Tail Risk Hedging Strategies – What Is It? (Tail Hedge Examples)

Last Updated on September 19, 2022 by Quantified Trading

How can you hedge against huge losses from totally random and unpredictable events? How can you insure yourself from devastating losses that come out of the blue? This is what tail risk hedging strategies are all about. Tail risks in the stock market are hard to protect against, but in this article, we offer some ideas and clues. We look at different ways to potentially offset or neutralize tail risk in your stock portfolio.

Tail risk is often referred to as “fat tails” and it means that there are increased risks for rare events – more so than a normal distribution indicates.  We present you with six tail risk hedging alternatives: put options, foreign assets, cash, Cambria’s tail risk ETF, Ray Dalio’s All Weather Portfolio, and trend-following strategies.

However, tail risk is very hard to hedge against and it might cost money in the form of lower returns. We start by explaining what tail risk is:

What is tail risk? What is a fat tail? What is tail distribution?

Tail risk is often referred to as “fat tails“. In order to better understand the concept we made a chart to explain the difference between a normal distribution (bell curve) and a fat tail distribution:

Normal vs fat tail distribution
Normal vs fat tail distribution

If a trader or investor uses the blue line as the expected outcome, he might be filled into believing the risk is much lower than it actually is. But the fat tail distribution might indicate otherwise and subsequently, the trader underestimates the risk he is taking.

We can argue that fat tails are a more realistic outcome of an event. Why? Nassim Nicholas Taleb, the author of The Black Swan and seen as the mastermind behind the philosophy of tail risk, argues that random huge movements in the financial markets happen more frequently than the normal distribution indicates. For example, 1000 coin tosses are a perfect example of a normal distribution. Any Monte Carlo simulations of sets of coin tosses are less likely to deviate from the long-term mean of a 50% chance for head or tail. But statistical studies of financial markets indicate “freak events” have fat tails.

Hence, tail risk is something that is rare and seldom. If we look at a probability distribution, the unwanted tail risk is normally on the left side of the distribution curve and happens more frequently than a normal distribution suggests. Hence, it’s frequently referred to as left tail risk. Opposite, right tail risk (right fat tails), are unexpected positive outcomes.

Negatively skewed vs positively skewed distributions

Watch the trader who makes consistent money. He is the one who is going to blow up.

  • Trading proverb

We have previously written an article that covers negatively skewed trading strategies. The difference between a negative and positive skew can be illustrated like this:

Negative vs. positive skewness.

When a distribution is positively skewed, it means that both the median and the mean are greater than the top of the distribution curve (the mode). Opposite, when the distribution is negatively skewed, both the mean and the median is less than the top (the mode).

Does negative and positive skewness relate to trading? Yes, because negative skewness has the potential of ruining you. Let’s make an example:

Let’s assume you are writing deep out-of-the-money calls (not covered calls). This is a strategy that has many small winners, but unfortunately a few big losers. Even worse, there are theoretically no limits on the losses. You can be successful at this strategy for a long time, even many years, until a freak event makes a stock soar multiple times. Thus, one loss can wipe you out and even bring down years of profits. This is why you need to understand if your strategy has a positive or negative skew.

Negative skewness is also called left fat tail. Why the left side? Because the left side contains the losses, while the right side has the winners. As traders and investors, we are more concerned with the losers than the winners. If we contain the losers, the winners tend to take care of themselves.

Below is a distribution that has a “fat” left tail risk and “thin” right side profits:

Tail risk in a trading strategy.

The distribution shows many more losers on the left side than on the right side (from 10%). Thus we can clearly see why this is called left tail risk.

The strategy distribution above gives a positive expected outcome because of the many small winners. But is this strategy an accident waiting to happen because of the negatively skewed distribution?

Tail risk and Nassim Taleb

We might argue that Nassim Nicholas Taleb is the “father” of tail risk, at least he has helped in bringing the concept to the “masses”. His best-selling book, The Black Swan, made the concept understandable, but he had already covered it in his second book published in 2001 called Fooled By Randomness. We strongly advise reading all of Taleb’s writing!

