What Is Tail Risk?

Tail risk is broadly defined as the probability of rare events that are outside the normal distribution of outcomes we typically see. Odds are if you have a portfolio of any type (even those invested in AAA bonds or cash), you have tail risk.

What is Tail Risk and How Can I Manage It?

On the chart below, I have plotted the daily price move on the X axis and the frequency of that outcome (on the Y axis) over two decades in the S&P 500. You may notice a few things:

  • The curve does not have a normal distribution.
  • The highest point of the curve (as shown by the green arrow) is not at 0, but slightly above it.
  • On the extremes of the curve (as shown by the red arrows), the left side is a lot longer and fatter than the right side.

Visualizing the Fat Tail of the S&P 500

tail risk hedging

Why is the peak above 0%? It's because the most common day in the stock market is one that is calm; nothing much but a minor positive equity drift (as stocks tend to go up over time). So the next time your friends ask what you expect the stock market to do tomorrow you can reply "it will be slightly higher."

The extremes of the graph or the tails are what we are focused on instead. There is an especially fat tail on the left side of the graph, illustrating the downside risk in the S&P 500. These large moves of 3+ standard deviations occur a lot more commonly than a normal distribution of returns would imply.

Using Skew to Measure Tail Risk

Thankfully we don’t need to spend hours pouring into company financials to have a good estimation of risk. All we have to do is look at the skew (the implied volatility of different strike prices for the same date and underlying).

This fat left tail is common in all equity indexes and in most single name equities. Though there are some equities, specifically biotechs and heavily shorted stocks, that exhibit a fatter right tail. This illustrates that the most common daily move is a small move down, but if a large move does happen, it will most likely be to the upside.

Imagine a small biotech company looking to develop a cure for cancer. As each day goes by, they deplete their cash reserves. Odds are the company will slowly fail. Yet if they do hit a miracle cure (or even positive trials), the stock will skyrocket. Most stocks will have tail risk to both sides, resulting in a volatility smile or smirk (as shown below with Apple (AAPL)).

hedging tail risk

Stressing Our Positions

In order to protect ourselves against tail risk, we need to first stress test a worst possible situation for our positions.

Any bank will have its own department to manage risk. They employ multiple methods, such as Value at Risk (VAR), to try to manage risk as best as possible. For those of us without fancy software or a team of risk managers, there are some simple methods we can use.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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