The market can never drop, that’s the sentiment on Wall Street today! The second longest bull market in history has now dragged on for almost nine years. Anyone keeping track of the market will tell you that prices are at an all time high and that markets will continue to break records well into 2018. In a sense, there is some truth to these claims, but in another sense, there is something that everyone seems to be missing . What is that you ask? Well, its what traders like to call a Black Swan Hedge.
Black Swan is a term coined by the economist Nassim Nicholas Taleb, a finance professor, writer and former Wall Street trader. According to Nassim, a black swan event depends on the observer. For example, what may be a black swan surprise for a turkey is not a black swan surprise to its butcher; hence the objective should be to “avoid being the turkey” by identifying areas of vulnerability in order to “turn the Black Swans white”. In other words, by preparing for unlikely events (such as a massive market sell-0ff), traders can avoid being the turkey by buying hedge positions to protect themselves against such unlikely events.
What Nassim really means is that traders should assume that a systemic failure in our financial system is possible and traders should prepare themselves in the event that such a systemic failure occurs. Taleb argued that it is important for people to always assume a black swan event is a possibility, whatever it may be, and to plan accordingly.
How To Prepare For A Black Swan Event?
Bloomberg recently published an article describing how traders are more bullish than they’ve ever been since 2008, with some traders paying through the nose to see if the S&P index will snap higher into 2018. The average put-to-call ratio is near the lowest since March of last year. What this means is that put options on the S&P Index have gotten extremely cheap relative to call options, and traders are simply blind to any potential downside risk.
Traders have become less and less willing to pay for any downside protection on the market, which in turn drove the downtrend in a measure known as skew during most of last year’s second half. Since the start of this year, investors have chased higher and higher premiums on call options, which is contributing to the historically low level of bullish positions, the data shows. Here is a snap shot from the data provided by Bloomberg:
The Data also reveals that more than 5.4 million S&P 500 calls have been exchanged in 2018 (we are only 16 days into 2018), the most on record to kick off the new year. The average ratio of bearish-to-bullish options volume over the past 25 days is near the lowest since last March.
Cheaper Bets, Higher Returns!
So what can we do with cheap put options? Cheap put options are like a cheap insurance policy on a very expensive home. Neither you or the insurance company anticipate anything bad happening to your home, so you are offered a very low premium to protect your home against hurricanes, floods, or anything of such kind. Even better, you can purchase an insurance policy on your neighbours’ home, so in the event that your neighbour’s home is destroyed, you could get paid alongside your neighbour. There is no limit on how many put option contracts you can buy. If you want, you could buy put options on the entire index (the S&P) or on a special company that you think might falter during an economic downturn. Because the put options are so cheap, they offer an opportunity to protect against a Black Swan event. So instead of being the turkey, the trader becomes the butcher and the rest of the market becomes the turkey!