Building A Tail Risk Hedge With Options

Photo by Bert Gort on Unsplash

People buy insurance for valuable assets like their home and car. Investment portfolios are typically among someone’s largest assets, yet investors rarely buy portfolio protection. When it comes to protecting one's portfolio, investors are mainly concerned with equity risk. Bonds are less volatile since future cash flows are more certain.

Buying downside protection for stocks is not unlike other forms of insurance. You pay a fixed premium and receive a payoff if a certain event happens in the future. In financial markets, options can be used to buy downside protection.

My hedge model is focused on partially hedging extreme “tail risk” events and not routine 10% stock corrections. The majority of market risk models are based on a normal distribution, which implies that financial market returns are evenly distributed. Basically, a normal distribution says that an equal amount of really bad and really good things will happen. History has shown that market returns are not normally distributed. The image below shows that significantly negative S&P 500 monthly returns (in blue) have occurred more frequently than what the normal distribution (in red) would predict.

Source: Evestment

This behavior of market prices being more volatile than anticipated isn’t unique to the stock market. On October 15, 2014, the 10-year U.S. Treasury yield rose 40 basis points in a single day. This was a 7-sigma event, meaning a move of that magnitude should statistically happen once every 3 billion years (according to a normal distribution). On June 24, 2016, the British pound fell 8.1% against the U.S. dollar, a 15-sigma event. Financial markets mirror life: improbable events happen more often than anybody expects.

Hedge Structure

There are three main decisions to make when buying options: the underlying instrument, the option’s strike price, and the option’s maturity.

Underlying Instrument: I use SPY, the most liquid U.S. ETF, as the underlying instrument when hedging. SPY tracks the S&P 500 index and is highly correlated to the equity risk I’m concerned with reducing. U.S. and international stocks have historically exhibited stronger correlation in down markets. As Ben Carlson has pointed out, correlations between risky investments tend to go to one during corrections. Additionally, SPY options are more liquid than options on international stock ETFs. This translates to lower trading costs.

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Disclosure: Hedge strategy positioning was calculated based on the trend and macro strategies. Data on Movement Capital’s hedge strategy was created based on an interpolated series of SPY ...

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