We sat down with Joe DeSipio, Managing Member, Arin Risk Advisors, to discuss the importance of tail risk hedging and why options-based strategies could be a good diversifier in your portfolio.
In today’s volatile market environment, investment advisors are increasingly turning to listed options and volatility tools to manage risk, fueling demand for capital-efficient protection. As market environments shift and the relationship between stocks and bonds become less dependable, advisors are turning to options strategies to limit potential losses.
What is Tail Risk?
Tail risk is the probability of extreme outcomes happening at the far end of a probability distribution of investment returns. Statistically, tail risk outcomes lie three or more standard deviations from the mean.
Tail risk can occur on either side of the distribution: right-tail risk refers to meaningful gains, while left-tail risk refers to meaningful declines. Investors tend to fixate on left tail risk as losses are felt more intensely, underscoring the importance of hedging portfolios to limit losses.
Tail risk events are outsized moves relative to expectations and are not synonymous with market crashes. It is important to note that tail risk hedging is always important, not only during extreme market events. Investors should always be ready for changing market conditions.
Traditional Hedging Strategies
Bonds have historically been the diversifier of choice to incorporate into portfolios. The traditional 60-40 equities and bonds portfolio may not provide the protection it once did. For example, during the COVID-19 pandemic, investors saw a different outcome; bonds and equities both fell, breaking the consistency of fixed income serving as a dependable hedging strategy. Arguably, the joint decline of stocks and bonds in 2022 challenged the long-held belief that bonds serve as a buffer against equity risk. This shift led advisors to consider other tools that could help preserve capital during periods of market turmoil. This is where long-volatility strategies can fill the gap.
Where Options Fit In
Options are an important investment tool to mitigate risk and provide exposure to market outcomes.
Buying an out-of-the-money (OTM) put is a way to hedge tail risk because the investor pays a premium up front to minimize losses if a tail risk event occurs. If the market declines and the price of the underlying asset falls below the strike price, the put’s value rises, offsetting losses in the portfolio. Conversely, you can buy out-of-the-money calls for capital efficient upside exposure during right tail events. Options can provide more exposure and hedging opportunities than traditional equities and bonds allocations.
Education is Key
Receiving education from established institutions or individuals is crucial to understanding and approaching investment strategies. Cboe’s The Options Institute has been educating market participants for over 40 years, providing trusted courses and resources to learn about derivatives trading and navigate markets with confidence. Start with the basics like puts and calls, and learn the potential benefits of how options strategies can hedge tail risk in the markets.
Be Prepared for Any Market Condition
Traditional diversification methods are facing new challenges, especially in today’s ever-changing market environment. Advisors should consider learning more about diversifying portfolios by including options-based and long-volatility strategies as risk management tools. Staying educated and prepared when markets change is crucial to mitigating risk long-term.
To learn more about tail risk hedging and the importance of incorporating long-volatility strategies into portfolios, read more from Joe DeSipio, Managing Member, Arin Risk Advisors.
