There is an event in the economy, but more specifically in trading, that is particularly frightening: the Black Swan. And it truly frightens everyone: economic actors, politicians, investors. It is an unpredictable, unexpected, high-impact event that can change the face of the market and blow strategies and precautions to smithereens.

There are dozens of examples. In this article, we will describe the ones that have truly made history and provide some advice on how to effectively defend yourself (as much as possible).

What is the Black Swan

Formally, a Black Swan is defined as an economic-financial event, or at least one with economic-financial implications, with extremely significant effects, unforeseen and unpredictable. More specifically, for an event to be defined as a Black Swan, it must possess, in full, the following characteristics.

• An extremely low probability of occurring
• A huge impact
• Readability in hindsight

This last point is particularly controversial. The Black Swan is easy to explain in hindsight, after it has happened. This is not a detail. Much of its effects, which very often generate panic, derive from the awareness of why it happened. The effects, not by chance, are also due to sudden attempts at protection, reactions to events, which simply would not exist or would be muted if the Black Swan were not - in hindsight - readable.

Famous Black Swans

To better understand the meaning of Black Swan, it's good to give some examples. Some examples are actually very well-known events, precisely by virtue of their ability to make history and forcibly imprint themselves in the collective imagination.

The Tulip Crisis

The tulip crisis is the first speculative bubble in history. At the end of the 17th century, the Netherlands began to cultivate tulips. This flower soon became, by virtue of its beauty, a kind of status symbol and became an increasingly sought-after commodity. In a short time, prices began to rise, also due to the possibility of importing and growing new varieties. Within ten years, supported by a perverse demand dynamic, some bulbs reached frightening prices, equal to those of a house in the center of Amsterdam. Yet everyone continued to invest, perhaps going into debt, precisely because prices were rising. Then something unforeseen happened. Prices began to fall. Why? The cause can be traced back to a legislative intervention aimed at regulating the market. An initiative that, at the time of its launch, no one judged as dangerous for the tulip market. Instead, it represented the fuse that blew up the entire edifice. At that point, as always happens in bubbles, a race to sell began, leading to the ruin of the vast majority of investors, enveloped in a real panic selling. The bubble, in short, deflated. The tulip crisis is the classic case of a Black Swan. It was unexpected. No one could have imagined that tulips could have so much market. Much less, given the huge sums invested, could anyone have imagined that the business would implode so dramatically. It had a huge impact. The tulip affair had extremely significant effects during both phases. Not by chance, we speak of "tulipomania". It had effects especially at the time of the collapse, judging by the number of people who were thrown onto the street. It's readable in hindsight. Today it's easy to explain the why of the tulip crisis. Investors of the time had the same feeling, to the point of triggering a wave of sales. Everyone was aware of the disaster - when the disaster had already happened!

The 1929 Crash

It is the most famous stock market crash of all time. It began on October 24, 1929 and involved the entire American stock market, followed closely by the main Western markets. Just to provide an overview, within a few days the Dow Jones index crashed by 30%. A monstrous percentage, never replicated again (fortunately). What happened? Very simply, the markets had grown beyond their potential, driven by practices that were not exactly prudent, such as an overly lax approach to credit and an unscrupulous use of financial leverage. It was the latter, in particular, that caused the greatest disasters. It was enough for some institutions, which sensed the collapse, to call the margin to unleash the apocalypse. 1929 is the classic Black Swan. In fact... It was unexpected. Until the day before, the stock market had been making the usual gains. No one, at least among retail investors and probably even at the mid-to-high levels, expected not only the end of the run, but also the descent. Some, perhaps at the top, were expecting a decline. No one had predicted such a sudden and dramatic collapse. It had a huge impact. It's history. The 1929 crisis triggered a financial crisis from which the West only fully recovered after World War II (although from the mid-1930s things began to improve considerably). It's readable in hindsight. It's easy to understand the why of the 1929 crisis today. Actually, it had been easy even then. Also because some early signs had caught attention before October 28, to the point of pushing the Federal Reserve to a drastic rate hike.

