Eight Million Ways to Lose—External Event Risk

Disregarding particular markets for a moment, let’s ask which other flavors of event risk we face. What about weather risks, droughts, hurricanes, or in-temperate temperatures? No one controls the weather, surely. Such events will occur and we must have some means of dealing with the risk they pose.What about another risk generated by the legal system, that 12 ambulatory featherless bipeds with the proper number of chromosomes will decide out of the clear blue sky that something is a matter of “law” and thereby invade our pockets when we’re merely innocent bystanders?

We cannot anticipate or defend against willful morons. What about deliberate corruption,simple incompetence, or even unrealistic optimism on the part of the managers of a company whose shares or bonds we own? Any of these events will vaporize some amount of our capital, too often before we can even learn of them. Which of our set of broad markets offer us active means to protect ourselves to a considerable extent against these events and their kin?The answer here is clear, and it eliminates one of the broad markets from our consideration.

Much like insurers, from time to time we want an immediately available way to neutralize or mitigate our trading risk. Two of the broad markets offer us such a way, but one does not. This risk reduction mechanism is an options market, and moreover, an options market in which we can deal relatively easily. Options are available in the bond markets, but they are not feasible for us to use.

At this time, bond options are customized to a trader’s particular situation and request, are for all practical purposes completely illiquid, and are ordinarily available only to very large accounts.This situation compels me, at least, to limit my trading horizons to stocks and futures. If I cannot protect my capital by taking positive action either before or when a market moves adversely, as opposed to the simple supine action of willy-nilly accepting a loss, I see no reason whatever to trade in such a market. Invest in, maybe.

Trade in, excepting pure arbitrage, no.We can bring matters into sharper focus still by asking which remaining market, stocks or futures, offers us a better deal in terms of the frequency of and limits on occasional event risk. The logician’s adage is “anything not provably impossible is possible,” and this applies fully here. Any outrageous event you care to name will from time to time distort the markets in stocks as well as those in grains, meats, energy, interest rates, metals, and currencies.

The occurrence of this form of event risk is probably equal over the long term in these two broad markets, but the amount of risk generated by any specific such event differs markedly between them.Pick up a financial newspaper any day you like. Far more likely than not,you’ll find some number of companies whose share prices have risen or fallen 15% or 25% or even 50% in a single day, due no doubt to news events or rumors about the company.

Now, sometimes these events are avoidable.When definitive regulatory decisions are announced, for example an FDA decision to approve or reject a new drug, it’s not uncommon to see a company’s share price change by 60% or 75% or more in a day. Fortunately, the dates of most American regulatory decisions are announced well in advance,and we can dodge this sort of risk, as mentioned previously, by just staying away from the affected company’s shares at the indicated time.

However,there’s not a single thing the trader can do to mitigate a loss caused by surprise events affecting a company, and these occur far too frequently, with too much variety, and in far too many companies’ shares for my trading tastes. Just repeat “Arthur Andersen” to yourself 30 or 40 times, and if this point is not already quite clear, it will become so.

By contrast, the very nature of futures markets strongly inhibits these severe price shocks over a short period of time, barring the introduction of new supply/demand information (which, again, we can avoid by staying out of markets when such new information is known to be on its way). A 10% daily move is gigantic, and quite rare, in futures markets. Any futures market is by definition a market dealing in a standardized batch of goods, physical or financial, readily available in large amounts, and of specific quality, quantity, and/or term.

These markets are therefore structurally much simpler than stock markets, thereby holding fewer undefined and opaque risks and substantially lower potential for external supply/demand surprises.How so, you ask? Put bluntly, the Kansas City wheat market is not going to launch a surprise hostile takeover of the Chicago wheat market, ever. The Centers for Disease Control and Prevention are not going to issue a health warning about copper or 30-year bonds, ever.