Tail Risk Hedging Using Put Options: Is It Effective?

Tail risk hedging using put options is a risk management strategy employed by portfolio managers to protect against severe market downturns and mitigate potential losses. Put options are financial instruments that give the holder the right, but not the obligation, to sell an underlying asset at a predetermined price within a specific timeframe. In the context of tail risk hedging, investors purchase put options on their existing portfolio holdings or market indices to provide insurance against significant market declines. In the event of a market crash or significant downturn, the value of the put options increases as the underlying asset or market index declines. This allows investors to offset their losses in the underlying assets with gains from the put options, effectively providing downside protection. Tail risk hedging using put options can act as a form of portfolio insurance, helping to preserve capital and mitigate the impact of extreme market events.

How effective is the tail-risk hedging strategy?

We have discussed in a previous post the effectiveness of the tail risk hedging strategy. In short, it is not effective due to the premium paid for acquiring put options which can be substantial, especially when considering the need to continuously roll over or renew the options to maintain protection over an extended period. This cost can significantly eat into investment returns and erode overall portfolio performance.

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Reference [1] proposed a novel approach to tail-risk hedging. The authors utilized a dynamic programming approach with the portfolio’s variance and CVaR being the risk measures. They pointed out,

In this paper, we present a mixed risk-return optimization framework for selecting long put option positions for hedging the tail risk of investments in the S&P 500 index. A tractable formulation is developed by constructing hypothetical portfolios that are constantly rolling put options. Variance and sample CVaR are used as risk measures. The models are tested against out-of-sample historical S&P 500 index values as well as the values of the index paired with long put options of varying strike prices. The optimized hedged portfolio could provide sufficient protection in market downturns while not losing significant return the long horizons. This is achieved by dynamically adjusting the put option compositions to market trends in a timely manner. Allocations to different put options are analyzed in various market trends and investor risk aversion levels. The strategy overcomes the traditional drawbacks of protective put strategies and outperforms both directly investing in the underlying asset and holding a constant long position in a particular put option.

In short, contrary to prior research, the article demonstrated that an effective tail-risk hedging strategy can be designed by using an optimization-based approach.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Yuehuan He and Roy Kwon, Optimization-based tail risk hedging of the S&P 500 index, THE ENGINEERING ECONOMIST, 2023