Practical Costs and Approaches to Tail-Risk Hedging
Summary
The document considers how an investor might protect an equity holding against extreme losses, including buying far out-of-the-money puts. It describes purchasing equity index puts as a straightforward form of portfolio insurance, while emphasizing that maintaining this protection can be costly. It also mentions identifying risks that may be underpriced through company, scenario, or macroeconomic analysis, framing that approach as active investing as much as routine hedging.
The responses cite debate over whether put protection is worthwhile over long periods. One answer refers to research arguing that the strategy performed during the early COVID-19 selloff but was expensive to maintain in other periods; another says a put-protection index barely outperformed the broad market even through that episode. Alternatives discussed include holding assets expected to move inversely, such as bonds or gold, and reducing exposure or keeping cash. These are opinions and examples rather than a general hedge-sizing rule, and the discussion offers no tailored assessment of the investor’s specific shares, option price, or risk tolerance.
Key ideas
- Buying equity index puts is a direct way to seek protection against severe market declines, but can be costly to maintain.
- The cited discussion questions whether long-term put protection compensates for its recurring expense.
- Searching for underpriced tail risks may require company, scenario, or macroeconomic analysis.
- Potential alternatives include inverse-correlated assets, lower exposure, and cash reserves.
- The document provides no universal sizing rule or individualized evaluation of the proposed put position.
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Full text
# How do traders hedge against “tail side risk” in practice? # How do traders hedge against “tail side risk” in practice? In a recent CNBC interview, Black Swan author Nassim Nicholas Taleb gave a categorical advice about investing in the Corona period. “It is very unwise to do any form of investment without some form of tail risk hedge.” I understand the concept of hedging tail risk. But how is it done in practice? Suppose I have 100 Apple (AAPL) shares and want to hedge my tail risk. The current share price is around USD 350. So would I buy 100 deep out of the money Put options with a strike price of say USD 75 which expire in 12 months, for USD 84 (USD 0.84 per option)? I wonder if there is any kind of best practice or rule of thumb. ## Answer by Bob Jansen (score 9, accepted) https://quant.stackexchange.com/a/55264 With difficulty and high costs and secretively. Successful ones are the ones that are able to do it more cheaply. This is also the reason for their secretiveness: prices would go up. The costly but straightforward approach would be to buy equity index puts. However, I don't think anyone here can or will explain how you can tail hedge at scale significantly more cheaply and effectively. To support this negative answer, I offer this: In May 2020, there was a Twitter fight between Nassim Taleb (of Black Swan and tail hedging fame) and Cliff Asness (co-founder of 143 billion hedge fund AQR) on this very subject. The fight started after a report by AQR on their blog claimed the strategy happened to work in March 2020 during the (first?) COVID-19 sell-of but was expensive to maintain during all the periods before this. They conclude that over longer periods, buying portfolio insurance isn't a good investment. Taleb claims that tail-risk hedging can be done and should be done but I'm not aware of him or anyone else giving a general guide on how they exactly do it or point out where the AQR research paper went wrong. What you can, is do an analysis (company, scenario, macro or something else) and try to figure out where tail risks are underpriced in the market and buy the protection (for example John Paulson's bet against the housing market). In my opinion, this has more in common with active investing than hedging. ## Answer by Lars Wissler (score 5) https://quant.stackexchange.com/a/55277 First off, I agree with the comments and answers already here. "Simple" tail hedging is expensive in the long run and WILL lose you money. Best example is the CBOE Put Protection index (PPut). Even through COVID-19 it barely outperformed the SPX and that was the mother of all tail risks. In all other market phases you basically buy reduced volatility for quite a lot of return. Cheap tail hedging that will not lose you money is pretty much the holy grail of portfolio management and as such priceless information. Hedging in general needs good timing to be profitable and options are not the best options as they are expensive. A different way to hedge (non tail-risk specific) is buying an inversely correlated asset (i.e. bonds, gold). But frankly the easiest and most straight forward way to hedge is just to reduce exposure and have cash to buy when the price has fallen. Oh and yea Nassim just sells you quite obvious information literally everyone in the business knows and makes it seem incredibly complex and special. But in reality because its known it does not help at all. I mean, of course, after this run in this situation everyone wants to protect against "the second wave" but not loose performance if it goes up. And who knows that better than the people selling options. So those options are priced to perfection plus a little so the sellers make money. Disclosure: I am affiliated with www.leeway.tech and have a personal interest in its success.
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