The 1987 Crash

This stock market crash is less well known but still represents a good example of a Black Swan. Also because, unlike 1929, it was truly sudden, having essentially occurred during a single session, that of October 19, 1987. What happened? Again, very simply, after a period of strong gains, the entire market collapsed. Just to understand the proportion of the decline, on October 19, 1987, the Dow Jones posted -22%. The reason for the crash, from which recovery was made within a few months and did not spread in an endemic way, can be traced back to the abuse of technology: the first computerized trading systems, in fact, bought and sold automatically, upon the appearance of certain signals. It was they, in a sort of domino effect, who triggered the sales. Why can the 1987 crash be defined as a Black Swan? It was unexpected. No one, before the event occurred, expected that trading systems could cause so many problems and trigger, practically on their own, a real stock market crash. It had a huge impact. Apart from the -22% in a single day, and the aftermath that lasted months, the 1929 crash caused a rethinking of the technological tool. It's readable in hindsight. Today it is obvious to take the necessary precautions when using automatic tools. It was, almost immediately, even then. To the point that investors, recognizing in the crash a non-structural nature (unlike 1929), soon absorbed the losses.

September 11, 2001

It is the "blackest" Black Swan that can be conceived, at least from the investors' side. Who could have ever imagined that, in an era of relative peace, the United States would be attacked in such a brutal way, in the place that best represented its essence and identity? September 11 was simply unpredictable. Also by virtue of this reason, its effects from a financial point of view were dramatic. The stock market crashed, although the effects were initially visible only in non-American markets (the New York one was immediately closed for mourning and security reasons).

The Failure of Lehman Brothers

With this Black Swan began the crisis of 2008, and in a certain sense still casts its aftermath. So unexpected that even the rating agencies classified the American bank as solid. As for the scope of the event... Well, we can draw a veil of pity. The sovereign debt crisis of 2010-2012 A medium-term black swan. The crisis in fact developed over two years, following the dynamics of the contagion effect. It all started with Greece, then the crisis spread to Ireland and Portugal and finally touched Italy. Until that moment, the Euro area had seemed solid to everyone. Certainly, no one thought that an entire public debt could risk insolvency in one of the richest regions of the planet.

How to Defend Yourself from the Black Swan in Trading

The question arises spontaneously: can one defend oneself, on the trading side, from the Black Swan? The answer, however sad, is the following: not completely. After all, the Black Swan is an unexpected event, so the weapon of prevention is out of use by definition. However, it is possible to limit the damage by implementing specific initiatives before and after the occurrence of this type of event. Here is a small handbook. Diversify. It is the main tool of risk management. It is the only way, in effect, to contain losses when things go really bad. A good diversification should involve investing in assets that, among themselves, have a wide, stable and above all negative correlation. As much as diversification can be useful in situations of declines or even collapses, when a Black Swan occurs, it risks losing its effectiveness. Also because the Black Swan often goes beyond the rules of the market, including correlation. If any tool has the possibility to protect those who use it from the Black Swan, however, that is diversification. Consider Hedging. The term "hedging" refers to an approach that aims to contain losses by exploiting a basic principle. It involves opening an opposite position to the main one, of a smaller size but going in the opposite direction. In this case, if the main operation fails, the second one is successful and thus allows to limit losses. Hedging, just like diversification, is a very effective "insurance" approach when the market behaves normally. When the Black Swan appears, losses are still huge, but still prove less catastrophic than they would have been without hedging. Be wary of perpetually growing markets. If we exclude catastrophes and truly unpredictable events, such as 9/11, it is still possible to pick up some signals that announce the Black Swan. They are weak signals, but they can still be listened to. One of these signals is the excessive growth of a market, the swelling of a probable bubble. Even in this case, prevention is not possible, not completely: also because not everything that resembles a bubble then really is one (for example, Bitcoin has not yet "burst". However, with the help of good fortune, practicing the art of doubt can save the investor. Exit the market immediately. The only wise solution in case of catastrophe is... Running away. A rather trivial solution, but one that can often save lives. It has a big flaw: it's late. Often by the time you realize you're dealing with a Black Swan, it's too late anyway.