Just as a curiosity, we can mention that Nassim Taleb never labeled Covid 19 or the supply shocks in 2022 as “black swan events”. Quite the contrary, this is something he predicted many years ago.

Why do you want to hedge against tail risk?

You want to hedge against tail risk because a totally random event has the potential of creating havoc in your portfolio, as we explained above in the example of writing naked calls. Below are three arguments for why you might consider hedging against tail risk:

Hedge tail risk to avoid losses

No one likes to lose, and this applies to finance as well. Investors hedge against tail risk to avoid or limit losses in their portfolios.

Hedge against tail risk to survive

The winner of a match is not always determined by who is right….but in the end….who is left.

  • Tom Wiswell

In the end, the winner might be the ones still around to fight another day. Investing is a marathon, and you want to make sure you are still running when you see the finish line in the distance. Investing and trading are mainly about surviving.

If you use leverage, a tail risk event is what makes most investors and traders bite the dust and go belly up. Excessive leverage is not something we recommend if you want to survive.

Hedge against tail risk to avoid behavioral mistakes

Even if you don’t risk losing everything, you might want to hedge against tail risks.

The major risk for most investors is committing behavioral mistakes. We are all liable to trading biases!

Almost all investors are risk-averse, meaning we react more negatively to losses than positively to profits, and thus we might make fatal and bad decisions when we face big losses. Many investors “lose their heads” and sell in the middle of a meltdown, exactly the opposite of what is normally a wise thing to do. To avoid this, you should consider tail risk hedging or adjusting your portfolio to minimize the impact of tail risk events.

What is tail risk protection?

Tail risk protection/hedging is when you somehow manage your portfolio to be more or less immune to left side tail risks. Left tail events are extremely unprofitable and might cause severe losses, especially if you are leveraged. It might force you out of business or make you stop trading because of a lack of confidence.

However, you still want to make sure your portfolio can participate in events that contribute to the right side events (those that are profitable).

As you can imagine, this is balancing the pros and cons. Unfortunately, there is no hard answer for this and much boils down to preferences and trade offs.

Tail hedging strategies: How do you hedge against tail risk?

You can buy tail risk protection, hedges, and risk limitations.

The aim of hedging tail risk is to hedge against losses like the GFC in 2008/09 and Covid-19. In other words, you want to insure yourself against extreme, sudden, and random moves. While it’s extremely difficult to time big moves up or down in the financial markets, we do know that they will happen sooner or later. The legendary investor Charlie Munger has repeatedly said that you should not operate in the stock market if you can’t stomach a 50% drawdown.

The reality is that most traders and investors don’t know how they will react if they suffer a drawdown of this size. Because of this, many might be interested in tail risk hedging.

How do you hedge against tail risk?

As you’ll learn in this article, this can most likely only be done by giving up a little return. You pay for “insurance” while you are waiting for the meltdown. It’s like insuring your house: every year you pay insurance even though the chances of a fire are very low.

The problem is that the insurance in the financial markets is much more expensive than P&C insurance for a house. Tail risk insurance comes with a hefty price tag that limits your compounding.

However, when having market insurance, your portfolio will perform much better than the market averages during a “meltdown”. When the meltdown is over, you start compounding again at a much higher level than you would if you had not hedged.

Mark Spitznagel, a manager of a hedge fund and friend of Nassim Taleb, argues you can mitigate risk and still increase returns. He touched upon this in his book Safe Haven Investing.

Put options as a hedge against tail risk

The easiest and most obvious way is to buy put options that are “out of money” on a broad market index, for example, the S&P 500. A put option is like insurance.

For example, if S&P 500 is trading at 3500, you can buy a put that gives you the option to sell at 3300. If the S&P 500 drops below 3300, you have the option to sell at 3300 and not the lower market price.

