What are Black Swan Events?

According to Britannica, a black swan event is a “high-impact event that is difficult to predict under normal circumstances but that in retrospect appears to have been inevitable.” In the world of financial trading, it is a rare market movement with a severe and widespread impact across portfolios.

Decoding Black Swan Events

A black swan event unfolds when a system risk arises, exposing unnoticed vulnerabilities in the financial ecosystem. While the event may be triggered by an isolated shock, it spreads as quickly as wildfire across interrelated sectors. This results in wide disruption in the financial markets, triggering investor panic, which amplifies market instability. This domino effect is characteristic of black swan events and catches market participants off guard. This makes protecting the value of even well-diversified portfolios challenging. Notably, all black swan events can be rationalised with analytical evidence in hindsight. This is known as the hindsight bias in the trading community.

Examples of Black Swan Events

Prominent black swan events of the 21st century include:

Financial Crisis of 2008

Trigger: Bursting of the US housing bubble

How it unfolded: Housing prices plummeted, followed by a rise in defaults on mortgages.

In hindsight: The easy availability of credit since 2000 created systemic risks in the mortgage-backed securities segment. Sub-standard lending criteria and the bundling of complex financial products injected risk throughout the global financial ecosystem.

Impact: $10 trillion was wiped off the global financial markets, the S&P 500 plummeted 57% by 2009, and the US registered the largest number of bankruptcy filings from companies, including Lehman Brothers, IndyMac, Countrywide Financial and AIG.

Lessons for traders: The most important lesson from this event is that taking more risk than your tolerance level, due to ineffective risk assessment, is preparing to fail. Next, understanding the instruments you trade is crucial. Since the domestic and global markets are interconnected, gauging the complexity of financial products is paramount to effectively manage risk.

Coronavirus Pandemic of 2020

Trigger: Covid-19 outbreak

How it unfolded: The virus outbreak halted economic activity across the world, sending waves of panic across the financial markets.

In hindsight:  Modern supply chains and economies are too interdependent, without contingency plans in place. Globalised economies are easy targets for financial hiccups to go viral. Lockdowns and travel restrictions triggered mass panic, stifling investor confidence and inducing volatility in the markets.

Impact: TheS&P 500, which was at its peak in 2019, tumbled 34% in 2020. Healthcare expenditure peaked, reaching 8.4% ($1 in every $12 spent). Globally, the stock markets shed nearly 30% from their February 2019 levels. The US pharma market grew about 5%, from $534.21 billion in 2020 to $560.00 billion in 2021.

Lessons for traders: Diversification is critical to offsetting wider losses. This can be possible even with gains in a single sector. Employing safeguards, such as stop loss and risk limits, can lower losses via timely market exits. Having contingency plans can help you react quickly to market changes and take advantage of newer opportunities. Staying adaptable is critical to discovering and optimising these opportunities.

Events like the 1929 Wall Street Crash and the 1987 Black Monday were also black swan events that had widespread repercussions on the global financial markets.

Every Negative Event is Not a Black Swan

Some argue the Silicon Valley banking crisis of 2023 was not a black swan event. The first clue is that many analysts had been highlighting banks’ risk exposure for a while. However, its impact was similar to that of black swans, such as bank runs, failures and bailouts. Additionally, policymakers had the time to ward off the financial crisis through rapid credit and asset price growth.

Predicting Black Swan Events

Notably, science fiction and animated series like The Simpsons have infamously predicted black swan events successfully, thanks to the creators’ imagination. While accurately foreseeing such events is difficult, staying updated on global developments can help you prepare for various contingencies. Here are some examples of potential black swan events that could impact the global financial markets, given the current state of the world:

• A giant leap in quantum computing may disrupt the security of global networks.
• The US and China negotiate a trade treaty, ending the technology supremacy war.
• Solar phenomena, geological upheavals or sudden, severe climate change redefine our way of life.

Preparing for Black Swan Events

You will be surprised to learn that black swans were assumed to not exist. So, the term was coined to express the extreme rarity of their occurrence. Much like the fact that black swans do exist, these events occur and shake up the world. Market disruption on a global scale can occur at any time. When it strikes, the impact is far-reaching and unforeseeable. The common lesson these events teach is that traders must stay prepared for the unexpected.

While diversification is the key to managing risk exposure, using the below tips can help also you stay prepared:

Identify Volume Bubbles

Do you know why there is so much talk about an AI bubble in the financial markets? The horrors of the dotcom bust and the real-estate bubble still haunt traders who experienced them. Keeping an eye out for bubbles could help you lower exposure to sudden declines by diversifying outside the sector.

Visualise Order Books

Depth of order books offers insights into market resilience against sudden shocks. This allows you to anticipate slippage and significant price movements. This helps navigate the markets when the cascading effect of a potential black swan event is unfolding.

Stress-Test Your Strategy

Use different potential and improbable scenarios to test and refine your trading strategy. Employ analytic insights to prepare a contingency plan for black swan events. You could also keep aside some easily accessible liquid capital for unprecedented market moves.

Use Liquidity Heat Maps

Heatmaps, like those offered by Blackwell MT4 and MT5, reveal the strength or weakness of a group of currencies. Use these to identify strong levels of resistance and support to plan exits at critical points.

To Sum Up

• Black swan events are unpredictable.
• There have been two such major events so far in the 21st century.
• The impact of these events cascades rapidly across the global markets.
• Portfolio diversification is crucial to minimising the impact of black swan events.
• It is important to have a contingency plan to stay prepared for such events.

Disclaimer:

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