Black Swan Investing – Making a Fortune off Rare Events

by Darwin on October 31, 2010

For the uninitiated, a Black Swan event as outlined in Nassin Taleb’s excellent book The Black Swan: The Impact of the Highly Improbable is one in which it is so rare and unpredictable that virtually nobody is prepared for it.  Consider a small handful of 5 hedge funds that stood out as amongst millions of investors that bet early on that the housing market would collapse.  As improbably as that seemed, and as much as the investment banks, ratings agencies and government officials suggested they were wrong along the way, it did occur.  This was a quintessential Black Swan investment – betting on credit default swaps on tranches of AAA-rated mortgage backed securities that were anything but AAA quality.

How to Profit from a Black Swan Event

Often times, Black swan events are negative.  Perhaps a multi-million dollar inheritance from a long lost relative that you never knew of could be a favorable Black-Swan, or even more recently, very few investors could have foreseen a 70% single year return in stocks from the lows in March 2009.  Generally though, a Black Swan event is one in which it is so improbable, that those who avoid it consider themselves lucky – and those who actually bet on its occurrence can reap handsome rewards.
As an example, consider what would happen if the S&P500 rose another 50% from its current value by March 2011.  As improbable as it is, we’re on a 70% run now from the pivot bottom, but still well below prior highs, so what’s stopping it, right?  I mean, since US stocks are denominated in US dollars and our monetary policy has been to print money like it’s goin’ outta style, humor me.  So, the ETF (SPY) currently trades at $118 per share.  A 50% move would value SPY at $177.  A black swan investment on such an outcome might be to buy way out of the money call options on the ETF for March expiration.

  • Buy March 150 call SPY for .04
  • Each contract would then cost $4
  • A $177 closing value at expiry would value the (177-150)*100 = 2700
  • You’d return $2700 for every $4 invested (after commissions)

Types of Black Swan Events:

  • Stock Buyouts – Incredibly (and painfully), I made a buyout call on Aquantive (the day before it was announced.  My article was published at back in 2008 since Google gobbled up my old blog on the Blogger platform.  The options I had recommended would have turned my measly $400 investment into $24,000 in a single day for a 1 day gain of 6000%.  As luck would have it, I didn’t get around to making that trade the day of (I figured I’d get around to it some time that week) and the announcement sent shares up 70% while I waited on the sideline.  Anyway, a purely speculative bet on takeover news like that would be a positive Black Swan.
  • Binary Stock Events – Take the example of small Biotech companies with their fortunes riding on the result of a major clinical trial or FDA approval decision.  Such an event can send shares sinking over 50% or cause them to rise over 100% in a single day.  Now, options volatility often prices such events in, because in fact, they are somewhat predictable.  It may be uncertain just “what” will happen, but it is relatively certain that “something big” will happen, so the volatility premium spikes before anticipated FDA rulings, trial results publication dates and the like.  So, those are mini-swans, but more aptly considered “binary events”.  I’m also considering next week’s anticipated Quantitative Easing 2 announcement as a binary event.
  • World Events – 9/11 was a prime example.  If I think back to the single biggest shock I’ve ever experienced in my life, it was waking up to planes crashing into the Trade Center towers.  As horrific and shocking as that event was to the world, many people profited substantially, lending some to believe there was a much broader conspiracy (Billions were made in put options on airlines that week).  Conspiracies aside, someone (likely affiliates of Al Queda) placed sizable bets via put options on airline stocks just prior to the event.  Those Black Swans generated enormous returns (potentially feeding fuel to the terrorist financial engine).  Concerned citizens are able to hedge against extreme world events outside of the stock market as well.  For instance, if you live in Israel and are concerned about the repercussions of an attack on a nuke site in Iran (with the fallout being mass rocket attacks within Israel for retribution), you could utilized to hedge against such an event.  The contract for that event occurring by Jun 2010 is $5 with a $100 payout, so you’d profit 20 to 1 (or perhaps mitigate financial hardship you experience in your homeland).  As abhorrent as it may sound to “bet” on disastrous world events, there is a market for it, and millions are using it.
  • Invisible Black Swans – These are the most common.  You can’t see them in advance.  You can’t even contemplate them.  But they will occur.  Perhaps it’s a massive asteroid hurdling toward earth or it’s a novel flu strain that this time, mutates so quickly that no vaccine or immune response can protect a third of the world’s population and it puts the Spanish flu to shame.

