Trade-Offs in Using Options and Volatility Products for Tail-Risk Hedging
Article Quant Q&A · Author: AlRacoon
Summary
The document discusses whether long options, deep out-of-the-money puts, or volatility exposure can protect portfolios against rare, severe losses. It describes tail hedging as insurance that may lose value or incur ongoing costs during ordinary markets, while potentially gaining during crises. One response notes that established hedging programs can endure years of relative underperformance and that investors must sustain the strategy to benefit when a crash occurs. Another contrasts systematic long-volatility approaches with more discretionary timing, while the final response describes the variance risk premium as the cost borne by long volatility exposure and the compensation sought by short volatility positions.
The discussion offers no specific hedge sizing method, instrument selection rule, or performance study sufficient to settle whether tail hedging is worthwhile. It highlights the tension between persistent insurance costs and catastrophic exposure, along with the difficulty of timing volatility. Its examples reflect views and market episodes raised in the discussion, not a general guarantee that options or volatility products will hedge every portfolio effectively.
Key ideas
- Long options and volatility exposure can provide gains during severe market stress, but may cost money in normal periods.
- Tail-hedging programs can underperform for extended periods before a crisis payoff.
- Investors need to remain committed through the periods when the hedge loses value to realize any later benefit.
- Short volatility positions seek compensation for bearing risk but can suffer sharply during crises.
- The discussion does not establish a reliable timing rule or hedge-sizing method.
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# Hedging Covid-19 and other low probability high loss risks # Hedging Covid-19 and other low probability high loss risks Covid-19 and similar risks are low probability, high loss events. Does it make sense to utilize options to provide hedges for such events? For example, should one utilize long positions in deep out-of-the-money puts as a hedge to such catastrophic events? It seems to me that such positions provide the similar risk and payoff profiles to effectively offset such risks as the catastrophic/material impairment of real money buyside portfolios. How would one go about sizing and structuring such a hedge? And is it feasible in the marketplace? ## Answer by RWP - Down by the Bay (score 10) https://quant.stackexchange.com/a/54097 There's no easy answer to your question, as noob2 pointed out. You can look online for info from Universa. That fund does exactly what you are asking: https://www.universa.net/riskmitigation.html Of course, post a crash, such as the one we just experienced, the cost of hedges is larger than it is prior to such events. Understand that you aren't going to find any really good info on what to buy at what times. Info such as that has real value and no one in their right mind would be forthcoming with such information. Does it make sense to utilize options to provide hedges for such events? Maybe, It Depends, At Times... Some large investors employ hedging programs. These programs tend to lead to years of market under-performance followed by a "making right": https://markets.businessinsider.com/news/stocks/50-cent-fund-ruffer-3-billion-coronavirus-hedges-sell-off-2020-4-1029080177 "We have performed in a lackluster way for years, and part of the reason for that is because we were worried about a sell-off like this," Ruffer boss Henry Maxey said. Realizing that "make right" assumes you stick with it, which many can't, and don't: https://www.institutionalinvestor.com/article/b1l65mvpw5xpts/The-Inside-Story-of-CalPERS-Untimely-Tail-Hedge-Unwind ## Answer by AK88 (score 5) https://quant.stackexchange.com/a/54104 I have also been looking into this stuff for a while. Apparently there are not that many tail risk funds, the prominent ones being Taleb and Spitznagel's Universa and Bhansali's LongTail Alpha. Obviously, all these guys have tons of papers and books on this topic. Spitznagel provides some nice case study on prototypical tail hedging in his book called The Dao of Capital: Austrian Investing in a Distorted World. Another interesting place is Chris Cole's Artemis Capital Management. I am not sure if his fund specializes in tail risk hedging, but his views on volatility and long term asset allocations seems very peculiar. Yet another crowd is vol guys at banks -- they may not be net long or net short vol, but high volatility is definitely better than no volatility for them. On the other side, you have got places like AQR, MSCI, and pension funds. What is interesting about them is that they tend to be proponents of systematic factor based investing. AQR and MSCI have pointed out that (systematic) long vol loses money over time and there is no way that these funds can recover even if there will be a catastrophic event. Their research is compelling, no doubt. However, what about discretionary long vol strategies? As in, you are not ALWAYS long vol, but you construct your portfolio in such a way that it actually won't bleed during normal times. Does this bring us back to market timing issue? Do people like Taleb/Spitznagel de facto have to be right every ten or so years because of the broken clock phenomena? Or do they actually posses alpha skills? But what happened to diversification in March? We have seen that neither bonds nor gold was good enough hedge in recent market rout. The only greenery that you could find was vol. Maybe this will make people re-consider their asset allocation? So there are lots of questions than answers. And as always, the truth seems to be somewhere between the "long vol bleed to death" and "short vol blow up spectacularly" extremes. Maybe that's why some people end up in philosophy instead of being PM ... ## Answer by phdstudent (score 3) https://quant.stackexchange.com/a/54102 One of the most straighforward way to hedge tail risk and buy insurance is just buying the Vix. A few hedge funds made a lot of money on the VIX lately. What's the downside? Well in normal times (which are most of them) you actually need to pay for that insurance. That's called the variance risk premium. So imagine, that you think this are normal times. You actually want to be short on the VIX and gain that premium. You can make a lot of money by shorting the VIX in normal times. The flipside? If a pandemic like this happens you lose a lot of money again. Below the returns of one of the main ETFs that were short on VIX. In normal times you made a lot of money. In bad times it tanked and collapsed. Of course instead of being short on the VIX you could have been long, and then you have insurance in bad times but you lose in good times. As in everything you have to time the market which is close to impossible. E.g. at today's date should you be long or short on the VIX?
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