Protect Yourself from the Unknown UnknownsApr 30, 2013
Chad Karnes, CMT
Investors usually focus their risk management on the hazards they know about. However, it's frequently the risks we don't see that pose the biggest threats to our portfolios. Luckily, we have ways to protect capital.
In 2010 it was the "Flash Crash" that sent markets spiraling down
In 2011 it was the debt ceiling debacle and the corporate fraud of MF Global that sent markets down over 20%.
This was followed up in 2012 by Knight Capital's $440MM trading "glitch".
And just the other day we had a mini-flash crash on the S&P futures all because of a false tweet from a news outlet.
How many of these events were predicted (the answer is none)?
As if investing wasn't already difficult enough, it is the things we don't know, the "unknown unknowns" that can really hurt us. We call them rogue waves.
As the examples above demonstrate, not having protection in this environment is downright dangerous. Luckily we have some options.
A look at the most recent Rogue Wave
Before we talk about the recent mini-flash crash, here's a quick recap about the significance of rogue waves (sometimes referred to as "Black Swans"):
"Rogue waves (also known as freak waves) are large and spontaneous ocean surface waves that occur at sea and are a threat even to very large ships and ocean liners. In oceanography terms, any waves whose height is more than twice the significant wave height (SWH), is considered rogue. Interestingly, rogue waves are not necessarily the largest waves found at sea, but instead, unexpectedly big waves for a certain ocean atmosphere. Furthermore, exceptionally large waves are often caused by a conglomeration of factors, rather than just one."
Rogue waves don't just exist in nature, but in financial markets too...unexpectedly big waves that occur given a certain, usually relaxed, atmosphere.
On Tuesday 4/24, at 1:09 eastern time, the markets (NYSEARCA:VTI) plunged on the back of a "hacked" Tweet from the Associated Press. This was a financial rogue wave.
Within a few minutes, the S&P 500 (NYSEARCA:SPY) was down over 1% instantly wiping out over $130B in wealth. The chart below captures that moment. Needless to say, no one expected such an event.
This time the markets quickly corrected, and the wealth was regained. But, the bigger questions should be, what if next time the markets don't snap back so effectively? Or, what if the rumor was actually true? Portfolio protection is definitely needed to mitigate such risks.
"The Unknown Unknowns"
In the ETF Profit Strategy Newsletter one of our "Mega Investment Themes" has been protection from rogue waves. In this day and age of extremely high correlations there is a greater potential for unforeseen (and even unrelated) events to affect your portfolio. We will never know exactly what they are, but we do know they will occur.
This is why we have been big advocates of buying portfolio protection during times of low costs and high complacency. The most recent was in late as March when the VIX (CHICAGOOPTIONS:^VIX) was trading at 11.30.
On 3/17 in the ETF Technical Forecast we identified the high level of complacency (and increased levels of risk) shown by historically low volatility (NYSEARCA:VXX), historically high levels of "dumb money" speculative buyers, and extreme levels of bullish sentiment (NYSEARCA:VIXY).
All of these were signs that the market was ripe for a surprise, which indeed occurred in mid-April as the markets pulled back 4% and the VIX shot up to 18 by mid-April (up 50%+ from our March suggestion).
We also were advocates of buying the VIX on 1/23 when the VIX was at 12.46 as well as throughout December where we suggested, "Buying below 16 and certainly below 15 remains a good strategy to hedge your portfolio or capitalize on volatility". Each of these instances saw a VIX (NYSEARCA:UVXY) spike to at a minimum the upper teens.
The chart shown below provided to subscribers on 3/17 highlights some of the long VIX recommendations over the past year (red arrows). Using technical analysis and relative strength techniques we have been able to identify ideal times to hedge your portfolio from known and unknown risks by buying volatility options and ETFs when they were cheap.
The rogue wave from 4/23 is just one example of an infinite amount of unknown unknowns that can affect your portfolio adversely. Using our technique of buying volatility calls would have protected you during the recent flash crash as the VIX and its ETFs rallied over 8% that day as the final chart shows.
Many volatility options shot up over 100% in that few minute period, certainly protecting, but also allowing investors to profit from rogue waves.
We certainly will never know all the unknowns out there, but that doesn't mean we shouldn't try to protect our portfolios from such unpredictable events. VIX call options and various Exchange Traded Products can be used to help hedge downside risk. (But, beware of some of the risks of Volatility ETPs explained here)
It also doesn't mean we should just buy the VIX blindly. Just as with any investment, there are better times to buy than others. The ETF Profit Strategy Newsletter uses the VIX along with technical analysis and sentiment measures to find the better times to protect your portfolio as well as identify high probability trading set ups for stocks, bonds, forex, and commodities.Follow us on Twitter @ ETFguide