall market.

So right now at the time that we're doing this video, SPY is about 206, kind of trading in this range and, if we actually look on the analyze tab of our beta weighted portfolio, we just go down here and we beta weight our portfolio to SPY, now we get this portfolio equity curve that looks like this and this is that green line in expiration.

Basically, it shows us where we make our money overall relative to where the SPY is. So we have these two break-even points up here. This is our higher break-even point and this is our lower break-even point on our overall portfolio.

Again, this is the zero barrier for all of our profit or loss and right now SPY is trading right here on this dotted line, 206.16. That's exactly what we just showed you. Again, this is all live, real time.

So as long as the market SPY stays between basically 209 and 197 over the next basically 18 days until expiration that's coming up. Between 209 and 197 we stand to make a pretty good chunk of change so here's 209 which is right here and here is 197 which is basically right under here.

So this is our profit window for the market, okay? Now, in this case, we're a little bit bearish in tilt because the market just jumped up a little bit higher today.

That means that we need the market to move a little bit longer for us to be completely neutral but having this context of understanding that we have positions on both sides and if the market were to close at say 200, we might lose on a, b, and c position but we'll win more on c, d, and e position, right?

Or we might lose on, you know, x, y, z, but win on a, b, c. It doesn't really matter, it's just keeping that whole overall portfolio or beta weighted portfolio in mind. We use that on the risk profile here in Thinkorswim. Most broker platforms now have this but again it's a great way to give yourself a little bit of exposure in either direction and make some money.

So right now, again, we're a little bit bearish in tilt because the market has jumped up, so we need to get back a little bit more to neutral. It's never a destination.

It's always a goal to continue to maintain as neutral of a portfolio as possible but as long as the S and P closes somewhere around 205, 206 and kind of stays in this range, we should make about 5,200 dollars for the expiration period. So we still stand to make some real money.

Again, we could lose on a couple positions here and there but overall the portfolio should generate about 5,200 dollars right now. So again, the only way to lose in this options trading game is to get knocked out by a Black Swan event.

The longer you stay in, the higher you chance of success becomes. Treat this as a business, not merely a weekend hobby. Understand how these numbers work and how these probabilities work.

You're only chance of winning in this business is realizing that a Black Swan event is bound to happen the longer that you stay engaged in the market and that your success is determined based upon if you can survive that Black Swan event.

And again, the only way to survive it and to live through it is to keep your allocations small, 1 to 5 percent per trade, and try to maintain an overall neutral portfolio which means don't have all of your trades in one direction.

It seems like common sense, and it is, but it's really hard when you start actually start applying it which is hopefully what we're going to get into as we get further into track number three here.

So again, thank you so much for checking out this video. If you have any comments or questions or feedback, please let me know. Add them in the comments section right below.

If you loved this video, thought it was extremely helpful in understanding how to manage your way around Black Swan events or if you know somebody who you think might get some use out of this video or might find this video helpful, please share it online.

Help spread the word about what we're trying to do here at optionalpha.com and until next time, happy trading.

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