Out of the money means the options are unlikely to get exercised unless the market drops a lot. If you for example buy put options 5% out of the money on a rolling basis, you stand to gain a windfall if the market drops a lot. The downside is that you have to roll over the options many times and might face “pin risk“. Thus, it comes at a cost.

Buying puts is the opposite of selling puts.

Own foreign assets

You don’t have to limit yourself to only US or local markets.

Diversification into foreign real estate, bonds, and commodities has provided reasonable good hedges in terms of volatility and drawdowns. There is plenty of research documenting this.

Cash is a hedge against left tail risk

First, you don’t have to invest 100% in stocks. We often say the best way to hedge a risk is to not take the risk in the first place. No one says you must own equities, and cash and bonds are an acceptable “sleep at night” choice.

– Meb Faber

Cash is not a good investment in the long term because of inflation, but cash is king when there is a meltdown in the markets. Cash is an underappreciated asset.

We are not suggesting keeping huge amounts of cash, but 5-10% can be useful. Despite high inflation rates, cash has been one of the best asset classes in the first 4 months of 2022 when more or less all asset classes fell in value except commodities. Just look at these YTD returns on May 22, 2022:

  • S&P 500: -18.40%
  • Nasdaq 100: -28.10%
  • LT Treasuries: -17.90%
  • Bitcoin: -38.00%
  • Gold: -2.20%

Cash, of course, lost less (only the loss of purchasing power).

Tail risk ETF (ticker: TAIL): Meb Faber and Cambria’s tail risk ETF

Because as we get closer to the end of this bull market, whenever that be, we see many investors are wondering two things: 1) will “whatever’s next” be as bad as 2000 and 2008; and 2) if so, is there a way to avoid it?….Therefore, in this white paper, we’ll cover four signs of an aging bull, briefly revisit traditional strategies to help protect your portfolio, then highlight a strategy that has the potential to actually profit during a bear market.

– Meb Faber in Worried About The Market?

Luckily, Meb Faber has already done quite a bit of research on the potential cost of “insuring” your portfolio. In an article called Worried About The Market? Faber discusses how certain asset classes have performed during market panics (in relation to the stock market).

In the article, Meb Faber uses put options as insurance. It’s beyond the scope of this article to go into depth about puts, but a put offers insurance, as explained above:

The basic idea is that if the market (or your stocks) rolls over, a put option you’ve previously purchased will enable you to either sell your equities at the pre-determined strike price (play defense), or if you don’t own the underlying investment, you’ll be able to profit as the underlying’s market price falls, therein increasing the value of the put you own (play offense)…. We refer to this as a “tail risk” strategy…..For simplicity sake, and since the data is public, the tail risk strategy we will utilize is one that buys monthly 5% out-of-the-money options on the S&P 500. We then invest 90% of the portfolio in 10-year U.S. government bonds.

Meb Faber went on to calculate the tail risk hedging strategy performance during certain bear markets:

Meb Faber’s tail risk hedging strategy. Source: Worried About The Market?

As you can see, the tail risk hedging strategy of being invested 10% in put options and 90% in 10-year bonds performed best of all assets, hands down.

But this assumes you time the market perfectly and know when a crisis happens, which is highly unlikely. What happens if you are invested in the tail risk hedging strategy at all times? The tail risk hedging strategy comes at a cost and you are paying for the protection. And this, of course, will affect the portfolio performance negatively.

But remember, this strategy comes at a cost. You’re paying for the protection. That means investing in a tail risk strategy has some similarities to purchasing insurance. And that’s going to affect overall portfolio returns for those of us who aren’t perfect market-timers…..In the same manner, if you are able to avoid a car crash for a year, then your auto-insurance premium can be viewed as having gone down the drain (but we nonetheless renew our auto-insurance each year).

The relevant question to ask is:

Do the strong returns for the tail risk hedging strategy balance out the poor returns in rising markets? How much of your returns do you need to sacrifice to get tail risk insurance?

