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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?

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    $\begingroup$ This a big subject. There is a lot of discussion of it under the title of 'Tail Hedging' or 'Tail Risk Hedging' with all sorts of different points of view and conclusions. Some say options are good for this, others say they are too expensive and/or cannot provide the insurance needed by big institutions (not enough liquidity). $\endgroup$
    – nbbo2
    May 13, 2020 at 15:39
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    $\begingroup$ @noob2 this is interesting. But could you perhaps provide some further sources on such discussion? It would be interesting to read further about this. $\endgroup$
    – Hamish Gibson
    May 13, 2020 at 17:34

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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

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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 ...

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  • $\begingroup$ Are you familiar with QVR Advisors ? Would you consider them to be in the first category you mentioned? qvradvisors.com $\endgroup$
    – nbbo2
    May 14, 2020 at 8:10
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    $\begingroup$ AFAIK they do not have pure tail risk hedging mandate, they mostly do relative value (see here bnnbloomberg.ca/…). Btw, Benn is a must follow on twitter. $\endgroup$
    – AK88
    May 14, 2020 at 14:23
  • $\begingroup$ Ernie Chan's tail risk strategy skipped my mind: qtscm.com/accounts. This I think would be in the first category. $\endgroup$
    – AK88
    May 14, 2020 at 14:26
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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?

enter image description here

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