A Flock of Black Swans: Are the outlier events that rare in financial markets?

Are the following dates meaningful for you: Aug 24th 2015, Oct 15th 2014, and May 6th 2010? If not, don’t sweat it… these dates are mostly remembered by traders in financial markets, as these dates mark dates of the infamously events known as “Flash Crash”. A Flash Crash is an event that comes, out of the blue, and drives the market insane for a short period of time (mostly in a form of market’s sudden collapse). But once it ends, the market returns to (relatively) normal form. These events cannot be predicted, and cannot be explained using the conventional probability theory, and are often known as “Black Swans”.

“Black Swan” takes its meaning from the ancient saying that presumed black swans do not exist (which was later found out to be incorrect, as these existed in the wild). Nassim Taleb refers to the “Black Swan Theory” as a theory that holds three main characteristics:

⦁    The probability of the events is non-computable, as the normal distribution assumes these can never happen (beyond +/-3 Standard Deviation).
⦁    These events are impossible to predict, and their effects are disproportional to the probability they assumed to have.
⦁    The magnitude of these events is usually high and these events play a dominant role in history.

Is the financial market really normally distributed?

Endless numbers of papers were written about financial markets and the probability theory. All of them concluded that financial markets are definitely, not distributed normally. Financial Markets’ distribution holds “Fat” Tails and “Skewed” Returns. These two characteristics help us explain how events, that the probability theory assumed would never happen in our lifetime, happen over and over again.

Let’s look at a few examples from the recent history:

May 6th 2010 – US equity market collapsed 10% in a matter of 6-minutes, before rebounding (ending the day “only” 3.5% down”). This event is a 6 Standard Deviation event. In other words, this event should happen once every 1 million years.

Oct 15th 2014 – On a normal Friday morning in the US market, a 10-year Treasury Bond yield collapsed 0.3% in a matter of 10-minutes. To put that in context, this move is equivalent to 16% move in equity market, a 7 Standard Deviation event in the US Treasury Market. Likelihood of witnessing such a move again should not exist (this event happens once every 2.5 million years). Guess what, it just happened last month…

Aug 24th 2015 - Soon after the US equity market opened, the trading day major indices collapsed 5%, and recovered some of the loss, ending the day 3.6% down. Dollar rallied at the same period about 2%, but retraced back. This event is 5.5 Standard Deviations, so the chance of seeing such events exists only if you will live to the age of 1.7 million years...

 

You can obviously see where this is going… Although the mathematics and probability theory tells us that there is absolutely no chance of these events occurring, they keep on happening. In fact, over the last 6 years, the S&P 500 had 34 days where it gained/lost more than +/-3%, which is above/below +/- 3 Standard Deviations.

 

 

Why these events keep on happening over and over again?

Few major developments over the last couple of years have increased the rate of these occurrences:

⦁    Technology Developments – the rise of algorithmic trading (High Frequency Trading) and sophisticated machines have caused a very sensitive market. In the blink of an eye, algorithms send millions of trading orders. This development added a significant risk to the market (just google “Knight Capital” to see what happens when algorithmic trading goes wrong…). Faulty algorithms and HFT market manipulations have been the primary causes of these events.

⦁    Drying Liquidity – After the 2008 financial crisis, several banks and investment firms (namely big hedge funds) pulled out of different markets, causing drying liquidity. In illiquid markets, every small trade can cause enormous waves. Even the most liquid markets (US Treasury, US Equities, or G10 currencies) are less liquid than before, which makes the shallow liquidity to act as a fertile ground for massive moves.

⦁    Banks’ Risk Limits and Regulation – Since 2008, increasing regulation and extremely tight risk limits have caused banks to be quite risk-averse. Despite their role of providing liquidity to the market (to the clients, the market-takers), and to warehouse the risk, they were forced to cut their risk limits to avoid experiencing the 2008 crisis all over again. Trading floors nowadays have a very strict and cautious risk profiles, which means that in case of large moves, they will eventually stop-out on their positions, and effectively intensify the ripple effect.

⦁    Global Interconnection – The “Chaos Theory” claims that “something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world”. This is very much true in financial markets. The recent years brought the world a whole lot closer, and investment managers nowadays hold huge portfolios, with holdings all the way from China to the US, from currencies to commodities. When things hit the fan, the risk of massive capitulation increases dramatically, and no asset is safe.  A very famous example of this is Procter and Gamble (P&G), a blue-chip company, which fell on May 6th 2010 as much as 37% at one point.

How can we take advantage of these Black Swans?

There is an old and famous joke about a very religious guy that lived by the bible, prayed every day, and never did harm to anyone. When he died and went to heaven, he asked God: “Every day I prayed, asking for only one thing… to win the lottery. Why didn’t you fulfil my prayer?” God answered: “if only you would have bought a lottery ticket…”
It is obvious that to have the chance of “hitting the jackpot” we need to be in the game… paying for cheap lottery tickets in financial markets is always a wise thing to do (but make sure that they are really cheap…). Buying small options for cheap, putting trades where their risk/reward is extreme will both keep you in the game, and will act as protection for any event even as rare as being hit by an asteroid.