Tail Hedging
The idea of protecting investments by “hedging” (investing in a way that contradicts the majority of positions held in a portfolio) has inspired investors to devise various hedging methods that can be very effective in a volatile market. As the Stock Market experiences extreme volatility, it is greatly beneficial for investors to explore different hedging techniques that can potentially offset losses in their portfolio. Specifically, I feel “tail hedging” is a very effective strategy that investors can deploy to protect investments in current market conditions.
The concept of tail hedging centers on insuring an investor’s portfolio from large swings in the market using the “tails” of a normal distribution curve as potential hedges. In this case, the normal bell curve represents possible moves in the market with theoretical probability. Notice how the “tails” of the curve are very thin with a small chance of occurring as the standard deviation is great.
Image: MIT News
However, in the case of a large unexpected selloff, an investor with a long portfolio could potentially use this strategy by allocating a small portion of his portfolio towards investing in the “tail” of the distribution curve to limit losses. For instance, if an investor with a portfolio value of $100,000 was to set aside .5% of their total equity exposure towards tail hedging, the investor could potentially break even in the event of an unexpected 20% move in the market. Basically, investors would use the .5% allocation and invest in options (type of stock derivative which gives investors the right to buy/sell an asset at a specified price) in indices such as S&P 500, Nasdaq, or Dow Jones. In order to determine an appropriate strike price for the option contract, an investor should select a strike price that is 10-30% out of the money with a delta around .5 if investing in put options. Furthermore, the options should have an expiration date around 2-3 months. This way, investors can roll the options to later expiration dates and keep the hedge as portfolio insurance. For reference, call options would be used to hedge against a short portfolio while put options would be used to hedge against a long portfolio.
Using this idea, if we were to currently put this strategy into action it would like something like this:
SPY (the S&P 500 ETF) is trading at $304 at the time of writing this article. So given our portfolio is long, we would select puts with a strike of 270 (which is roughly 10% below the current trading price) and an expiration of Aug 21. With a current implied volatility of 22.5%, the put options would be $76.9 per contract ( .769 per option and 1c= x100). With a portfolio value of $100,000 we would only have $500 to invest in the trade (.5% of $100,00). Therefore, we could only afford 6 contracts for a net total of $461.4 for the put options (6x $76.9).
Let’s say after a month, SPY takes a huge dip and is down 15%. Now, our put options would be worth $17.306 ($1,730 per contract) for a total of $10,383 for all 6 contracts. As a result, this trade would net us $9,922.2 in profit ($10,383- $461.4). However, due to the index’s 15% dip, we could assume around a 12.5-17.5% loss on our equity positions. So, at the midpoint, a 15% loss of our $99,500 in equity exposure is $14,925. Although, we need to subtract our gains from the hedge which was $9,222.2. This results in a net loss $5702. While we didn’t break even, we still greatly reduced our net loss which would have been $15,000 without the hedge.
Thus, investors should greatly consider tail hedging as it is a viable hedging strategy in current market conditions.