Meb Faber went on to quantify the lowered returns and lower drawdowns by diversifying a percentage of your portfolio to tail risk protection:

Meb Faber’s tail risk hedging strategy performance.

We would say the returns are pretty much as expected: the overall returns fall significantly. Based on this, we assume most investors will reject such a tail risk hedging strategy.

However, we know most investors are not infallible and make behavioral mistakes: buying market tops and selling market bottoms. By having put options you offset some of the unrealized losses (look at the row called drawdowns) and this might make it easier to hold onto your positions.

Ray Dalio’s All Weather Portfolio (All Weather Principles)

First, you don’t have to invest 100% in stocks. We often say the best way to hedge a risk is to not take the risk in the first place. No one says you must own equities,
and cash and bonds are an acceptable “sleep at night” choice. So instead of 100% in stocks, investors could own 80%, or 60%, or even less with the remainder in cash or bonds.

  • Meb Faber

The quote from Meb Faber fits perfectly for Ray Dalio’s All Weather Portfolio: The All Weather Principles are exactly what this is all about, namely being diversified into other asset classes than only stocks. Owning many different assets is a smart way to lower the risk and reduce tail risk.

The famous investor Jeremy Grantham once said that “the more investments you have and the more different they are, the more likely you are to survive those critical periods when your big bets move against you“.

One of the reasons why the All Weather Portfolio might be a good tail risk hedge for stocks is because of the allocation to commodities (and indirectly trend-following):

Trend following as tail risk hedge strategy

We know that mean-reversion strategies frequently fall prone to fat tail – they tend to be negatively skewed. Such strategies have a high win rate, many small winners, but unfortunately, a few big losers might wipe away much of the profits. The few outliers (the tail in the distribution curve) are NOT to your advantage.

The “opposite” strategy, a trend following strategy, has a rather different risk profile: many whipsaw signals that lead to a low win rate, many small losses, but a few rare big winners (outliers). The few outliers (the tail in the distribution curve) are to your advantage.

Commodities are especially useful to catch trends. For long periods of time you might get whipsawed, but the few big trends might recoup all the small losses. And because commodities are inflationary, they often provide good returns when stocks and bonds are weak. Trend following strategies work.

The YTD performance of certain asset classes on May 22, 2022, was all negative.  What about trend-following funds during that period? Practically all trend-followers are having a stellar year:

  • Lynx +28.78 (Swedish systematic trend hedge fund)
  • Eurekahedge Trend +18.75 (index of trend-following funds)
  • Barclay CTA Index +8.10 (index of mostly trend-following funds)
  • Paul Mulvaney Trend +87.80% (a trend-following fund with one of the best track records out there)

Compare this to the main asset classes:

  • S&P 500: -18.40%
  • Nasdaq 100: -28.10%
  • LT Treasuries: -17.90%
  • Bitcoin: -38.00%
  • Gold: -2.20%

This is why you might want to diversify into trend-following funds or ETFs.

We have written in earlier articles about why you need to complement your stock portfolio or trading strategies portfolio with assets or strategies that have a low correlation to your other stocks or strategies:

Hedging tail risk strategy example: Cambria’s TAIL ETF

Meb Faber and his asset firm, Cambria, offer a fund that has the sole purpose of offering tail risk protection. It’s an ETF and has the appropriate ticker code “TAIL”.

This is what they write on their website:

The Cambria Tail Risk ETF seeks to mitigate significant downside market risk. The Fund intends to invest in a portfolio of “out of the money” put options purchased on the U.S. stock market. TAIL strategy offers the potential advantage of buying more puts when volatility is low and fewer puts when volatility is high. While a portion of the fund’s assets will be invested in the basket of long put option premiums, the majority of fund assets will be invested in intermediate term US Treasuries. As the fund is designed to be a hedge against market declines and rising volatility, Cambria expects the fund to produce negative returns in the most years with rising markets or declining volatility.

