How to Sleep Well at Night – Even as Black Swans Lurk

How to Sleep Well at Night – Even as Black Swans Lurk
Aug

18

2017

How to Sleep Well at Night – Even as Black Swans Lurk

The fear of financial “bombshells” can rob a high net worth investor from a good night’s rest. Here is how YOU can sleep tight.

If you’re a stock investor, these are the best of times. The market seems unstoppable. As the S&P spikes to ever higher peaks, media types tout the “sustainable” nature of the rally. A “healthy” trend based on strong earnings, they tell us.

Maybe so.

There is, of course, no reason to believe that stocks will come crashing down anytime soon. But if you have any significant portion of your wealth parked in stocks – you know the risk (at least if you’ve been in the market for 10 years or more.)

Black

A bomb could go off at any time.

Whether that be a political bomb, an economic bomb or a literal bomb, it could bring fast and furious liquidation to stock assets.


The good news is, there are several pro-active steps you can take to clip its wings, should it fly into your pond.

In the markets, such a bomb is called a “Black Swan,” famously coined in Nassim Nicholas Taleb’s book featuring the term in its title.

For instance, 9/11 was a Black Swan. The 2008 financial crisis was a Black Swan (even though it happened in slow motion.) Sometimes, overvalued markets can simply collapse for no real reason at all, a cycle of selling that breeds panic, thus feeding on itself. A “reason” is usually assigned later.

One never knows around which corner the swan lurks – often appearing at the most unexpected times. And even if you remain confident in today’s market bull, the thought of the dreaded bird is enough to cause a high net worth investor to sleep with one eye open – especially at today’s dizzying stock valuations.

Sleep at Night Investing

One of the top things I hear when meeting a new client for the first time is “I like your philosophy of “sleep at night” investing.”

While I cannot claim to have coined the term, I certainly do subscribe to the philosophy.

In the seemingly unstoppable bull market in stocks, I choose not to participate. I long ago gave up trying to predict what stocks will do – let alone the “when’s” and “why’s” of it. To me, trading stocks is more about trying to guess the mood of the general public, rather than applying precise measurements that give me some idea of “fair value.”

Buffet may disagree. But Buffet also said invest in what you know. What I always knew was silver, oil, coffee and corn.

In my opinion, at least those products make sense. There is a supply. There is a demand. There are seasonal tendencies for prices to move a certain way. These things can be measured.

Will these things always tell you what prices are going to do? Of course not. But they can help you garner a pretty good idea of what they’re not going to do.

As an option seller, that’s most often good enough.

If you want to sleep at night, my first suggestion is to follow Buffet’s advice and invest in what you know – or – follow Kiyosaki’s advice and invest with somebody who knows it.

Commodities

Individual commodities markets can be less, or even uncorrelated to the events shaping stock prices.


But that doesn’t address the black swan. Even in commodities, where individual markets can be less or even uncorrelated to equities – or events shaping the direction of equities – a black swan can still happen. In my 33 years of trading commodities and options, I’ve seen the swan rear its ugly head.

The bad news is, you can never completely eliminate the possibility that you might see one – regardless of your asset class. The good news is, there are several pro-active steps you can take to clip its wings, should it fly into your pond.

Below are the 5 safeguards I’ve found to be most effective in protecting your investment capital from this most unwelcome fowl.

5 Ways to Protect Your Wealth from a Black Swan Event

Diversify – Both in Asset Class AND in Strategy: If you have accumulated any amount of wealth at all, you already know the value of diversification. Yet too few investors, even high net worth investors, are properly diversified. How many asset classes is your wealth spread across? If you answer “tech stocks, oil stocks, healthcare stocks and consumer staples stocks”, guess what? You may have a diversified stock portfolio. But its ALL still in stocks. A Black Swan event could sink the entire index, taking your money with it. Consider alternative asset classes such as precious metals, real estate, collectables and of course, commodities.

But diversification of asset class is not enough. A Black Swan event can be something that effects the entire economy – even the global economy. Simply “buying” other assets may not be enough. In 2008, the value of everything went down. True diversification also means diversification of strategy. It means investing in strategies that can potentially profit from up, down or sideways markets. For instance, you may have had oil and gas holdings in 2008. The values of these holdings collapsed along with everything else when the financial crisis hit. Yet, had you been short crude oil calls, it would have been a profitable time indeed – and losses on stock or real estate holdings could have been at least partially offset by holdings in this alternative strategy.

