Create your own tail risk insurance using derivatives, part 2

Let's start with the simple, easy, reliable way

In our first part of this series, we argued that tail risk can only be effectively provided by some kind of financial derivative product, since derivatives can exponentially increase in value in large market moves. What’s more, they do so predictably and consistently. For instance, if war breaks out and the stock market crashes, your venture capital positions may crash too, may grow, or they may do nothing. Gold and silver will probably increase in value - but not exponentially, and in any case, they too may drop.

But an out-of-the-money put option on the same stock market index will, for sure, mushroom. The key thing to realise is that, since an option is a derivative, the option’s huge jump in value is simply maths - its value is ‘derived’ from the stock index itself.

This article is about how you can create this kind of tail risk hedge for yourself. This is precisely the kind of approach which has been long advocated by Nassim Taleb, along with his colleague Mark Spitznagel. While some funds have tried to jump on the increased popularity of ‘tail hedging’, generally speaking it is impossible for an effective tail hedge to be created by the mere purchase of an ETF (for proof of this, look up the historical stock chart of a ‘tail hedge’ ETF such as Cambria). Once again this comes back to maths; once a fund claims to be a tail-hedge, it can no longer be a pure derivative. Thus it cannot mushroom as a derivative does. And the simplest, easiest, most reliable hedge is a derivative product of the investment you own; one which will exponentially increase in value if the underlying plummets (during a grey or black swan event).

For example, if you hold £10,000 (let’s make the numbers easy) in the FTSE, and war breaks out, the FTSE may drop by 15% in a single day, taking you to £8,500. If you had owned, say, 10 out of the money puts on the FTSE, which each may have cost £10 (thus, £100 in total), each may now be worth £170 (thus, £1,700 in total). This would be an example of tail risk insurance actually making you money in a crash, since - in this imaginary example - your portfolio would be worth £10,200 (as opposed to £8,500).

The simplest strategy for do-it-yourself tail hedging is thus to start with your portfolio and then purchase derivatives, particularly options, which will give a large payoff in the event of a tail event. Crucially, you need to calculate and then buy the level of insurance you actually need. Getting this wrong - as with any insurance -either means that you are under-insured when you need it, or that you have lost money through paying for insurance that you didn’t need.

In the next section, we’ll get into the details: what exactly is an ‘out of the money’ put? How do you go about buying them?

And more importantly, what kinds of black and grey swans should we be ready for?

Photo by Josep Castells on Unsplash