(We marked in bold.)

Currently, the main holdings were:

  • US ten-year Treasury Bond 86.6%
  • TIPS 5.5%
  • Long SPX put options 4.2%
  • Cash 3.7%

How has the performance been? As the prospectus indicated, the return has been negative: Since its inception (April 2017) the CAGR has been -6.92%. This is to be expected because the stock market goes up (in the long term) and TAIL has an inverse relationship to the stock market.

How has Cambria’s Tail Risk ETF performed during a crisis? Does tail risk hedging work?

The chart below shows Cambria’s Tail Risk ETF since inception:

The performance of the ETF TAIL (tail risk ETF).

 

Cambria’s Tail Risk ETF did what it was supposed to do during the weak market in the 4th quarter of 2018, during the pandemic in March 2020, and in the selloff in 2022. If you had allocated for example 5% to Cambria’s Tail Risk ETF, this position would have contributed 1.28% to the upside during the Covid-19 mess. If you had allocated ten percent, it would have been 2.56%.

Below is a tail risk hedging example and backtest of being invested 90% in SPY (S&P 500) and 10% in TAIL with weekly rebalancing:

Example of tail risk hedging strategy: 90% SPY (S&P 500) and 10% TAIL (Cambria tail risk ETF).

How does this compare to buy and hold SPY? The chart below shows SPY (S&P 500) in the blue line, and the tail risk strategy example in the red line:

Tail risk strategy example: buy and hold S&P 500 vs 10% allocated to tail risk ETF.

Diversifying 10% to Cambria’s tail risk ETF helps alleviate some of the downside risks when the markets turn ugly, but in the long run, you have to bear the costs of the tail risk insurance.

What happens if we increase the weighting in TAIL to 25% (and S&P 500 down to 75%)? We get the following equity chart:

Tail risk strategy example: buy and hold S&P 500 vs 25% allocated to tail risk ETF.

The overall return goes down (red line) but you have smaller drawdowns. Returns and “safety” are all about trade offs!

Our own experience of tail risk hedging strategies

During 2019 we hedged our portfolio against tail risk by buying out of the money puts on the ETF SPY (S&P 500), a bit like the tail risk strategy described by Meb Faber.

We gave up in October 2019, because the pain of seeing the options expire worthlessly is too high to bear.

In practice, this strategy slowly bleeds you for funds until you hit the rare big payday. We believe very few investors can tolerate such ongoing pain. Unfortunately for us, just some months after we stopped, the Covid-19 sent the index into a steep fall and we would have made a nice profit on our puts.

Tail risk strategies are difficult because we are risk-averse

Think about this: If you make 500 000 in year one and nothing in the following nine, you will most likely be a lot unhappier compared to receiving 50 000 evenly in all ten years.

Behavioral experiments suggest our happiness depends far more on the number of positive feelings than on the amount when they hit. This means any payment is much more important than the size of it. In order to have a pleasant life, most people should thus spread these payments evenly.

Even worse is if you make 500 000 in year one and give back 400 000 over the next nine years. It most likely feels better to receive nothing because you have nine miserable years.

Because most of us are like this, tail risk strategies are extremely difficult to follow. It’s a constant path of misery until you one day hit the jackpot.

Tail risk strategies – conclusion

Risk is a fact of life and something you can’t avoid. Life is a risk. The same is the stock market and financial markets. In order to get the long-term returns offered by the stock market, you have to accept drawdowns in your portfolio. If you are young and have decades before you need the savings, it’s probably better to just invest and do nothing (forget about it).

However, if you are getting closer to retirement, it might be a good solution to mitigate risk by employing some kind of tail risk strategy. Imagine being about to retire in the year 2000 or 2008 and only be invested in stocks and witness the value drop significantly when you start withdrawing your capital. It’s devastating.

Some of the tail risk strategies mentioned in this article could be helpful. But the trade-off can only be judged by yourself.

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