Tail Risk Hedge Meaning and its essential wisdom for every stock market investor: Hello reader. In today’s article, we shall briefly touch upon the topic of a tail-risk hedge and discuss its use and application for a stock or an option trading portfolio.
Tail risk is a critical topic for options traders and investors to understand, especially for those who have a portfolio that relies on the unidirectional movement of the market to make a profit. This probably includes every single investor on the planet who own stocks as part of his portfolio and makes money when they go up.
In this article to understand tail-risk, we shall divide it into the following parts. Without much ado, let’s get started!
What exactly is a Tail-Risk?
Now, this is going to get a bit dry but I am still going to try and keep it interesting for you. If you are among those who have a good memory of high school mathematics, you might recall what a normal distribution looks like. If you don’t that is fine too, just know that it is the same archaic graph they use in most companies to measure employee performance.
Next what you need to understand is that the concept of tail risk revolves around a simple fact, that most of the returns delivered by an asset be it real estate, stock, or mutual fund, mostly happen around the mean or the average return that has been historically delivered by that asset. In a perfectly normal distribution show above, that would right about where the dotted line divides the bell curve into two equal halves.
But oftentimes there happen to be those certain extraordinary times when the asset delivers a return far away from its average. This could be an exceptionally bumper profit or an excruciatingly painful loss. These are the returns showcased in the far edges on either side of the bell curve.
Now in the stock market, you could say there are days when the market goes wildly up or crashes abysmally. On the days when the market does make a wild move up, an investor stands to make a decent profit and certainly no loss. If you are anything like me you will certainly love those days. But, there are days when the market just goes down, sometimes for days on an end, if you have been through a market crash you will know that those days are simply painful.
It is these events of unforeseen market crashes, which simply cannot be predicted but are likely massive devastations in its wake, which is referred to when we talk about tail-risk. In the graph we saw earlier, it is those days the market makes a significant move from the mean to the downside, It has got a more popular monicker these days, A black swan event!
Now that you know tail-risk is something that is unforeseen and has the potential to bring you a big loss. ( Take a moment here to think about what could be your tail-risk in your career, job, investments, and relationships, etc.)
If you are a real estate investor, a period such as the Covid pandemic could have ceased your rental income for months on end. Else, if you are an online business, the actions of a regulatory body or the intentional breakage of an undersea optical fiber cable big enough to disrupt an entire country’s network could the one.
Tail Risk Hedge – How do we manage a tail-risk?
Now we cannot certainly account for every single thing which could go wrong but is there not anything we can do to manage such a risk in the stock market? Are we truly helpless against such mathematical probabilities?
Apparently, we are not! and we can do it in the same way we protect the other important things in our lives like our car, our health, our home, etc. by buying another beautiful financial instrument called insurance.
In the stock market, these insurances take the form of something called put options. If you buy a cheap put with a strike far away from the trading price and when the market makes an unexpected giant move downwards, these cheap put options see their prices rise to many multiples of their initial cost and thereby offsetting the losses the market crash may have otherwise caused you.
The exact amount and price of puts you would need to buy to protect your portfolio is slightly complicated and is the topic for another post, but know that the rewards of doing so sometimes give outsized returns. The prospect of these outsized returns is a convincing argument enough for many hedge funds out there to spend millions of dollars in talent and research on protecting their portfolios from such unforeseen events.
What are the cons of tail-risk strategies?
While managing and if possible profiting from a market down move may seem alluring, the truth is tail-risk investing or trading strategies are not without their own problems
The principal problems associated with this approach are as follows.
- The tail-risk event statistically has a low probability of happening and also may never happen.
- The investment made into the put option to protect your portfolio may be lost if the market trend upwards or move sideways.
- The hedging by buying puts can get a bit complicated and if not managed properly can also create substantial losses
- When many market players start hedging their portfolio against tail-risks it is a sign of fear seeping into financial markets. This fact alone could make the markets behave in a choppy manner during certain periods.
For the above reasons, many notable and reputed fund managers have called out tail-risk investing, some even going to the extent of calling it a bogus strategy. Their main argument has been centered on the fact that in the long term, stock markets have always trended up and the greatest insurance for the market has been the liquidity pumped in by the federal banks worldwide.
The cost of additional insurance that slows eats up returns have been seen as an unnecessary complication when a far simpler strategy of buy and hold has been able to achieve decent returns for most investors.
Notable Practitioners and thought leaders
In recent years, accounting for tail-risks has gained a lot in popularity and has benefitted a lot from the work and writings of Nassim Nicholas Taleb. His work and writings in “Black Swan” and “Dynamic Hedging” have been the corner stone of this emerging discipline over the years.
Taleb, has been very vocal about investors discounting the damage a black swan causes to the portfolio. His assertion that avoiding major drawdowns even if it involved paying a small upfront cost paid off rich dividends over the long term compared to a completely unhedged portfolio.
Interestingly his protege, Mark Spitznagel made over 3,000% returns in March 2020 through his hedge fund which specialises in tail risk investing.
Tail Risk Hedge – Key takeaways
Tail-risk is an unforeseen market move that can destroy huge amounts of wealth for investors. However by employing proper risk management through buying of assets that profit from an adverse market event, Investors can reduce their downsides greatly.
Although employing continuous hedges may eat up returns deploying them prudently could help avoid considerable pain during a market crash.
Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.