Protecting against those black swans

optionMONSTER

All the talk about the Fed backstopping this market makes me nervous. I worry about those traders and investors who actually begin to believe that nothing bad can happen. Because bad things can happen, more often than people and their models expect--even to a market that the Fed is trying to support.

I'm not speaking as a perma-bear; as this market continues to go higher, you can't fight the tape. But I do worry about those individuals who might be lulled into a false sense of complacency.

On one recent weekend, I crashed my bike. I hit my head hard enough to get a slight concussion. (I was wearing a helmet, which obviously saved me from more serious damage.) I have been riding and racing bikes for more than 25 years, and this was the first time that I ever crashed alone on the road. This was my own little "black swan," which, according to Nassim Taleb , author of the book that bears that title , is a rare and unpredictable event that can have big consequences.

Yet I was reminded that it could have been much worse. A friend in our town, where encounters with wildlife are common, told me that his son's soccer game had to be suspended when a young moose wandered through the field last weekend. Then another friend told me of a more serious incident--a true black swan. The brother of a mutual friend was killed on his bike. He was descending one of the local mountains when a deer ran into him, crashing him and ultimately killing him.

The news made me feel both sad and lucky. Weird, bad things can happen. They happen in life, and they happen in the market.

I am not saying that this market will explode, just that this is a unpredictable world we live in. And those of us who are traders and investors subject ourselves to an even wilder environment. The Fed may be able to backstop the market to some degree, but it can't control flash crashes. Or hijacked Twitter feeds. Or hijacked planes.

We can't protect ourselves against all of life's craziness, but we can insure against the insanity of the market. Buying puts is the easiest way to do it, though there are others, like buying volatility products or "inverse" funds that go up when the market goes down. (See our Education section)

I do not buy protection because I think the market will fall apart. I buy protection for those "unknown unknowns" out there. The ones that neither I--nor the Fed--can see coming.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter of May 15.)


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