Black Swan Theory: What is it and Why Does It Matter?
In cryptocurrency, risk analysis and management skills are crucial to turning a real profit. There is a huge opportunity to take advantage of the stock and crypto markets during black swan events. We’ve completed a deep dive into black swan theory to show you how to do just that.
As a crypto trader, a good understanding of this theory is beneficial. While everyone else is left confused after a black swan event, you can rest easy, having already prepared for the consequences.
In this article, we explain what the black swan theory is, how to predict a black swan event in the crypto market, and several risk management strategies. We will also analyze real-life examples of black swan events, and their consequences.
What is the Black Swan Theory?
The term black swan theory was first coined in 2007 by Nassim Nicholas Taleb, a Lebanese-American risk analyst, options trader, and mathematical statistician. Taleb wrote about black swan events in an essay published by the New York Times titled ‘The Black Swan: The Impact of the Highly Improbable’.
Taleb was inspired by the story of how black swans (the animal) were discovered. British explorer James Cook and other Europeans first explored Australia in 1770. They were shocked to report to the rest of the world that not all swans are white. Taleb used this example to illustrate that our learning can be severely limited when it is based only on our past experiences or personally observable data.
Three major factors classify black swan events. They are:
Black swan events are outliers. They do not fit into the scope of regular expectations. This is because they are so rare; if they occurred frequently, we could easily predict and expect them.
Black swan events carry huge consequences. Whether the effects are detrimental or beneficial entirely depends on the circumstances of the event.
When we predict something, we often look to the future. We can guess the likelihood of an event. We can weigh the probability of it raining or shining over the weekend, and modify our plans to fit the weather.
Black swans, though, are only predictable and explainable in hindsight. This is because the world has become so complicated that it is impossible to be aware of everything. It is also impossible to accurately measure uncertainty, especially of an event you are not aware of.
You may be very familiar with the risks of cryptocurrency and stock trading, and you may be able to analyze their impact and probability. Unfortunately, you cannot analyze a risk you are not aware of, like a black swan.
The essay made waves in many industries. It was a completely new perspective of defining many catastrophic events that the world had experienced. Preparing for black swan events is now a part of many risk management strategies in the financial and technology sectors.
Black Swan Events Throughout History
There have been many well-documented black swan events in recent history. You have probably heard and even experienced several. The Covid-19 market crash of 2020 was a fairly recent example that affected the whole world. These events are great learning opportunities for investors looking to improve their risk management strategies and keep their cryptocurrency portfolios safe. Here are a few more examples for you.
The Dot Com Era and Bubble
Many began to see the value of the internet in 2001. Especially after the immense Y2K bug panic followed by relief when nothing happened. Unfortunately, a huge recession hit the economy not too long after.
Investors were keen to pour venture capital investments into tech companies, ignoring traditional analysis metrics. They focused on the chance of another major technological advancement and being part of the next Apple or Microsoft. Some companies, such as Qualcomm, had shares rising over 2000% in value.
The bubble bursting was caused by stock prices inflating so high, that companies had to default and rapidly shut their doors. Stock prices fell fast, and the effects of the recession were felt for years.
The 2015 Swiss Franc Peg
Forex currency traders were in a panic when the Swiss National Bank took off the Swiss franc peg of 1.20 against Euros. A currency peg is a standard and specific exchange rate. It keeps exchanges of currency between two currencies stable and reduces the risk for traders, investors, and businesses.
When the Swiss franc was no longer pegged to a stable rate against Euros, investors and traders immediately poured their money into it. The franc was considered an extremely safe currency to invest in before the peg. Afterward, it had appreciated by 30%, becoming even more valuable than Euros.
While it was completely unexpected at the time, many could theorize practical explanations for the bank’s actions. The strongest theory is Switzerland’s perception of the Eurozone deteriorated after the European debt crisis in 2011.
Switzerland may have wanted to distance itself from the weakening currency. They could potentially strengthen their economy by unpegging the Swiss franc, especially knowing how it performed with currency traders.
The Terra (LUNA) Coin Crash
You may have heard about Terra, a public blockchain platform with two stablecoins, UST and Luna. Stablecoins are a type of cryptocurrency with a stable underlying value, which is less volatile than other coins. Stablecoins are usually pegged to the currency that backs them, like US dollars.
Terra kept the UST coin pegged to the value of one US dollar. To create USDT, Luna is essential. Hence, the two are closely tied. To attract more traders, Terra created the Anchor Protocol, which gives an incredibly high (19.5%) interest rate on staking.
In early 2022, UST’s peg was released and over 2 billion dollars was taken from the Anchor Protocol, much of which was then sold. Crypto traders first tried to use this to their advantage, exchanging the now cheaper UST for more LUNA. With LUNA, they could create more UST and wait for the coin to increase in value.
Unfortunately, that never happened. UST and Luna metaphorically crashed and became untouchable to traders, who tried to sell away as much of it as they could. At the time of writing, the value of LUNA is just 0.01 USD, literally one one-hundredth of its original price.
