Investing 301: Trading with a Black Swan

In my third installment of my investing series, I discuss the level of trading I deal with, including my recent dive into ForEx trading after the Brexit decision. I also run through the probability of extremely unlikely events and how humans have an inability to properly plan for these, “black swans”.

If you’re familiar with the first two installments of my stock series, then you’ll know I prefer to buy broad based indexes as part of each paycheck I receive. In this fashion, I am able to increase my tiny slice of global economic pie and I leave it at that.

The remaining 5-15% of my portfolio is what I refer to as my “play fund”.

Using the term, “play,” is deliberate as it overly emphasizes my understanding that this money could be lost at any time. Such are the dangers associated with trading in individual securities.

I can’t emphasize this last paragraph enough.

As a CPA (or maybe as a young millennial in Chicago), I have a lot of friends that range from “dabbling” in the market to actively making a living based on buying and selling securities.

One close friend of mine who has his CFA prefers to buy and sell options. His approach is to buy options to buy the market or an index at points that are drastically higher or lower than where it currently is.

These are essentially long shots. The probability of it happening are so low, the risk to reward ratio is very high.

This is a similar concept to what Nassim Taleb refers to in his book Black Swan.

In short, humans have an inability to predict uncommon events. We tend to be overly optimistic that the WORST CASE scenarios will NOT happen. These are events that you might consider outliers, but in reality, they happen more often that we would like to admit.

Of course, the book dives into decades of research and plenty of fascinating factors that drive this behavior, but this particular post is about how we can benefit from knowing this human blindspot.

When the price of the market experiences dramatic volatility, or price fluctuations, my friend stands to profit. His inexpensive options give him access to buying and selling at a massively discounted rate.

This year witnessed a rather volatile January & February which allowed my friend to essentially create enough profit in 2 months to last him for half the year. Similarly, he made enough money last August to last him 9 months.

The downside here of course is if the markets remain calm and flat, then his options will expire and he will run out of money. Again, there are risks involved here.

Recently, he had another successful month after UK voted to leave the EU.

I’m a big fan of Warren Buffett’s quote, “Be fearful when others are greedy and be greedy when others are fearful.”

I don’t believe my risk tolerance is high enough to rely on black swan events, but I wanted to be there to profit in the wake of them.

With the price of many UK based companies dropping dramatically, I wanted to take the opportunity to be greedy when others were fearful.

But, there was a gap.

Enter foreign exchange rates.

If you’re buying shares in a small foreign company, then the revenue that company makes will nearly be 100% denominated in that country’s currency.

If the company is larger, then they likely have more sales internationally and thus, denominated in various foreign markets.

What this means is if a small British company increases its sales and profit margins, but the value of the pound sterling decreases more, then from a foreign perspective, that company will be worth LESS.

As someone who just wrote that sentence, I, myself, am still having a hard time figuring it out.

What I do know is Sterling dropped massively after the UK exit.

Investing 301: Trading with Black Swans - Picture - Sterling
As my buddy did before, I’m sure a lot of people put options in place and took advantage of such a large drop.

Given my recent curiosity with foreign exchange rates, I’ve been digging through some materials online.

Thankfully, the internet is filled with plenty of videos, tutorials, inexpensive programs, and other informational products on learning, well, basically anything.

One such resource I’ve used recently is here. In my opinion, anyone who takes the time to break down the fundamentals of ForEx to educate the public, is serving a benefit to society.

What I’m enjoying most about this process is that, after reading so many books on personal finance, I’m constantly realizing how much I don’t know.

Truth be told, I consider personal finance and investing to be two separate spheres that have maybe a 10% overlap. But, perhaps I can dive deeper into that comment on another post.

Another Buffett quote is, “The more you learn, the more you earn.” That’s what I’m banking on.

Do you consider yourself a trader? Have you dabbled in ForEx trading or investing in individual companies abroad? Are you more conservative than me and prefer to trade a small portion of your assets or none at all?

