Will a Black Swan Event Cause the S&P 500 to Drop by 40%? (+2K Views)

So says Sara Nunnally (http://www.taipanpublishinggroup.com/)  in excerpts from an article* which Lorimer Wilson, editor of www.munKNEE.com  (It’s all about Money!), has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.  Nunnally goes on to say:

The Black Swan Theory

The Black Swan theory was developed (popularized) by Nassim Nicholas Taleb in his 2007 book of the same name, The Black Swan. The term is now used throughout the investment community to describe unexpected events (outliers) of large magnitude and consequence…Basically, you can think of a black swan event as an event that doesn’t make statistical sense at the moment, but has a small probability of occurrence. Not only can these “outliers” or extreme unpredictable events be catastrophic for our wallets, but they may change the way we look at the safety of our investments forever.

If more of these black swan events occur and are burned into our memory, we may begin to believe that these abnormal events are more common than they are and those subsequent fears may actually exacerbate the repetition of these occurrences. It’s like having five tornadoes hit the city of Philadelphia in a summer – something that seemed impossible is occurring in front of your eyes and becomes reality, and it triggers massive changes in the minds of the people that live there…

What Are the Chances of a Black Swan Event?

Believe it or not, mini catastrophes and outliers happen every week. We option traders usually know what to look for when it comes to signs of impending doom but sometimes there are no abnormalities or warnings of these types of events…Take Research in Motion, for example. It went from $70 per share down to $29 per share in less than 120 days. The options did not predict this early on. Statistically, there was less than a 0.05% chance of this happening…

I did some basic calculations using my own techniques and found some interesting statistics:

• Looking at the options prices in the SPX and how the index has moved over the past year, I actually came up with the same probability as Mark Spitznagel.
• I see a 19.89% chance that the S&P 500 could get down to 762 by June 18, 2014 – which would be a 40% drop.
• I also figured that there is about a 10.5% chance that it could go back to the low of 666 by June 16, 2014.
  

So What Could Really Happen to the S&P 500?

For the market to drop so dramatically, there has to be a catalyst, something out of the ordinary – a black swan needs to create a black swan event, if you will. Back in 2008-09 it was a complete meltdown of the banking system and housing market that sent securities 57% lower.

[While] the charts and some basic fundamental estimates [suggest that] it’s more realistic that a correction would bring us down to the 1,100 level in the next year… I would instead focus on the potential catalysts for catastrophe: a bubble bursting in China’s housing and growth boom, a major terrorist attack, earthquake or other natural disaster, a double-dip recession here in the U.S., eurozone stability crumbling under sovereign debt contagion, etc. Any of these situations could occur; the questions you have to ask yourself are:

• What’s the probability of an occurrence?
• How will my portfolio be affected?
• What am I doing to hedge (protect) myself?

How Do You Profit or Protect Yourself From a Potential S&P 500 Drop?

You can protect yourself…[by] learning to use options, and option spreads specifically. They can dramatically reduce your risk and exposure to events like this. They can also increase your probability of success in your trades. You can also buy put options against your long stock positions. These are called “married puts.” Basically they are like insurance policies for your stocks. In my book, I discuss all of this in detail.

I actually used an option strategy on RIMM because I believed that the company would get smart and turn around. They failed miserably, but instead of losing $40 on the trade, I lost about $8. This was much more tolerable, and I can now deal with my mistake and move on as opposed to having my account decimated.

We will all have losing trades and make mistakes, and every so often when that black swan appears, you will want to be prepared. Instead of losing it all to the swan, use the right strategy to dramatically reduce your risk and live to play with the black swan another day.

*http://seekingalpha.com/article/276014-black-swan-event-will-the-s-p-500-drop-40?source=email_watchlist

Related Articles:

1. Stock Market is Due for a 15-20% Correction – Here’s Why  https://www.munknee.com/2011/06/stock-market-is-due-for-a-15-20-correction-heres-why/
2. Today’s Market Breadth is Bad Breath for Tomorrow’s Market – Here’s Why  https://www.munknee.com/2011/05/todays-market-breadth-is-bad-breath-for-tomorrows-market-heres-why/
3. Why – and How Best to Play – a Major Stock Market Correction is Imminent  https://www.munknee.com/2011/05/why-and-how-best-to-play-a-major-stock-market-correction-is-imminent/
4. A Violent Correction Is Coming For the S&P 500! Here’s Why  https://www.munknee.com/2011/06/a-violent-correction-is-coming-for-the-sp-500-heres-why/

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.