How do traders hedge against “tail side risk” in practice?

Question

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 1

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 2

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.

Answer 3

Taleb equates famous put sellers like Niederhoffer with all derivative traders who short derivatives, so does this guy with an axe to grind, https://steadyoptions.com/articles/how-victor-niederhoffer-blew-up-twice-r124/ They are ignorant of risk management a naked put need not be more risky than buying a share, but I am not in the business of educating. I keep it to myself, thanks. This is the basis of his famous quotes, eat like mice, shit like elephants, and also behind the famous sucking up nickels in front of a steam roller, lovely quite picturesque, good to scare people off because as every economist worth his salt knows once an arbitrage is exploited there is no super-profits just marginal revenue. Which is my main beef with Tom Sosnoff everything he says is pretty spot on, and he is more honest than Taleb, but if everyone trades the way he recommends as he shows on his tasty trade channel, there would not be much money to be made from trading that way, in fact there would end up being more option sellers than buyers he should think that through some time. Most people even Finance MBA's on Wall street have a very limited financial literacy they are focused on orthodoxy, as the economist J K Galbraith coined it, the conventional wisdom, he said that facetiously. As Shakespeare wrote, "there is more in heaven and earth than is dreamed of in your philosophy, Horatio!"

Answer 4

Extreme value distribution theory and methods is the mainstay of actual quants to stress test a real portfolio or stock, eg.`

Utilising fextremes POT method in R from the book by Bernard Pfaff Portfolio Risk Modelling and Portfolio Optimization with R

Here is the code.

Here is the diagnostics.

Hedging with instruments of extreme tail risks is generally not done, they act as self-insurers would and underwrite with enough cash reserves. The debacle of Black Monday 1987 showed the complete and utter failure of futures and options as "portfolio insurance " methods, as portfolio insurance exacerbated the drop and severity of the fall in 1987's crash, it does not work in chaos, portfolio insurance except in small instances for individual traders. Generally, if a portfolio proposes unrealistic risks it is closed out or restructured, to eliminate as much risk as possible.