The crypto market can be risky and volatile at the best of times, and as a developing industry, it is only reasonable that many unexpected events might occur. Keep in mind that not all black swan events are negative. J.K. Rowling became an astronomical success after she published the Harry Potter series, even more so when her books became adapted into feature films.
Her inspiring story is also a black swan event, as it is extremely rare and unexpected to become a millionaire solely from publishing novels. The impact of her writing was also extreme, as it gave birth to a multinational multimedia franchise.
How to Trade, Black Swans and Risk Management Strategies
Black swan events are improbable and unexpected, so how can we prepare for them? Just knowing what the black swan theory means is a good first step. As a crypto or stock trader, you should already be aware of many of the risks and benefits of the market.
How to approach a black swan event
Though it is impossible to be certain of a future black swan event’s occurrence, there are ways to manage the risk of a black swan and recognize when one is beginning. Taleb described two ways to approach the black swan phenomena.
The first is to consider what is normally expected and to rule out the outliers. You can focus on only ordinary cases, which are very probable and have been experienced in the past. This is similar to judging a person’s character by the many pleasant or otherwise normal times you have spent with them. If they were bright and happy during regular days, you can reasonably predict they will continue to be.
The second method is to consider all the extreme scenarios. You can determine the potential consequences and impact of each unlikely and extraordinary event. If their effect is strong cumulatively, you might be able to consider them a black swan.
If you were to use this method to judge someone’s character, you might think of many extraordinary things that they could experience. How would you predict they act after winning the lottery? What about if their car was washed away in a flood? These are more difficult scenarios to analyze but are more closely aligned to the black swan theory.
Risk management strategies
You can learn how to trade while considering black swans. There are several more risk management strategies that you can generally apply to your crypto trading, but may also be beneficial in the case of a black swan.
- Position Sizing: Avoid risking your entire account on one trade and diversify your portfolio. Research several options, determine which have the lowest risk, and use a fixed percentage of your account to invest. If one or more trades fall through, the majority of your assets will still be safe.
- The Barbell Strategy: Keep the majority of your funds in safe, stable investments while allocating a smaller portion for riskier, and potentially highly profitable investments.
- Don’t Rely on Standard Deviation: While standard deviation is used frequently in finance to measure investment risk, you should avoid using it for your risk management. The use of squared averages limits the variation in measured risk. In real life, movements can exceed the standard deviation and can exceed your expectations.
- Don’t Just Predict Extremes - Study Your Vulnerabilities: You may be predicting and preparing for extreme cases already, but don’t overlook analyzing your vulnerabilities. Gauge how you would be affected by different scenarios, and prepare backup funds for collateral damage. There is a large chance you may lose some of your returns while trading. Accepting that a black swan event may result in collateral damage to your account is an effective means of damage control. It stops the damage before they become too disruptive.
<<Pro tip>>: Want to learn more about managing risk as a crypto trader? Check out this article
Black Swan Events in Cryptocurrency
There are several black swan events that experts have been studying in the cryptocurrency industry. Matthew Hougan, vice president of research and development at the cryptocurrency asset management firm Bitwise, has cited a black swan regulatory risk.
Hougan’s concern is regulatory interference in the cryptocurrency industry by governments who may endeavor to shut down crypto trading. China, South Korea, and the United Kingdom are three top players in the crypto industry. If any one of them were to develop strict anti-cryptocurrency regulations, it could potentially crash the value of several virtual currencies.
This has been the case for Ethereum and Cardano, traded mostly in China and South Korea respectively. However, the impact does not stop within the crypto industry. Hougan also thinks that institutional markets, such as universities, hospitals, and charities could also be highly affected.
A black swan event could also be caused due to inverse volatility of exchange-traded funds (ETF), and low liquidity or trading volume of cryptocurrencies. ETF allows investors to bet on the stability of the market for companies, often those in the S&P 500 Index. Low liquidity makes trading very difficult, as it restricts the opportunity to sell. A low trading volume also indicates low market interest.
However, if you believe in the long-term potential of the crypto market as YouHodler does, then black swan events are extremely rare opportunities. It’s not often we get the chance to buy strong assets at bargain basement prices. Black swan events allow us to do just that. Hence, it’s a good idea to always be prepared to invest, even when the market is filled with fear and loss.
How to Predict Black Swan Events
Now that we have laid the theoretical foundation of black swan events and analyzed real-life examples, we can look at how to predict black swans.
The short answer is that we cannot accurately predict black swans. Not even experts in the industry can do so. By nature, black swan events are rare and have a low probability of occurring.
Still, you can prepare for more general improbable events that are sure to disrupt your cryptocurrency trading. You can develop your black swan plan with our recommended risk management strategies and learn how to trade safely.
Should you buy Bitcoin in a bear market?
Black swan events are scary. There’s no doubt about that. It’s even scarier when they are the catalyst for long-term bear markets. However, the stock market and the crypto market have both proven they bounce back eventually. If you can learn to control your emotions and change your perspective from one of the losses to gains, then you will see bear markets for what they truly are. Opportunities. At the moment, crypto is on sale, so it’s the perfect chance to buy crypto at lower prices.