29 August 2010

How to minimize losses during "Black Swan" financial crises

Excerpts from a WSJ article about the use of puts to hedge large market drops:
In financial terms, a black swan usually results in drastic moves in the market—events such as the 1990 Iraqi invasion of Kuwait, the Sept. 11, 2001, terrorist attacks and the recent financial crisis. Statisticians call these events "fat tails" (because they occur on the fringes, or tails, of a bell curve), while professional investors try to manage their "tail risk."

Today, there are as many as 20 hedge funds specializing in tail-risk strategies, most of which have formed in the past 18 months... Retail investors are getting more access to black-swan-oriented strategies, too [via mutual funds]... Some individual investors even are considering setting up black-swan portfolios of their own...

The old cure for extreme events was simple diversification: spreading your bets among a broad array of asset classes. But the financial crisis showed that asset allocation isn't always reliable when markets tumble in unison...

[T]he strategy typically involves buying lots of out-of-the-money "put" options on everything from stock indexes and interest rates to currencies. Put options confer the right to sell the underlying instrument if the price falls to a certain level. Because they offer protection, their values soar during market panics, producing big profits for the holders. But if the market doesn't plunge, the options expire worthless, and the investor must buy new options to replace the old ones. If markets hold steady or rise for long periods, those costs can add up...

Another risk: Because black-swan events are so unpredictable, the markets' reactions to them can be equally unpredictable. Just because an approach worked last time doesn't mean it will work in the future. Some of the new products launched in the past two years might not perform well under duress.

Of course, it takes a lot of diligence for ordinary investors to trade puts and calls on a regular basis. Those trades can be especially tough to swallow when markets are going up and options are expiring worthless.
Much more at the link.

1 comment:

  1. All this is why I have never invested in the stock market, other than an index fund and a mutual fund tax-deferred annuity.


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