Tastylive: Markets Can Crash at Anytime. My Two Tools to Manage That Risk
Market risk can vary depending on circumstances. However, the use of statistics can mitigate much of that risk. Most traders will look at the potential move of a stock, option, or other trade based on a standard deviation.
Typically, 68 percent of all outcomes will occur within one standard deviation. Two standard deviations will cover 95 percent of data. That’s the tool most used by traders, since it should result in a trade playing out in the expected way most of the time.
At three standard deviations, 99.7 percent of all observations should occur. Anything outside of that level is considered “tail risk.” It’s typically tail risk that tends to play out when markets have a big drop.
For instance, in 2020, the S&P 500 dropped from about 3,300 to 2,100 in the span of a few weeks. That’s a significant tail event. Likewise, the rally in April to June saw a recovery of that drop in just 50 days.
Traders noticed that there was a negative skew to the market – indicating market fear over the speed of the decline. The normal distribution model didn’t hold.
Investors should look for negative skew when determining a market crash. And when there’s a market rally off of a crash, there tends to be a positive skew, which can lead to big returns for buy-the-dip investors and option buyers.