Create your own tail risk insurance using derivatives, part 3
The first of two simple strategies for all seasons
In this series, we’re focusing on how retail investors can create ‘tail insurance’ for themselves. That is, how individual investors can structure their investments so that a large market crash is effectively - and predictably, reliably - hedged. You can catch up on the previous sections here and here.
In this article, we’re getting into the details: what exactly is an ‘out of the money’ put? How do you go about buying one? We’ll also consider the first of two easy strategies for tail insurance using derivatives.
But firstly, what kinds of black and grey swans should we be ready for? A ‘grey’ swan is an event which you could, in theory, recognise is coming at some point. People may claim afterwards that it took them totally by surprise. But others were saying it was coming. A ‘black’ swan, in contrast, is entirely unpredicted and unpredictable. Market crashes, which is what we are focusing on insuring here, can be caused by both grey swan events and black swan events. For instance, the 2008 crash was technically a ‘grey’ swan, as many had noted ahead of the event that there was a financial disaster waiting to happen. This is rightly noted by Taleb in The Black Swan, and has been highlighted by various documentary movies, such as Inside Out and The Big Short. Mark Spitznagel has repeatedly argued that there is further financial instability yet to be uncovered. In summary: you may expect a ‘grey swan’ crash at some point due to your own financial analysis. But even if not, we need to be ready for black swan events. Unforeseen natural disasters can have rapid and drastic effects on the markets. So, we need tail hedges.
The simplest approach is to do this: buy an appropriate value of ‘far out of the money’ put options, tailored to your actual portfolio. A put option is an option to sell the ‘underlying’ (a stock or index, for instance) at a given price (called the ‘strike price’). In contrast, a ‘call’ option is the option to buy the underlying. When the price of a stock or index drops, the value of a put option starts to mushroom. The faster and larger the drop in stock price, the more massive the increase in the value of the put option. You can think of it like a fire in a building: the worse the fire (the stock crash), the greater the desperation (price) for the fire escape (the put option). The key is to buy your put options when you don’t need them - just like insurance. That’s when they’re cheap. If your stock broker also deals in listed options, you can buy your put options through them. If not, open a account with an options dealing broker - there are many, and you can find them online. This will be your ‘tail insurance’ account.
A put option is called ‘out of the money’ if its strike price is below the current price (‘spot price’) of the stock/index. Out of the money puts are thus cheap, which is why they work so well as insurance:
Calculate your total holdings in public stock. Example: you hold £10,000 in the FTSE 100.
Insure your holdings by buying far out of the money put options on either the same stock index (if your investments are in an index), or on the individual stock (if you have significant holdings in a specific stock). Buy a value of put options equal to 0.5-1% of your total holdings, at a strike price 25-30% below the current or spot price. Example: if the FTSE is trading at 7000 (spot price), you buy puts at a ‘strike price’ of 5000 or 5500. You spend £50-100 in total, which is 0.5-1% of your total holdings in the FTSE.
Repeat steps one and two for each separate stock or index you hold. You may choose to do the same with any commodity holdings you may have. Whilst it is true that gold, silver, and oil can have a tendency to rocket up in price in times of war and other disasters, they can also plummet. Thus, you may choose with commodities to hold out of the money call options to gain from this. But of course, if you hold commodities in your portfolio, then you will already gain from a rocket in price. What we are interested in here is in insuring your portfolio. Thus, it is worth buying puts for gold too - since, in many financial crashes, gold has plummeted along with stocks. Review long-term charts to see this.
In our final article, we’ll consider an alternative method to insuring your portfolio. This final method will be one which you can consider if a sizeable portion of your portfolio is not in public securities, but in venture capital, start up investing, and so on.
Photo by L.Filipe C.Sousa on Unsplash