If you want to learn more about these two concepts, I recommend watching Michael Gross’s excellent video on the topic at www.OptionSellers.com/Diversify.


Option credit spreads are about as close to “swan-proof” as you can get.

Sell Options Out of the Money – Deep Out of the Money: Think you’re covered because you have an equity option selling portfolio? Think again. A black swan event can gut even a properly managed equity option portfolio. One of the main reasons for this is that stock options must be sold painfully close to the money to collect any kind of premium. Commodities have leverage, yes. But that leverage allows you to sell options at strikes deep, deep out of the money. That means selling 30, 50 even 100% out of the money in some cases. This can allow you both time and space to maneuver should a black swan event occur – a luxury not afforded to the stock option seller. If you want to be prepared for a black swan, use this advantage to sell deep out of the money options.

How to sell deep out of the money options is a main topic covered in our free publication The Option Selling Solution, available at www.OptionSellers.com/Solution.

Consider Credit Spreads: Option credit spreads are about as close to “swan-proof” as you can get. You can still take a loss, of course. But credit spreads give you a pre-defined, absolutely limited loss potential on your short option position. There are dozens of different option credit spreads to choose from. However, we highlight the top few strategies that are most practical for the individual investors in our book, The Complete Guide to Option Selling, 3rd Edition (www.OptionSellers.com/book.)

Exit First – Ask Questions Later: Option Selling can be a forgiving strategy, even in the worst of times. That doesn’t mean the swan can’t hurt you if it pierces the option selling veil. Fast moving markets can bring losses – even to the most prepared option seller. But selling options at 30-100% out of the money means that your positon will rarely go in the money as a result of a 1 or 2 day move. The 2008 financial crisis took months to play out, and slowly dragged those who “held on” down with the ship. Had they exited when the iceberg was first struck, damage would have been minimal. There may be virtue in holding stocks for the “long term.” But its not a virtue for option writers. If there is an “event” in your market and your underlying contract is reacting, stick to your pre-defined risk parameters and exit when triggered. For instance, if you’re option has doubled in premium at the point from which you sold it, there is something going on in that market you did not anticipate. Prudence means exiting first and then reassessing with a clear head. You can always re-enter the position later and maybe even take a higher premium. This concept of premium based risk management is covered in our e-seminar at www.OptionSellers.com/Risk.

Blackswan

Black Swans don’t necessarily happen over night. Selling deep out of the money strikes gives you time to exit, even when they do.

Small Positions/Many Markets/Large Cash Cushion: As you know, I did not invent the concepts of black swans or asset diversification. I DID invent the concept of the submarine method of risk management in an option selling portfolio. The Submarine method means holding a large net cash position (up to 50% or more) with the remaining capital allocated to small positions spread across many uncorrelated markets. Hard to do in stocks. Easier in commodities. The price of silver has little to do with the price of natural gas, which has little to do with the price of coffee. This concept was invented to address the possibility of black swans. For instance, an event that causes panic selling in stocks may be bullish for gold, but bearish for oil. How will it affect sugar prices? Will it help our hurt soybeans? Its hard to say. The point is, by having small positions, a healthy mix of puts and calls in a variety of markets, and a large cash cushion – a black swans effect on the portfolio is theoretically minimized. If it does have an outsized effect on one or two markets, the small position size means they can be relatively contained.

GRAPH:

The submarine portfolio model: An effective counter-measure to the black swan.


The cash cushion absorbs any subsequent increases in margin requirement. In short, a submarine is designed so that a single hit (ie: a black swan) won’t sink the whole portfolio. (The “submarine” structure was named after the individual sealed compartments of a nuclear submarine – each capable of being sealed off from the rest of the ship.) To learn more about the submarine portfolio structure in option selling, watch our video at www.OptionSellers.com/submarine.

As mentioned earlier, there is no way to 100% bulletproof your portfolio, short of going to all cash, from a black swan.

However, if you practice the concepts discussed here, you’ll have effectively taken substantial and proven measures to mitigate, if not counter the effects of the dreaded bird – and target a solid return even if she never appears.

It’s what I call sleep at night investing.

Here’s to sleeping tight.

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