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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.

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    $\begingroup$ You may find this April 2020 story bloomberg.com/news/articles/2020-04-09/… illuminating. Calpers had a tail-risk hedge for 3 years, but got rid of most of it just as the markets began to react to the COVID-19 pandemic. $\endgroup$ Commented Jun 27, 2020 at 12:08
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    $\begingroup$ "Taleb telling you to worry about long tails" has about the same level of information content as "the sun will probably rise tomorrow morning". What else would he say, unless he suddenly decided everything he has done so far is wrong??? $\endgroup$
    – alephzero
    Commented Jun 28, 2020 at 0:54
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    $\begingroup$ This is a little bit of an older paper (2 pages) but it provides a consice overview and hopefully it will help a little cboe.com/micro/buywrite/benchmarks-fact-sheet.pdf. This one is a little more detailed before 08 the PUT index seemed to perfom better than it does now: citeseerx.ist.psu.edu/viewdoc/… $\endgroup$
    – Jorisdrees
    Commented Jun 29, 2020 at 10:47
  • $\begingroup$ The first link appears to now be located at: cdn.cboe.com/resources/education/research_publications/… $\endgroup$ Commented Dec 31, 2021 at 7:08

2 Answers 2

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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.

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    $\begingroup$ That sounds like a wise, albeit somewhat disappointing answer. What about buying deep out of the money put options (as in my example), which are usually cheap? $\endgroup$
    – twhale
    Commented Jun 27, 2020 at 19:24
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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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  • $\begingroup$ For me as a novice, your answer is very helpful. I originally studied economics and had to go through all the math of asset pricing theory, including options. But it sank away and am brushing it off now. Incidentally, I also studied philosophy. And from that perspective I find Taleb wonderful. It is now clear to me that his ideas about hedging tail risk cannot be implemented easily and cheaply. But philosophically, I think his ideas are very relevant - because they also apply outside the market. And they are relevant and useful there, I find. $\endgroup$
    – twhale
    Commented Jun 28, 2020 at 11:11
  • $\begingroup$ This isn't the most extreme of tail risks, but then in a really extreme tail risk scenario, the markets aren't going to be working anyway. $\endgroup$ Commented Jul 13, 2020 at 23:43

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