Wayne I actually meant metaphorically, rather than literally, but thanx for the pic. Quoting the odd stock (ELN) that got hit by the black swan phenomena, does not mean that stocks inherently have fatter tails than indices. As I've said, you'd have to study your particular market, but generally I believe that indices have fatter tails due to the strong correlation of stocks during a big down move. This is also the way that the market see's it, as evidenced by the steeper vol skew in indices Vs stocks.
I suspected that was the case, but I had this nice picture...... Yes I take your point re vol skews. But I suspect there are other reasons for that other than the thickness of the tails. I would be interested to see some statistical work on this... all dumbed down so I can understand it of course. Meanwhile, food for thought. Cheers
Indices don't gap, well they do but only small gaps, and your "black swan" risk is only to the downside, while stocks gap relatively frequently up and down so it is easier to manage risk with indices rather than with stocks.
Wayne There is a function in Excel that measures Kurtosis (KURT). It measures the Fischer kurtosis whereby in a "normal" distribution Kurtosis measures 0. Checking (historical) Kurtosis is a peice of p!ss. MTE Back swan risk isn't directional. Bin Laden captured, Christ appearing, Bush resigning (LOL), probably not brilliant examples, but there are equal and opposite factors that would cause the market to surge as opposed to fall. Are you saying stocks have fatter tails than indices ? I'm not necessarily disagreeing, it's just that they don't in the markets I trade.
I think what Profitaker says is that a stock moving in 3% steps can gap for example 40% but an index moving in 0.5% steps can also gap significantly (say 15%). The risk in the index is that the usual 0.5% steps can be deceiving and lead to the opening of a relative large position that will be hurt more with the Black Swan.
Hi gbos Good to hear from you - it's been a while ! Hope all is well (?). Yes, that would be a good example of an index having fatter tails than the component stocks, even though the index vol is less than the component stocks vol. Volatility and Kurtosis are two completely different parameters, which can confuse. It's the correlation of stocks during major moves (especially down, but also up) that causes the fatter tails in the indices. Once again, every market is different, but my experience of equity and index markets is that fatter tails exist in the indices than do in the component stocks. What do you think ?
I know that the "black swan" event can happen both ways, but it is more likely to be a market crash than a market rush, don't you agree!? I think there are more potential "black swan" factors for individual stocks than there are for indices.
I'm with MTE on this one for now. Without the means to prove it: There is more fear of a black swan in idicies, especially on the downside hence the vol smirk... also index options tend to be chronically overvalued. But certainly in the stocks I look at, there are FAR more occurences of BS's. With stocks, there is at least the possibility of a gap every quarter, with reporting season. Even 911 didn't produce a 15% gap... and anyone short gamma was probably already defending anyway. That's just my obsevation.
MTE... Well, yes, vaguely, at least historically. But we are talking â Black Swan â so unlikely an event that itâs hardly within our comprehension and therefore shouldnât be considered to favour any particular direction. However fat tails, at least fatter than a ânormalâ distribution describes is a fairly regular occurrence, and is measurable. In an index it is a fact that stocks correlate highly in any major move, down as well as up. This causes fatter tails to exist in the indicies than in stocks. Fat tails has absolutely nothing to do with volatility, though it could possibly be cause for some confusion. Anyway, this shouldnât cause too much debate as fat tails are easily measurable both historically (from EOD data) and implied (check out vol skews). As for managing risk....index options generally more strikes and liquidity so yes, more choices available. But I wouldn't necessarily see that as a good reason to trade one as opposed to the other. wayne I agree. You must ask yourself.....why ?