Master Distiller

24 comments… add one
  • Jon @ Be Net Worthy Aug 5, 2016, 5:52 am

    I used to trade in individual stocks and even sold options for a while, but lately, I am almost 100% in index funds with some alternative investments thrown in as my “fun” money. Precious metals up almost 100% this year – WaHoo!

    And, I agree with your point above, personal finance and investing are very different. Speculating and investing are very different too, and it’s important to know the difference!

    • Distilled Dollar Aug 10, 2016, 6:14 am

      Wow – I didn’t realize precious metals are up so much this year. Maybe I should invest in some foreign mining companies. 😉

      Although, with precious metals, I do find it interesting how many different companies might be along the full supply chain. The mining corporation might be struggling financially whereas the refining corporation is a great buy. Looking directly at precious metals would need an understanding of how they are utilized or in the case of gold, a broad understanding of what influences the buy/sell calls. I might need to dive in more over time!

  • Matt @ Optimize Your Life Aug 5, 2016, 7:14 am

    Really interesting. I am super intrigued and always tempted by the gambling side of investing. I also intend to set up a play fund, but don’t really know how much of a solid index fund base I should have before diving in. I agree completely that you need to recognize that the play fund could completely disappear, which is what keeps holding me back.

    • Distilled Dollar Aug 10, 2016, 6:15 am

      As long as you are investing with index funds, then you can always start off with 1% as a play fund. This is of course assuming you want to do it and your last hurdle is determining what %. Over time, you’ll drift towards what you find as the best solution. For me, it is probably in the 5%-10% range.

  • Brad, Financial Coach Aug 5, 2016, 7:22 am

    I sometimes use call options to set a price at which I’d be willing to buy a certain stock if it dropped. Then I let it sit and while and hope I can grab a few shares at a discounted price during a dip. I don’t do it often though – I’m a big fan of buy & holding index funds. This is a nice “trick” for the 10% risky part though.

    • Distilled Dollar Aug 10, 2016, 6:17 am

      Funny enough, I used to have a friend who executed the same strategy, specific to the 10% dip portion. He used to also build in the ability to sell as soon as the stock dropped another 10% (after executing on the option to buy). From that perspective, he limited his losses to “only 10%”. Overtime he did well, but I think the trading activity set him behind the market for those years.

  • TheMoneyMine Aug 5, 2016, 7:48 am

    I am definitely not a trader anymore.
    Many years ago, when I started buying stocks, I did buy individual stocks and in different countries, which I know realize was just about perception and not any kind of financial analysis.
    Some of it worked very well. And then some of it didn’t and I was (almost) back to square one.
    To this day, I only purchase broad based index funds because I don’t think I’m smart enough (or have enough time) to evaluate individual stocks.
    The only stocks I own now are stocks in the company I work for (because it’s discounted) and BRK (again, perception probably has a major role to play here).

    • Distilled Dollar Aug 10, 2016, 6:20 am

      I also own BRK in my play fund – which you might already know. I enjoyed the option to attend Berkshire (which I did for 3 years). The learning I got out of that has more than paid off the price of the shares – which have actually gone up in value – so a win/win in my book! 🙂

  • FinanceSuperhero Aug 5, 2016, 10:12 am

    I’m not a trader and most likely never will be one. I don’t knock those who try it, as there is obviously room for great success. However, I’m just not comfortable with it, primarily because I do not have the time necessary to learn the ins-and-outs at this stage of my life.

    • Distilled Dollar Aug 10, 2016, 6:21 am

      A sagely approach! Hah, I agree 100% and that’s why my play fund is so small compared to the larger index fund approach I utilize.

  • earlyretirementnow Aug 5, 2016, 11:06 pm

    Good post. And good series!
    About the foreign equity exposure: you can now get a lot of foreign equity ETFs that are currency-hedged, so you’d take some portion of the risk out of the equation. Another small advantage of the currency hedge: The “cost” of that hedge (which is done through FX forwards or futures) is the interest rate differential. But since the US has relatively high interest rates relative to Europe and Japan (the largest weights in the non-US equity portion), the “cost” of hedging is actually a benefit right now. You’re shorting the currencies with low and even negative interest rates and make a few tenths of a percentage point extra.
    Best of luck!