What Does Nassim Taleb recommend?

I read an article a few years back where the Black Swan author actually recommended holding something like 95% in TIPS (Inflation protected Treasuries) and using the remaining 5% to buy out of the money options contracts to participate in massive market upside.  His thinking was that routine stock market pertubations make investing 100% in stocks too risky and inflation is the biggest concern of his, so one could protect against hyperinflation (relatively) with TIPS and participate partially in a massive market move upward in any given year.  However, he wrote this before we were looking at the biggest bond bubble in history.

The inverse is true for a market crash as well of course.

As a takeaway though, I want to highlight that a true Black Swan event is so rare that betting on Black Swans is likely to be a painful lesson in death by a thousand cuts.  It’s well known that most out of the money stock options expire worthless.  The vast majority of all WAY out of the money options expire as such.  Speculating becomes expensive, even at just a hundred bucks per position.  Think about what you’re hedging against or betting on and why.  If you’re interested in what I invest in, check out my monthly portfolio updates and subscribe to my RSS to follow in real time.  And if you don’t have a trading account just yet, check out optionsxpress for low cost and trade execution.

You Should Definitely check out the book – it was an incredible read!

{ 6 comments… read them below or add one }

ctreit October 31, 2010 at 10:25 pm

I knew a trader who was betting against Japan unsuccessfully for about 5 years before the market collapsed. He made his money in the following years and is now a very respected fund manager. But he sure had to hang in there for a few years sticking to his conviction. – I think that it makes probably more sense to ignore black swan events and follow hard rules when to get out. Then you don’t get caught up in sharp moves against you. And you can make a ton of money in 5 years which would not make it a problem to give some of it back in the 6th year.


Darwin October 31, 2010 at 10:41 pm

True, the maddening knowledge that one was “too early” has plagued many geniuses who ended up being drained early. Heck, Long-Term Capital Management was early (and right) and almost collapsed the entire financial system. Some of the guys buying CDOs against mortgage-backed securities started in 2005 and they slowly paid millions until 2007 keeping those positions alive.


Scott H Thompson November 1, 2010 at 5:31 pm

I like that you point out the positives and the negatives of a black swan investment strategy, because it is definitely something you have to think through. I’ve been trading (buying, really) options for years, and you have to understand that most out-of-the-money contracts expire worthless, as you point out. The payoff profile of a long option position can be very attractive, but timing has to be a huge consideration, and it takes practice.

I’ve been giving a lot of thought to Taleb’s barbell strategy recently, mostly because part of me worries that stocks will not be a good long-term investment during my lifetime, unlike that of my parents. What if stocks don’t provide an average return of 5-8% each year for the next 40 years? I think many people expect stocks to give a good return just because they can’t imagine it not happening, and they’re certainly not prepared for it. I’m trying to develop a strategy that will be robust to stocks not performing well, but I haven’t worked it all out yet.

Anyway, great post!


Darwin November 1, 2010 at 9:12 pm

My overall philosophy’s a bit more one-sided. I tend to hedge more on the downside and if the market runs, so be it. Most of my money’s in retirement accounts which are 100% aggressive long equities anyway, so if my trading account suffers some losses on expiring options and shorts, not a big deal in the grand scheme of things. I’ve been doing real well in this flat market, but nothing lasts forever!


Money Reasons November 3, 2010 at 12:21 pm

At work, we call swing for the bleacher investment s “lottery tickets”, since we didn’t know of the term “Black Swan”. I’ll be sure to use that term going forward, I like it!


Stock Market Hacker November 5, 2010 at 5:06 pm

Well said. Black swans are covered in the excellent book of the Long Term Capital collapse. Those Nobel prize winners though that it was impossible that their worst case scenario would come to fruition. enter the 1996 Asian market panic to shatter their notions.


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