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LIKE ARMORERS WELDING protective plates onto battle tanks, investment-bank derivatives desks are increasingly "black swanning" the portfolios of major investors.
If the stock market declines by 20% or more, these black swan hedges will surge in value, and offset any losses investors would experience in their stock portfolios.
Black swans refer to unexpected events with profound market impacts. The phrase was popularized by Nassim Taleb, a derivatives trader who wrote a well-received book, The Black Swan: The Impact of the Highly Improbable. Examples of black swans include terrorist attacks in the U.S., the failure of major banks, or almost any other financial hobgoblin that reasonable people consider unlikely to occur.
"The feel that you need to be black swanned is high when uncertainty is higher because you can't look investors in the face and say, 'I'm not prepared if the black swan comes,'" says a senior trader at a top bank who is designing these trades for clients.
Because black swans are unpredictable, investors are using a varied approach in the options market to protect against long-term economic troubles, and to profit from short-term market hiccups such as Tuesday's decline in response to further evidence of weakness in the housing market, and ahead of Friday's release of revised gross domestic product data that is expected to show the U.S. economy slowed more than first reported by the federal government.
The common black swan footprint is dealing with long-term economic uncertainty by buying far out-of-the-money puts on the Standard & Poor's 500 index (SPX), the primary barometer of the U.S. stock market, that expire in a year or more. These puts are inexpensive, but would surge in value if the stock market declines 20%, and implied volatility, a key part of derivatives prices, surges higher.
To contain the damage of near-term stock-market declines, investors are buying "put spreads" on the Standard & Poor's 500 index and iShares Russell 2000 Index Fund (ticker: IWM). Many investors consider the Russell 2000 Index to be a pure-play on the U.S. economy because its components include small companies whose businesses are mostly focused in the U.S.
A put spread entails buying a put option that almost immediately increases in value if the stock market declines, and selling another whose price will not change unless the stock market declines 10% or more. The strategy is often used when options prices are very expensive, as is the current case.
These black swan trades are also occurring in many other markets, including currencies and mortgage-backed securities.
The oddness of these bearish maneuverings is that many of the investors who are "black swanning" their portfolios are actually buying stocks in anticipation of an economic recovery whose onset is difficult to predict, traders say.
"Accounts are maintaining a high percentage of cash, and protecting their variability," the senior trader says. "The average portfolio looks like a bunch of quality stocks that will rip higher if the market recovers."
This includes stocks that pay high dividends, or will benefit from a turn in the nation's economic fortunes, including copper and technology stocks that pay dividends or have huge piles of cash, including Apple (AAPL). The senior trader says many clients are buying Cisco Systems (CSCO) and shorting Juniper Networks (JNPR).
Though the options market is girded against the black swan, a "black helicopter" conspiracy theory is moving around trading desks. One sales trader who deals with many hedge funds opines that Wall Street is sending a message to the White House by pushing stock prices lower to ensure a Republican victory in the congressional midterm elections this November. If the Democrats lose control of Congress, the hope is that the Bush administration's tax cuts will be reinstated, which would cause the stock market to surge higher. President Obama has said he will let the tax cuts expire.
"It's a conspiracy theory that everyone is talking about," the sales trader says. "No one thinks a one-year tax-cut extension is priced into the stock market."
So it is that black swans skate across the market, while black helicopters circle overhead.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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