    • Distilled Dollar Aug 10, 2016, 6:25 am


      Yikes – ForEx hedging, another realm I need to learn more about. As a CPA, I’ve seen the difference companies have when they hedge against and when they don’t hedge against currencies.

      That is interesting that the cost can turn into a net positive. I assume there is still an inherent cost, so while it might be offset from the interest rate, would you not be exposed to a greater return (potentially) without the cost of hedging included?

      • earlyretirementnow Aug 10, 2016, 9:19 am

        The inherent cost is very small. It can’t be more than a few bps (0.01%) per year to actually implement the hedge. Fees would be a different story. I would make sure that the FX hedged ETF has a similar expense ratio to the unhedged ETF.
        Example: Japan. Ishares unhedged (EWJ) and hedged (HEWJ) have both a 0.48% expense ratio. WisdomTree has a hedged ETF (DXJ) also at 0.48%. Seems to be the magic number, 48bps, haha
        MSCI EAFE index: Ishares Hedged (HEFA) has 0.35% fees, unhedged (IEFA) has only 0.12% fees. That’s a substantial difference.

  • Dollar Engineer Aug 6, 2016, 11:22 am

    My strategy is pretty similar to your’s Matt. I stick to the monthly dollar cost averaging into index funds and then have that play money. Like you said, realizing that you could lose a majority of that money and being okay with it is huge in my opinion. If you realize your risk then if your individual stocks start taking a beating you won’t panic and sell. One of my friends jokes that when taking some risks you can only lose 100% of your money, but your gains are possibly infinite haha.

    • Distilled Dollar Aug 10, 2016, 6:27 am

      Exactly – eliminating the panic and sell option! Easier said than done though! I still recall when Tesla went from 119 to 109 and I was freaking out. It was a few dollars, so I was surprised to see how emotionally charged my thinking process was. I held on, but it was still a big learning lesson for me.

  • Jeff Proctor Aug 7, 2016, 8:26 am

    This article pretty much sums up my exact investment philosophy of “vast majority in index funds, then some play money on the side”. It’s just too reckless and irresponsible to regularly trade your entire portfolio on a regular basis, no matter how educated you are on the market. Human emotions applies to all of us, even investment pros!

    Thanks for this article; great stuff!

  • amber tree Aug 7, 2016, 4:29 pm

    Nice post as part of your series.

    My portfolio also has play money to make directional bets on the market. So far, so good. Let’s see when we hit the wall.
    Options is also part of my plan. I do not take long bets on the black swan. I sell options on ETFS and stock I do not mind to own. The goal is that they expire out of the money…
    Forex is still an virgin territory for me… I am curious to read your stories here

    • Distilled Dollar Aug 10, 2016, 6:32 am

      I knew writing this post that not many of my readers actively work with options – but I knew you would swing by to offer some insight! Thanks for sharing as your options approach seems to be working for you so far. I’m curious to see how it develops and if you stick with your guns or alter your approach if you hit the wall as you mentioned.

  • Patrick Aug 8, 2016, 5:03 pm

    I’m not a trader so much as a semi-informed investor.

    The bulk of my investments are index funds. But I do have an individual IRA that I actively manage, using, also another Buffett adage: “Don’t buy any stock you can’t plan to hold for 10 years”. I’m using that adage for creating a dividend growth portfolio out of that IRA.

    • Distilled Dollar Aug 10, 2016, 5:56 pm

      Great adage! It helps me ignore the daily headlines and focus more of the big shifts over the year that are brought up on the quarterly earning calls.

  • Dividends Down Under Aug 15, 2016, 9:45 pm

    Hi Matt, we don’t do any forex trading, options or things like that. We do invest individually in companies we think have very long term futures and should pay us ever-increasing dividends for a very long time. We like it that way 🙂


    • Distilled Dollar Aug 16, 2016, 6:42 am

      Diving into forex has been tricky, even after finding the right tools to learn. My next move might be to learn more about high yield stocks, since I’ve seen those mentioned quite a bit in the FIRE community.

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