Tail Risk Hedging
A practical guide to tail-risk hedging
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One of my favorite financial strategies was executed by Mark Spitznagel in 2020.
The strategy is tail-risk hedging.
Simply put, Mark’s fund, Universa Investments, buys short-term options contracts that protect against a sudden market crash. These contracts involve highly convex and out-of-the-money options, which only yield a payoff in the event of a major crash.
So every day, Mark loses a bit of money doing this. But once in a while (historically every 5 to 10 years), a black swan appears and Mark makes an enormous amount of money, enough to cover all the losses and some more.
How much money? When the S&P 500 cratered 30% in the immediate aftermath of the 2020 global pandemic, Universa’s flagship “Black Swan Protection Protocol” fund earned a staggering 3,612%.
The fund's performance barely matched that of the S&P 500 from 2008 to 2019. But after the 2020 crash, the average annual return of the fund was 76%!
While not to be “that guy”, it’s hard to argue that the current market run-up and stock valuations are normal. Here are some signs that have us worried.
US technology stocks relative to the S&P 500 reached 2.2x in July, the highest level ever recorded. (higher than the dot-com bubble and two standard deviations away from the historical average)
We are currently investing 5% of the U.S. GDP into AI spending (source: KKR)
Meta is offering up to a billion $ (yeah, with a B) packages to poach AI talent from other companies. (And people are rejecting it!)
While no one can be certain about how AI will unfold, it makes sense to hedge against a scenario like the dot-com crash.
Tail Risk Hedging
The strategy, in theory, is very simple. You buy Put Options (the right to sell the index at a specified price) well below the current market price. In typical environments, market volatility is very low, and buying short-dated puts that are significantly out of the money is relatively inexpensive.
For example, if you are buying a $SPX put today with the end of August as expiration, the following are the bid and ask for varying strike prices.
As you can see, to hedge against a 5% drop, you would need to pay ~7.5 times more than if you were hedging against a 20% drop (refer to the Bids). The massive difference in premium is because, based on historical data, a 20% drop would be much rarer than a 5% drop within a month.
To give you an example of how Mark Spitznagel made those incredible returns, if you buy $1K worth of 3,000-strike puts and say the index ends up falling 60% in August (which has never happened before), you would walk away with a cool $2.6 million.
A warning — since you are betting on an extremely unlikely event to happen, most of the time, it won't occur, making your Puts worthless.
But, once in a while, something so crazy happens (Pandemic, 9/11, 2008 crisis, Liberation Day, etc.) that your Puts become incredibly valuable, offsetting all your previous losses. (In the case of Universa, they started in 2008 and had to wait 13 years for the next crisis to unfold)
Implementing Tail Risk Hedging in your portfolio
Not all of us are accredited investors with access to Mark’s hedge fund. Here are some relatively easy methods to implement this in your portfolio: